The Moral Hazard of the Story

Moral Hazard is a classic problem in insurance. It's when the insured decides to take more risks after entering into an insurance contract with the insurer. The reason is because sometimes the payoff for letting the insured event occur is greater than its cost. So they behave more recklessly. The problem is everywhere. Sam Peltzaman from the University of Chicago wrote about how seatbelt laws lead to more accidents as drivers drive more aggresively (now would you predict that more SUVs are involved in head-on collisions?). Welfare benefits that result in more money by having children while unemployed is another one. IMF coming to the rescue of developing countries lead them to engage in more irresponsible macroeconomic policies.

It boils down to what happens to the cost of engaging in certain behavior after the insurance is bought. If the amount of the coverage is more than the amount of the damage then it becomes a subsidy for risky behavior, the price of risky behavior just went down so he consumes more of it. This is why we see insurers under insure all the time. Some risks are left uninsured when the potential moral hazard is too high. I'm looking at my external hard drive with all the backup files in it. Why do I have this itch to hit my laptop with a hammer? Or wish for those Windows meltdown? :)