Glossary · Economic ideas

Moral hazard

Moral hazard is the extra risk people take when someone else will bear the cost if things go wrong, as when insurance makes people a little less careful.

Also called: moral hazard problem, too big to fail, bailout risk

In plain words

You borrow a friend’s bike, and the friend says: “Don’t worry, it’s insured.” Would you lock it as carefully as your own? Most people get a little sloppier when someone else pays for their mistakes. That is moral hazard.

It is not about bad morals: it is about incentives. When you are protected from the cost of a risk, you have less reason to avoid it. Insurers, lenders and employers all have to deal with it.

The usual fix is to keep people partly on the hook: a deductible on insurance, a down payment on a loan, a bonus that can be taken back if a deal goes bad.

The more of a loss someone else pays, the less reason to avoid it. A deductible keeps part of the risk with you.

Example

Why insurance has deductibles

An insurer covers 1,000 bikes worth $1,000 each.

If owners always lock up, 2% are stolen a year: 20 bikes, $20,000 of claims, about $20 a year per bike.
Fully insured, some owners stop bothering, and thefts rise to 5%: $50,000 of claims. The price of the insurance has to rise to about $50 for everyone, careful or not.
With a $250 deductible, owners pay the first $250 of any theft, so locking up pays again. If thefts stay near 2%, the insurer pays 20 × $750 = $15,000: about $15 per bike.

The deductible is not there to annoy you: it keeps the reason to be careful, which keeps insurance affordable.

One level deeper

The term comes from 19th-century insurance, where it meant the risk that a policy itself changes behavior. Economists separate it from adverse selection, the risk that the people who buy insurance are the riskiest to begin with: moral hazard is about behavior after the deal, adverse selection about who signs up.

In finance the big worry is “too big to fail”: if lenders and managers believe a big bank will be rescued, they may take more risk, since they keep the gains while the public shares the losses. It was one of the most debated questions after the 2008 crisis.

Deposit insurance shows the trade-off well. Insuring deposits (in the US as of 2026, up to $250,000 per depositor, per bank, for each ownership category) stops bank runs, but it also leaves depositors little reason to check whether their bank takes too much risk. So banks are supervised and must hold capital instead.

Why it matters

It explains why insurance has deductibles and copays, and why loans need down payments.

It is at the center of debates about bailouts: rescuing a failing firm limits the damage today but can encourage more risk tomorrow.

It shows up at work too: a manager paid on this year’s profit has a reason to take risks that only hurt later.

A common mistake

Myth: Moral hazard means people are dishonest.

In fact: It describes ordinary, legal behavior that shifts when the costs shift: driving a rental car less gently, or a bank lending more boldly with a safety net under it. No one has to lie or cheat.

Questions people ask

What is an example of moral hazard?

Someone with full car insurance parks in a riskier spot; a bank that expects to be rescued makes riskier loans; an employee paid a big bonus for short-term results takes long-term risks.

What is the difference between moral hazard and adverse selection?

Adverse selection happens before a deal: riskier people are more eager to buy insurance. Moral hazard happens after it: having insurance makes people take more risk.

How do companies reduce moral hazard?

By sharing the risk: deductibles and copays in insurance, collateral and down payments in lending, bonuses paid in shares that must be held for years, and monitoring.

About the numbers

This page explains a term. It is not investment advice.