Business risk and moral hazard

February 8, 2021
by Noriyuki Morimoto

The relationship between insurance and moral hazard is a classic issue. For example, insurance that pays for failing an exam induces moral hazard by inducing intentional failing behavior. The same is true for suicide in life insurance.

So for example, in the case of automobile insurance, moral hazard is avoided by reflecting the customer’s own accident history in the insurance premium, so that efforts to avoid accidents lead to lower insurance premium that benefits the customer.

Regardless of what business you are in, various risks associated with it have to be taken in order to carry out your main business. For example, if you run a satellite broadcasting business, you need to launch a satellite, which comes with the risk of huge loss in the case of failure, so insuring your business would be a natural decision. Insuring the risks associated with the main business is a desirable approach in terms of concentrating management resources on the main business.

On the other hand, the main business itself has its own essential risks. However, the risks of the main business cannot be insured. Grade-failure insurance is not possible because taking an examination is the main business of the student. Insuring the risks of your core business always causes moral hazard.

However, the boundary between the risks of the main business and the risks associated with the main business is unclear. If what was considered an incidental risk and insured is, in fact, an essential risk for the main business, it will unintentionally create a cause for moral hazard.

For example, what is the main business of a bank? If the main business is to take credit risk, wouldn’t hedging that credit risk cause moral hazard?

 

[Category /Industrial Finance]