Monday, April 9, 2012

Moral Hazard or Just Standard Political Hazard?

Often, it is argued that offering property insurance, particularly at a "low" cost, for properties in hazardous areas creates a moral hazard and causes the great flock to become nonchalant about the disaster risk.  In turn, the risk is increasingly difficult to insure because it is increasingly expensive.  There are two prominent options for solving this problem that are notably coupled: do away with government managed insurance programs (e.g. NFIP and Citizens) and increase the cost of insurance.  The two solutions are coupled because private insurance will increase the cost of the policy to avoid insolvency.

The moral hazard argument has moved beyond the insurance business interest group and is found in expert analysis of disasters and losses.  It has made an appearance in the  esteemed Galloway Report  and much more recently in the Congressional Testimony of disaster insurance expert Howard Kunreuther.   While speaking about Small Business Administration disaster loans
It creates a moral hazard problem by encouraging people to locate their homes and business in hazard-prone areas...
However, as I see it, there are two reasons while the moral hazard argument is false.  First, a moral hazard depends on having the ability to cause the loss or increase the probability of the loss oneself.  Where disasters are concerned, there seems to be no moral hazard as no one can cause the loss nor does anyone have an interest in the loss occurring.  Further, substantial deductibles are in place as the traditional means of controlling the potential for moral hazard.  Second, although some homeowners are able to purchase land for development and may choose to do so in a flood plane because they can buy cheap insurance, most people buy homes that have already been built.   Building a large concentration of homes in vulnerable areas is the decision of government and developers, not would-be-homeowners.  And while such decision makers would fall into the category of "people"  they are not the public interest people or the "we the people" implied in the above statement.      

No less of a problem for insurability than a large moral hazard are the large political affects of the availability of insurance.  The present homeowners insurance arrangement, insulates land management decision makers (e.g. city commissioners, state politicians, and building code enforcers) from responsibility of poor land management because the costs of their decisions are managed between insurer and insured.  Land managers, as a third party, are advantaged by the existence of the insurance contract.  In this case, those responsible for land management decisions are able to use the property insurance contract between insurer and homeowner, to protect against the political risk of losing the endorsement of the building interest.  The cost of managing this additional political risk is passed on to policyholders.  The practice of passing on political risk to policyholders and insurers is largely uncontrolled and challenges the ability of insurers to maintain the disaster risk as insurable.

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