Moral Hazard and the Socialistic Underwriting of Risk

By Paul A. Cleveland

Given the utter failure of our government in recent years, it should be evident to everyone that the federal government should not meddle in private economic affairs. Nevertheless, that lesson has not been learned. Perhaps there is no place where this truth is surer than the insurance business. During the 1960s the federal government monopolized flood insurance in this country. In doing so it put U.S. taxpayers on the hook for billions of dollars of losses in property damage resulting from various floods in our nation. In no place has the foolishness of this policy been more evident than in the aftermath of the hurricanes that ravaged the country in recent years. Katrina and other storms like it prove the folly of this practice. Such so-called insurance was at heart responsible for the enormous size of the catastrophe that befell the city of New Orleans.

One of the main problems in underwriting the risks associated with property losses is identifying the likelihood of incurring them. Moreover, this problem is complicated by the fact that those purchasing insurance do not practice as good of safety measures as they would have if they were personally responsible for the losses themselves. This kind of lax behavior on the part of the insured is called the problem of moral hazard. Private insurers generally account for such behavior by placing restrictions on policy holders which require them to undertake certain safety measures. In addition, they also adjust premium payments to account for any remaining losses that might arise for this reason. The full premium charged by the insurer is designed to provide sufficient funds to cover any losses while providing the insurance company with a return on investment.

The essential problem that has arisen since the government’s entrance into the flood insurance business is that it neither adequately accounts for the underlying risks associated with the kind of insurance provided nor does it account for the problem of moral hazard. Unlike private insurers, the federal government does not operate for profit and thus has no reason to adequately address the fundamental elements of insurance. Rather, it simply assigns a premium and if that is insufficient to cover the losses that result from some natural disaster it calls upon taxpayers to pay the remainder. As a result, taxpayers are expected to pay regardless of the size of loss.

The problem of moral hazard in this case becomes especially pernicious. Since the government is not especially interested in linking premiums to expected losses, it also does not account for the problem of moral hazard. That is, no further requirement is needed to build in a flood plain than to pay the fixed premium. As a result, more construction in such zones is encouraged even though that raises the likelihood of even greater losses should something bad occur. This was especially evident in the case of New Orleans. Even though it was well known that the levies were insufficient to withstand a storm the size of Katrina, the lack of such a storm over the years coupled with the underwriting of moral hazard by the federal government led to real estate development projects that greatly exceeded what would have likely been built if the owners of that property had been forced to buy insurance in a private market. That is, the federal government essentially encouraged a disaster on a grander scale than what would have been the case had the federal government never entered the flood insurance business.

One would think that now is a good time to rethink such government involvement and begin to limit its activities in what are essentially private matters in order to more adequately protect ourselves from future disasters. However, it does not appear that this is the direction that the debate is taking. Instead, many advocate even greater government involvement. But this would be the most foolish course of action and will eventually insure even grander disasters than that caused by Katrina. The world we live in is not perfectly safe and disasters will occur. Whether it is flood insurance, or health insurance, or any other form of insurance, we can be sure that the government’s involvement will be disastrous.