The morals of moral hazard: a contracts approach

• DOI: http://doi.org/10.1111/beer.12121
• Date: 01 January 2017
• Author: Matthew McCaffrey
• Published date: 01 January 2017

The morals of moral hazard: a

contracts approach

Matthew McCaffrey

Lecturer in Enterprise, Alliance Manchester Business School, University of Manchester

Although moral hazard is a well-known economic concept, there is a long-standing controversy over its

moral implications. The language economists use to describe moral hazard is often value-laden, and implies

moral judgments about the persons or actions of economic agents. This in turn leads some to question

whether it is actually a scientific concept, or simply a convenient tool for criticizing certain public policies.

At present, there is no consensus about the moral meaning of moral hazard, or about whether the concept

can be salvaged by economists. As a first step toward resolving this problem, I suggest a contracts approach

to moral hazard. I use the ‘title-transfer’ theory of contract to clarify the moral content of moral hazard,

thereby increasing its value to scholars in numerous disciplines. A contracts view is useful for economic

policy discussions because it does not include hidden value judgments. At the same time, however, it is also

valuable for ethicists because it directly explains a moral dimension of behavior under moral hazard,

namely, the violation of property rights.

Introduction

In the last five decades, economists have become

increasingly concerned with the incentive problem

known as ‘moral hazard’. Yet while economic

theory and empirics have studied it at length, its

‘moral’ side remains ambiguous and controversial.

What exactly does the ‘moral’ in ‘moral hazard’

mean? And why does an ostensibly positive sci-

ence describe an economic problem in normative

terms? Answers to these questions are important

because they influence our understanding of eco-

nomic theory and policy, which may be biased if

basic terminology assumes immoral behavior by

the individuals it describes. In fact, critics argue

just this: moral hazard has long been a vague

and value-laden concept, even though its scien-

tific, value-neutral veneer is repeatedly used in

policy debates to justify reductions in insurance

and public goods provision (Rowell & Connelly

2012). Accurate or not, this criticism underlines

the fact that the moral content of moral hazard

matters a great deal for both public policy and

human welfare generally. Yet solutions to the

questions posed above continue to elude

economists.

This paper makes several contributions to the

existing literature: first, it surveys the history and

present state of the debate over moral hazard; sec-

ond, it discusses some neglected writing on the

morals of moral hazard; third, it provides a partial

resolution to the ongoing controversy by presenting

it within a framework of contracts. To introduce the

underlying problems, the second section outlines the

history of the term moral hazard and the ways it

incorporates value judgments, paying special atten-

tion to the overlooked ideas of Frank H. Knight.

The third section then proposes a view of moral haz-

ard based on the ‘title-transfer’ theory of contract.

This approach removes the hidden value judgments

from traditional theory while still allowing for a

moral evaluation of incentive problems. Finally, the

fourth section applies the contracts framework to

contemporary economic terminology. The title-

transfer view shows that economic language is often

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doi: 10.1111/beer.12121

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Business Ethics: A European Review

Volume 26 Number 1 January 2017

morally ambiguous at best, and implies immoral

behavior or bad moral character at worst. The con-

clusion suggests directions for future research.

The moral heritage of moral hazard

The early insurance industry

The term ‘moral hazard’ carries significant moral

baggage, and some scholars even argue that

‘Appearances to the contrary, moral hazard has

never been a straightforward, purely logical or scien-

tific concept’ (Baker 1996: 239). Its historical devel-

opment has been ‘a process of perpetual discovery

and reordering, rather than ...a linear, forward pro-

gression towards greater clarity and rationality’

(Leaver 2015: 91). Moral hazard’s complex geneal-

ogy is vital for explaining why the concept is dis-

puted, and how its ambiguities can be resolved.

Previous work on moral hazard has studied its ety-

mological and sociological history in detail (Baker

1996; Dembe & Boden 2000; Laffont & Martimort

2002: 7–27; Rowell & Connelly 2012; Leaver 2015).

The word ‘hazard’ derives from Old French. It ini-

tially referred to games of chance, and then to the

notion of chance itself. In the 17th century, as a

result of its connection to chance and gambling

odds, the term was incorporated into early probabil-

ity theory. Probability was then put to use in the

19th century by the ‘moral scientists’, who began to

discover regularities in important characteristics of

human life and death. These regularities became the

basis for the insurance industry, which coined the

term ‘moral hazard’. Early adopters used ‘moral’ in

its customary sense, to refer to good and bad, right

and wrong, virtuous, and vicious, and so forth.

(Baker 1996). However, morality was also used in a

subtler way. The word derives from the Latin for cus-

toms or mores. In this usage, moral behavior is that

behavior which is conventional and proper for the

members of society. In fact, this definition was

adopted by the moral scientists in their efforts to

describe the behavior of rational people. For them,

‘moral’ simply referred to people’s subjective estima-

tions of risk. However, these two meanings of moral-

ity were combined by insurers, who implicitly

adopted both in their writings (Rowell & Connelly

2012). The word ‘hazard’, because of its connection

to gambling, was already associated with improper

behavior, and the addition of the word ‘moral’ fur-

ther indicated a specifically moral danger associated

with probability and contained within insurance

contracts.

1

Moral hazard thus became a way to explain how

individuals could either influence the probability of

losses to insurers or take advantage of unfortunate

events. These outcomes represent what have come to

be known as ex ante and ex post moral hazard,

respectively (Abbring et al. 2008). Ex ante moral haz-

ard refers to a person’s effect on the likelihood of an

event, while ex post moral hazard involves behavior

after the event has occurred, for example, using more

costly resources than necessary to treat an insured ill-

ness. Historically, moral hazard was a way to

describe not only situations, but people. The stand-

ard ex ante example was fire insurance, where indi-

viduals might burn (or take less care not to burn)

their property in order to collect on a policy. Despite

its adoption by economists, moral hazard was con-

ceived as a moralistic term, and often referred to the

perfidy of the insured (Dembe & Boden 2000). It

reflected a negative moral judgment of consumers,

who were deemed likely to engage in ‘immoral’

behavior, for example, gambling or insurance fraud.

The historical precedent of the term is thus strongly

normative.

Ultimately, moral hazard became enshrined in

insurance practice even though it was loosely or

inconsistently defined and carried numerous moral

connotations. It implied several possible distinc-

tions and judgments, especially regarding the char-

acter of anyone deemed a poor insurance risk

(Baker 1996).

2

Moral hazard was thought to

spring from two sources: the character of the

insured, and the ‘temptation’ posed by the insur-

ance agreement (which is today explained as a

problem of incomplete contracts). However, insur-

ance texts rarely mention both simultaneously, and

historical evidence indicates the term was never

used in a precise or consistent way (Leaver 2015).

The combination and confusion of these two sour-

ces is one reason for the persistence of the debate

on moral hazard. This paper addresses the dispute

by developing an approach to moral hazard that

removes assumptions about character while also

explaining some moral problems of contracting.

Business Ethics: A European Review

Volume 26 Number 1 January 2017

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