On Insurance

Moral hazard is the changes in behavior which are due to the insuring of risk. When one has insurance against fire, for example, it lessens the incentive to invest in costly, if efficient, protections from fire. Indeed, if the value of the policy were to exceed the value of the insured thing, it would be worth your while to commit arson! This poses a fundamental problem to complete insurance markets against all possible sorts of risk — insurance cannot specify all the ways in which you are to act and not act in order to keep your premiums actuarially fair. 

It seems to me that a way to prevent moral hazard would be to insure against states of nature which correlate with, but do not guarantee, you suffering a loss, and importantly, you cannot create or control. Suppose we wish to insure against fire damage from wildfires — rather than compensate you if your house burns down, the insurance company pays you if a wildfire occurs in an area. You still have every incentive to prevent damage to your house, such as clearing bush, because your protective actions will not alter your payoff in any way. Another example is insurance against poor rainfall, or plague of locust — you still have every reason to invest in irrigation as before. You can also save substantially on administrative costs — you no longer need to assess the damage, simply that the conditions specified in the contract happened. It makes insurance subgame perfect — nobody has the option to deny damages on spurious grounds, nor to make false claims about damages.

So why are these sorts of insurance policies not universal? What has prevented adoption? It is not all clear to me what has. They are much more common in the developing world — India, for example, provides insurance against deficient or excessive monsoon rains — but in the United States, it is almost unheard of. Catastrophe bonds are sold, but they are only bought by large insurance companies — possibly due to law, as rule 144a of the Securities Act of 1933 exempts many securities from regulation, so long as they are sold to very large companies. They are, after all, derivatives in fact. The unfamiliarity of the form could scare away people from purchasing them. 

A more serious objection would be that, as the correlation of the event occurring and your goods being damaged decreases, your exposure to negative shocks increases. While these are counterbalanced by an equal and opposite increase in positive shocks (a wildfire occurs, and your house isn’t burnt down), the whole purpose of insurance is to guard yourself from volatility of any kind. This does not explain, however, why some combination of insurance policies would not be superior. A policy insuring the entirety of the house creates moral hazard problems — why not purchase a policy ensuring part of the value of the house against destruction from any source of fire, and part of the value effectively insured from your bet on a wildfire occurring. In this way, you guard yourself fully against wildfire while still incentivizing you to take socially optimal mitigation steps. 

This basic principle to mitigate moral hazard can be applied more broadly than simply private insurance. Think of welfare as the government solving a market failure — people would purchase insurance against being poor if they could buy it, but because it would change people’s behavior no one would sell it. The government paying people based on income, however, still creates a disincentive to work — in essence it is imposing a tax upon labor earnings. 

The government can get around this by not directly paying people who are poor, but by paying people for things which correlate with being poor, but are not under people’s control. Children are poorer through no fault of their own — pay them! People in certain minority racial and ethnic groups are poorer — pay them on the basis of race, not on income. This doesn’t even need to be on the basis of innate characteristics either — the government could divide the whole US population into randomly assigned blocks, and pay welfare based on the average poverty of that block. The key thing is that your private incentive is to (after subtracting whatever income effect there is) work as long and hard as you would beforehand. By changing who bears the costs and benefits of their actions, there is so much good we can do.