Moral hazard risk is the risk that is associated with a particular person or group. In other words, it is a situation in which another person takes on the risk of loss while another makes the decision on how much risk that person will have. This happens in finance with brokers or fund managers. It can also be seen in insurance where a person might not care as much about a certain property or equipment because the insurance company will cover the loss.
For example, Pete owns a barn that he has recently insured. Pete walks into the straw filled barn where he sees a loose wire from an electrical outlet. Normally Pete would fix this problem right away, but he doesn’t really feel like doing it. The barn is insured so it is of little concern to Pete whether the job get done today or tomorrow. He vows to fix the problem in the morning. Over the night the barn catches fire and burns down. The insurance company pays Pete for his complete loss.
The moral hazard here is that Pete simply did not care to take care of his property as he should have because he knew the insurance company would pay for the entire amount of the repairs. Insurance companies have to deal with this moral hazard all of the time. They even try and spend time valuing the amount of moral hazard risk.
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