During yesterday’s class meeting, we discussed (among other things) how contract designs and pricing strategies can “fix” the moral hazard that insurance might otherwise create. Insurance is “good” to the extent that it enables firms and individuals to manage the risks that they face. However, we also saw insurance has a potential “dark side.” The dark side is that too much insurance and/or incorrectly priced insurance can create moral hazard by insulating firms and individuals from the financial consequences of their decision-making. Thus, in real world insurance markets, we commonly observe partial rather than full insurance coverage. Partial insurance ensures that policyholders have incentives to mitigate risk. Furthermore, real world insurance markets are characterized by pricing strategies such as loss-sensitive premiums (commonly referred to as “experience rated” premiums), as well as premiums that are contingent upon the extent to which policyholders invest in safety.
In competitively structured private insurance markets, we expect that the market price for insurance will (on average) be greater than or equal to its actuarially fair value. Under normal circumstances, one does not expect to observe negative premium loadings in the real world. Negative premium loadings are incompatible with the survival of a private insurance market, since this would imply that insurers are not able to cover capital costs and would, therefore, have incentives not to supply such a market.
Which brings us to the National Flood Insurance Program (NFIP). The NFIP is a federal government insurance program managed by the Federal Emergency Management Agency (also known as “FEMA”). According to Cato senior fellow Doug Bandow’s blog posting entitled “Congress against Budget Reform: Voting to Hike Subsidies for People Who Build in Flood Plains”,
“…the federal government keeps insurance premiums low for people who choose to build where they otherwise wouldn’t. The Congressional Research Service figured that the government charges about one-third of the market rate for flood insurance. The second cost is environmental: Washington essentially pays participants to build on environmentally-fragile lands that tend to flood.”
Thus, the NFIP provides us with a fascinating case study concerning how subsidized flood insurance exacerbates moral hazard (i.e., makes moral hazard even worse) rather than mitigates moral hazard. It does this by encouraging property owners to take risks (in this case, building on environmentally fragile lands that tend to flood) which they otherwise would not be inclined to take if they had to pay the full expected cost of such risks.
There are many other examples of moral hazard created by insurance subsidies. Consider the case of crop insurance provided to farmers by the U.S. Department of Agriculture. The effective premium loading on federally provided crop insurance is typically quite negative (often in excess of -60%), thus putting crop insurance on a similar footing to flood insurance in terms of cost compared with actuarially fair value. Just as mis-priced flood insurance effectively encourages property owners to build in flood plains, mis-priced crop insurance incentivizes farmers to cultivate acreage which may not even be particularly fertile.
I could go on (probably for several hundred more pages – there are innumerable other egregious examples which I could cite), but I think I will stop for now…