What's Moral About Moral Hazard?

We acquired a puppy this spring. In addition to his charming habit of jumping up and down and wetting the carpet every time we return home, he has also taking to burying his toys in the corner of our sofa. This involves a lot of digging and scratching. Now, it also involves the purchase of a new sofa.

Having diligently search for a high quality sofa at the cheapest possible price, I discovered a good sale at The Bay. I also discovered The Bay will sell insurance against damage to the sofa regardless of the source of the damage. I specifically asked whether it covered damage covered by animals and I was assured it did. If I buy the sofa, would I be any less diligent at preventing my puppy from damaging it because of the insurance? If I would, maybe I should save the premium of over $100 and just step up my diligence?

In the insurance industry, this is called the problem of moral hazard. It has its origins in fire insurance and the proposition that the incidence of fire among a group of insured home owners will be greater than the incidence of fire among the same number of uninsured home owners. This is thought to be because those who are uninsured will be more diligent at reducing risks than those who are insured. Although I can find no statistical data to prove this point, the proposition is widely accepted as true. Moral hazard is different from cheating and fraud. It merely refers to the possibility that the presence of insurance will change the behaviour of the insured.

The concept of moral hazard has also been extended to changes in behaviour between two parties to a contract without the knowledge of one of the parties. This is why the concept of ‘moral’ hazard implicitly suggests ‘immorality’. In agriculture, moral hazard often refers to the changing behaviour of farmers in the presence of a program of government support.

Prudence is also part of morality. Aristotle considered it a virtue. It refers to the need to take very carefully calculated risks, to be wise in practical matters. When I arrange my finances so as to minimize tax and maximize my after tax income, I am being neither unlawful nor immoral. I am being efficient and prudent. I try and exhibit this behaviour in all my commercial transactions and in relation to all government programs. My behaviour is not immoral, it is prudent. All actions can have unintended consequences, including government programs. Farmers shouldn’t be penalized for being prudent and they shouldn’t be thought of as immoral for being program efficient. From my point of view, I can find nothing moral about moral hazard.

First Published in September 2003