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Sometimes risk can be shifted to a person willing to bear it--the speculator. A more common way we deal with risk is by buying insurance, which spreads or pools the risk. The idea is simple. If one out of 1000 homes will burn each year, and if each person contributes to a general fund 1/1000 of the value of his home, the fund will have enough (ignoring administrative expenses and the question of whether expensive homes are more or less likely to burn than cheap homes) to reimburse those whose homes burn down. The size of the insurance industry indicates that people are eager to pay to avoid risk. They pay and get nothing if fortune smiles on them, whereas if misfortune strikes, they break even because the insurance should just pay back the value lost in the misfortune.

People respond to incentives--they respond to changes in costs and benefits. Hence, insurance should change people's behavior because insurance reduces the costs of misfortune. When people make less effort to avoid misfortune as a result of insurance, this change in behavior is called moral hazard. For example, if an accident costs a person $1000 but insurance pays $900, the insured person has less incentive to take steps to avoid the accident or misfortune.

If the accident costs the person $1000 but pays $2000, the person not only has no incentive to avoid the accident but has an incentive to cause it. This seems to be what was happening in a bizzare example of moral hazard reported in the December 23, 1974 issue of The Wall Street Journal:

"[T]here is the macabre case of "Nub City," a small Florida town that insurance investigators decline to identify by its real name because of continuing disputes over claims. Over 50 people in the town have suffered 'accidents' involving the loss of various organs and appendages, and claims of up to $300,000 have been paid out by insurers. Their investigators are positive the maimings are self-inflicted; many witnesses to the 'accidents' are prior claimants or relatives of the victims, and one investigator notes that 'somehow they always shoot off parts they seem to need least.'"

Not everyone will torch his building if it is insured for $50,000 but only has a market value of $30,000. There are also costs of violating one's moral code and of getting caught and convicted for the crime of arson. But some people put into this situation will find a way to torch the building because they do not find the cost of violating a moral code very high and they consider the chances of being caught small, and other people will be less careful about avoiding fires. Moral hazard does not require that people intentionally cause the misfortune. If they simply take fewer measures to prevent misfortune, the same outcome occurs.

The problem of moral hazard also affects government programs that insure people against misfortune. A variety of programs help people who suffer the misfortune of poverty. Aid to dependent children helps people who suffer the misfortune of having children to raise that they cannot financially support. Unemployment compensation pays people who suffer the misfortune of losing their jobs. Food stamps and public housing help the poor. Yet all these programs also suffer from problems of moral hazard. They increase children born out of wedlock, unemployment, and poverty.

Moral hazard creates problems both for private insurance and the government. Private insurance usually does not cover 100% of a loss and tries to keep buildings and autos insured for less than their true worth. In addition, it is usually against the law to create the misfortune that you are insured against. Finally, if the problem of moral hazard is too great, there will be no insurance coverage for the misfortune.

The government can and sometimes does take a similar approach. It can give so little aid to those in distress that it provides little encouragement for people to put themselves in the situation, but it then provides little help for those in distress. As it expands a program to provide more aid to those in distress, it also encourages people to put themselves in distress. If people are paid to be poor, some will become poor. If people are paid to have children out of wedlock, some will. If people are paid to be unemployed, more will be unemployed. Thus government programs that act to insure citizens against some misfortunes have a basic tradeoff that cannot be escaped. Greater efforts to help those in need also increase actions that are considered socially undesirable. Unintended consequences abound in the area of moral hazard.

The insurance industry can also face problems of signaling and screening. People who buy insurance often have a better idea of the risks they face than do the sellers of insurance. People who know that they face large risks are more likely to buy insurance than people who face small risks. Insurance companies try to minimize the problem that only the people with big risks will buy their product, which is the problem of adverse selection, by trying to measure risk and to adjust prices they charge for this risk. Thus, life insurance companies require medical examinations and will refuse policies to people who have terminal illnesses, and automobile insurance companies charge much more to people with a conviction for drunk driving.

Markets in which price determines quality rather than quality determining price are also interesting.

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Copyright Robert Schenk