09.01.09 - 12:00 AM | James K. Glassman
When someone insures you against the consequences of a nasty event, oddly enough, he raises the incentives for you to behave in a way that will cause the event. So if your diamond ring is insured for $50,000, you are more likely to leave it out of the safe. Economists call this phenomenon “moral hazard,” and if you look around, you will see it everywhere. “With automobile collision insurance, for example, one is more likely to venture forth on an icy night,” writes Harvard economist Richard Zeckhauser. “Federal deposit insurance made S&Ls more willing to take on risky loans. Federally subsidized flood insurance encourages citizens to build homes on flood plains.”
In 1963 the Nobel Prize winner Kenneth Arrow, who happens to be the uncle of President Obama’s top economic adviser, Larry Summers, wrote a paper for the American Economic Review titled “Uncertainty and the Economics of Medical Care.” Arrow argued strenuously for vastly increasing health insurance, even if the government had to supply some of it, but he also recognized the dangers of moral hazard that health insurance causes. The ideal case for insurance, Arrow wrote, is “that the event against which insurance is taken be out of the control of the individual” who is insured—like, say, insurance against damage from a meteor crashing into your house. In health care, people who are insured (especially if the premiums are being paid by their employers) have greater incentives to risk their health by, for example, smoking than they would if they had to pay the bill for their lung-cancer treatment themselves.1 Insurers struggle to mitigate moral hazard by making people pay part of the cost of their care or, in the case of life insurance, by raising premiums on smokers or denying coverage to skydivers.
The most dangerous kind of moral hazard is produced not from explicit insurance policies (on which, after all, the insurer can raise premiums)