Moral hazard

Context: insurance, risk management

Moral hazard refers to the tendency where people who have acquired insurance on a particular item (whether a house, car, life or liability) will take less care in protecting such an item against loss. This is because it is less "painful" (or formally, utility does not decrease as much) to suffer the loss and have the insurance company cover it, and that prevention of loss (such as placing alarms in houses) are costly.

Along with adverse selection (=antiselection), moral hazard is a risk that an insurance company that wants to avoid ruin must manage. Usual strategies include:

• Charging a deductible (=excess) whenever a claim is lodged. Thus the insured still has to pay something whenever he or she claims. This will hopefully drive the insured to take more care.
• No claim discount schemes. Here the premiums are substantially reduced for those insured that has not made a claim during a certain time period. Insured are extremely attracted to these discounts, and thus are driven to avoiding claims. It so happens that such schemes are so consistent with credibility theory.
• Policy conditions placed on the insurance contracts, particularly exclusions. These are the things where the insurance company will not pay. While these will drive down claims, they also have an effect of annoying customers. So the insurance company will have to be careful what types of exclusions are placed on the policy, and whether everybody else is doing the same.

If one hears the phrase "moral hazard" nowadays, it's mostly likely in reference to the ongoing global financial meltdown. Generally speaking, a moral hazard is said to exist where it is possible for someone to disregard the risk of their actions because they know that someone else will be picking up the pieces if the risk doesn't pay off. Because they know this, their actions are likely to be more risky. Just such a situation existed and still exists for large financial institutions in places like Britain and America, who know that they can rely on governments to come to their aid if they get themselves in trouble because they are so vital to the economy as a whole.

Here is how it works. Large financial institutions spent many years operating a risky business model, relying on a huge and unsustainable asset-price bubble (think about what happened to the housing market in those years) to generate ever-higher profits and remuneration packages for their staff. When the credit crunch struck these institutions would, if left to their own devices, have failed: businesses shut down, employees sacked, and the like. But governments around the world couldn't let this happen because of the role the financial institutions play as the motor of the economy, and so they they bailed them out. As a result, the financial institutions did not have to suffer the consequences of their actions as the orthodox capitalist model says that they should.

We can sense straight away that the moral hazard is a little more complicated than it is often made out, because clearly the existence of the financial institutions provides at least some benefits to society; otherwise, we could just damn them all. But we do need a financial system, as we have learned during the credit crunch. The credit crunch has been an object lesson in what happens when the financial sector fails to operate correctly, meaning credit becomes hard to come by. This makes it much harder for individuals to get a mortgage and for businesses to operate normally or expand. When businesses can't operate normally, they begin making people unemployed, and stop paying the dividends that keep pension funds growing.

The fact we can't simply let the financial system fail is the origin of the moral hazard. You can imagine the financial sector like a public service or utility, water for example, except that it pumps money around the economy instead. If the water companies failed catastrophically, we wouldn't decree that there should be no more water companies, we would bail them out (perhaps literally as well as metaphorically) and try to ensure the disaster never happened again. After all, we need water.

But here this analogy must come to a close, because it is not sufficient merely to say that we need finance and hence we must bail out financial institutions. Clearly, we want to minimize the necessary bail-outs. To do that, society needs to find a way to prevent large financial institutions from believing they can behave as they wish because they are so vital that they will always receive a bail-out - in other words, a way to tame the moral hazard. The need to do so is made particularly urgent by the fact that the large banks are profit-seeking institutions, and that those seeking high profits are often tempted to take risks, especially if they know that if their risk doesn't pay off then the taxpayer will be footing the bill.

In democratic societies it is particularly urgent to find a way to resolve the moral hazard, because this sequence of failure followed by bail-out looks incredibly unjust to the taxpayer. We learnt this during the credit crunch. First, there was a catastrophic failure in the financial sector, which led to a recession. Shortly after, governments borrowed vast sums of money to bail out the financial sector, obligating the taxpayer to pay this money back at a later date. And so while the taxpayer groaned under this new burden, the banks and their staff carried on much as before, or so it appeared to the taxpayer at least; and to add to the problem, democratically-elected governments were quick to demonize the bankers, even though it was their own lax regulation and unwillingness to ask hard questions that allowed the disaster to happen in the first place. The latter made their anger all the more urgent, at least to cover their own tracks.

For the sake of completeness, governments ought to explain all this, and add that the public service spending everyone has grown so accustomed to in recent years has been possible because of the profits the financial sector was making, profits built on the back of a risk that eventually blew up in all our faces. Profits that we need them to continue to make. This is why the moral hazard can never be eliminated entirely, because the economy as a whole requires a risk-taking financial system to drive growth.

If we were to take away this profit motive from the large banks and instead make them into a sort of nationalized public service, then they would quickly cease to funnel capital into areas that fuelled economic growth. Even worse, they might become like the Chinese banks have during the credit crunch, spunking money everywhere for the sake of keeping the citizenry placated, but with no guaranteed way of paying for it. Worse still, they might become like Spanish or Irish banks before the recession, tied up in sweetheart deals with politicians to favour certain industries and people with political connections. The need to avoid the latter scenario explains why the British government has kept the nationalized banks at arms length, refusing to involve itself too deeply in their lending decisions; full state control may eliminate the moral hazard, but it brings a whole host of more unsavoury problems.

If the moral hazard cannot be eliminated, then it must be tamed. This is what western governments are currently busy trying to do through regulation, and this is a laudable goal, so long as it does not kill the goose that lays the golden egg. In doing so they must remember why the moral hazard exists in the first place: not because the financial sector is some parasitic and alien growth on the real economy, but because the financial system is integral to that economy. If we didn't need the financial sector, there would be no moral hazard, because we could simply let it fail. Finding the correct balance between allowing the banks' creative profit-making abilities to flourish and containing their irrational exuberance is much more difficult than populist bank-bashing, but it is also much more necessary.