Moral hazard and adverse selection describe two different ways that unequal information can distort a deal between an insurer and a policyholder, a lender and a borrower, or a buyer and a seller. Both stem from one side knowing something the other does not, but they strike at different points in the relationship.
Two Problems, One Root Cause
Both concepts trace back to what economists call asymmetric information: a situation where one party in a transaction simply knows more than the other. The timing is what separates them. Adverse selection shows up before a deal is signed, when someone hides facts that would change the terms if revealed. Moral hazard shows up after the deal is done, when a person changes how they act because they are now shielded from the consequences of that risk.
Both problems create inefficiency. Prices stop reflecting real risk, insurers end up covering losses they did not properly price for, and honest applicants can end up subsidizing dishonest or riskier ones.
How Moral Hazard Plays Out
Moral hazard happens when someone changes their behavior once they no longer bear the full cost of a risk. It shows up in banking, insurance and the workplace, and it does not require dishonesty at the outset, just a shift in incentives afterward.
Picture a homeowner living in a flood zone with no homeowner's insurance and no flood coverage. Without a policy backing them up, this person installs a security system and clears the drains before every storm, moving furniture out of harm's way. Once they finally buy home and flood insurance, that vigilance fades. The security subscription gets canceled, and flood prep becomes an afterthought. The insurer now carries more risk than it bargained for, because the policyholder's own behavior changed after the contract was signed.
Research by economists Allard E. Dembe of Ohio State University and Leslie I. Boden of Boston University traces the phrase back to English insurance agents, who originally used it to suggest fraud or poor character. The word