Once people obtain insurance, they may take more risk. Good insurance companies aren’t blind to this; they try to price their policies accordingly, and monitor conditions and investigate losses when they arise.
This tendency for insured parties to take more risk is known, broadly, as “moral hazard.” An interesting distinction is sometimes made between moral hazard and morale hazard. Morale hazard isn’t so immoral, it recognizes that people may simply take on more risk of loss if they have company on the downside. Things get more interesting, ethically, when parties that have obtained insurance or other forms of guarantees can actually have an incentive to cause a loss.
Consider a homeowner with a $200,000 house, and a fire insurance policy. Real estate values fall in the area, and the house is only worth $100,000. In this simple case, moral hazard is sometimes described as “the risk of fire from of a $100,000 house rubbing up against a $200,000 insurance policy.”
Sometimes, the line between morale hazard and moral hazard isn’t so easy to draw – especially when “insurance” takes the form of government bailouts.
Risk management issues in this area underlie most of our financial market crises since 1907, including our latest and greatest meltdown in 2007-2009. Relying on the prospect of government bailouts has always been important, but it has become less fashionable to admit to it, at least in public.
That’s why a recent story about the Chicago Public Schools just caught my eye. The article described how some bond investors made money on Chicago Public School bonds. I don’t necessarily begrudge them for trying to do this; that is how markets work. But I was a little taken aback when I saw a couple sentences and a quote from one large investor relating to the logic of the position:
"...The school system's bonds are a favorite for John Miller, Nuveen's co-head of fixed income, who said the firm bought when the market feared a default, a concern he called overblown. "At the end of day, this school system is critically important to Chicago-to the whole country really," he said. ..."