Skin in the game: Moral hazard and disaster risk reduction

Moral hazard can be found in many places but, ironically, much of it is created by the very existence of insurance. What’s more, outside sources of moral hazard can affect insurance – and insurers – greatly (though usually indirectly).

According to The Financial Times Lexicon “Moral hazard arises when a contract or financial arrangement creates incentives for the parties involved to behave against the interest of others.”

Specific to insurance, moral hazard is “the chance that the insured will be more careless and take greater risks because he or she is protected, thus increasing the potential of claims on the provider. The concept can be extended to any contract…that by its existence could prompt a signatory to take unnecessary risks.”

Risk Management Principles and Practices, the textbook used for the CRM (Canadian Risk Management) designation explains: “Purchasing an insurance policy is another moral hazard incentive – some people might be inclined to behave differently once they enter into a contract that shifts the financial consequences of risk to another party.”

So, according to the concept of moral hazard, a driver may drive faster or make more risky moves knowing they are covered by insurance, or a home buyer may choose to live next to a river or beside the boreal forest, let’s say, because they will be indemnified should a loss occur.

In another supreme irony, insurance-related moral hazard is not restricted to insureds. Insurers themselves can engage in morally hazardous behaviour if they are protected by reinsurance (i.e. the existence of reinsurance may incentivize an insurer to take risks it otherwise wouldn’t take). Indeed scholarly articles on moral hazard and reinsurance are many.

On the insurance side, moral hazard is primarily tempered through the use of deductibles. The deductible serves a couple of (related) purposes.

First of all, the deductible acts as a threshold – a minimum amount that a claim must exceed before a policy will respond.

Second, the deductible ensures that the party transferring the risk has ‘skin in the game’, a cost (albeit often relatively small) that must be borne by the insured before the policy responds.

Without the deductible tempering the behaviour of the party transferring risk, he or she may be inclined to file many claims on a regular basis – including small, frivolous claims, skewing the true purpose of insurance (which is to serve as a financial mechanism that protects against events that are of reasonably low probability but of medium to high impact). One need look no further than the Canadian healthcare system as a regime that is regularly inundated by users (often for frivolous reasons) because there are no fees or deductibles.

The possibility of premium increases; the levying of caps and limits and use of other restrictive policy language; and the possibility of partial or complete cancellation of coverage can also act as mitigative mechanisms to discourage the regular filing of frivolous claims and lessen moral hazard.

On the reinsurance side, moral hazard is mitigated through two primary means.

The first is through regulation. In Canada, the Office of the Superintendent of Financial Institutions (OSFI) restricts the use of shell insurance companies (i.e. companies that pass off all risk to reinsurers), in large part to prevent extreme risk-taking behaviour. (Like the mortgage issuers that bundled subprime mortgages into securities and sold them to unsuspecting investors leading to the credit meltdown of 2008, insurers that cede all their risks to reinsurers likely wouldn’t be overly particular about the quality of business they write.)

The second measure to mitigate moral hazard in reinsurance actually came from reinsurers themselves as several years back these companies made the switch away from proportional to excess-of-loss covers. With a proportional cover, the insurer and reinsurer share a pre-determined proportion of liabilities, meaning the insurer could be more inclined to write riskier business. The move to excess covers, where the reinsurer only takes on a loss that exceeds a specified limit, helped lessen unnecessary risk-taking and gave insurers more ‘skin in the game’.

Unfortunately for (re)insurers and society at large governments, too, often engage in morally hazardous behaviour. We see it in the area of natural disaster risk reduction – particularly on the flood side – on an all-too-regular basis.

Allowing individual houses or entire subdivisions to be built in high-risk flood zones knowing that provincial disaster assistance and private insurance is there in the event of a flood loss, and allowing homes to be rebuilt in the same place and in the same way after a flood event both constitute a form of moral hazard.

Many of the decisions made after the 2013 Alberta flood (eg. offering voluntary – and not mandatory – buyouts of flood-affected properties) and the recent decision to allow rebuilding of homes lost to the Fort McMurray wildfire on a flood plain are good examples of governments behaving in a morally hazardous manner.

Just as insureds have ‘skin in the game’ through deductibles and other measures, local governments need a financial disincentive to act in this manner. At present, municipalities face far more upside risk than downside risk when it comes to approving building in high-risk hazard zones. When the bailout comes from elsewhere, there is no incentive to make the right decision – the lure of an increased tax base is all too great .

Reducing natural disaster losses in Canada means breaking the cycle – taking a link out of the chain of events that leads to losses.

Local governments eager for growth and the tax revenue that goes with it need to hold some significant portion of the downside risk in order to give them pause for thought. Enough, at least, so they may think twice about making risky decisions that put people and property directly at risk.

The unnecessary risk-taking, passing of the buck and washing of the hands must stop.