Risk can be shifted to another person who is willing to
bear it--the speculator.
Another way of dealing with risk is by pooling it using
insurance. 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
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.
Because insurance changes the
costs of misfortune, and because people's choices depend on
costs and benefits, insurance should change people's
behavior. They should make less effort to avoid misfortune,
and 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 avoid the accident. If the accident costs the person
$1000 but pays $2000, the person not only has no incentive
to avoid the accident but may have an incentive to seek it
Sometimes moral hazard is dramatic. Fire insurance
encourages arson, automobile insurance encourages accidents,
and disability insurance encourages dismemberment. In a
story in its December 23, 1974 issue, The Wall Street
Journal reported this bizarre instance of moral
"[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.'"
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 is the result of maximizing behavior. A
person weighs the costs and benefits of an action, and when
benefits exceed costs, he takes the action. This does not
mean that if a person has a building insured for $50,000 but
only has a market value of $30,000, the owner will
necessarily commit arson. There may be costs of violating
one's moral code and of getting caught and convicted for
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 creates problems both for
private insurance and the government. Private insurance
tries to keep the insured value of any misfortune less than
the value to the insured person. It 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.