Estimating risks and managing moral hazard are the essence of the insurance business. That is easy to say when discussing moral hazard in a microeconomics course. When you personally are subject to hazardous moral temptation, it is more complicated.
That became apparent to us last Sunday. The wind came up sharply at 5:30 p.m. and within seconds, the trees in front of the house swayed fiercely. A spruce crashed against the house in a burst of exploding glass and snapping window frames, taking out windows in three rooms.
After the adrenaline subsided and we ran out to survey damages in the rain, thoughts turn inevitably to what this event would cost us. Just a week earlier, a letter from our insurer informed us that our deductible for wind damage was now $2,520.
Two possible approaches became immediately clear. If the total storm damage would be under $2,520, we should try to repair things as economically as possible and do as much of the work as possible.
If, however, we would be out of pocket $2,520 even if we scrimped and did the work ourselves, we would be better off simply hiring contractors because our out-of-pocket expenses were capped. We would not have to haul away spruce branches or risk our necks sticking down shingles on a steep roof.
Welcome to the world of moral hazard! In the everyday world, storms, fires and accidents happen. Damages need repair. Society benefits when destroyed or damaged property is restored to as great a degree possible relative to the resources used.
Society also benefits when we have insurance and other means of spreading risk of casualty loss. Households can carry out their affairs better if they can substitute moderate periodic payments for even small probabilities of catastrophic loss.
Sometimes, however, the societal good of insuring against casualty losses and the societal good of economy in repairing damage come into conflict.
The falling tree snapped a steel pipe supporting one end of the grape trellis. Should I call a landscape firm for an estimate on repairing the post and trellis or just get the welder out of the garage and weld up the old one? What about the broken century-old window sash? Should we demand a custom-made replacement to maintain the architectural harmony with adjoining windows or should I improvise with the router to make a fake grill that would fool most observers? Wasn’t the fascia board about ready for replacement anyway?
In all cases, the extra cost to society from the more thorough repair probably exceeds the extra satisfaction we would get from such repair relative to cheaper alternatives. Opting for the best possible will make society as a whole minutely worse off. But once we pass our deductible, we have no incentive to stint.
Relative to catastrophes across the globe, our little incident — and any perverse incentives resulting from it — is small. On a larger scale, however, billions of dollars are at stake.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.