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Peter Crabb: How health insurance reform promotes riskier health behavior

Fall is here and football coaches at every level are doing their best to motivate their team. Famous college coach Lou Holtz once said, “Ability is what you're capable of doing. Motivation determines what you do. Attitude determines how well you do it.”

As a wealthy and successful country, the United States is full of ability and positive attitudes. But motivation determines what we actually do day in and day out.

This week President Obama went to Wall Street to outline his plan for reforming the financial industry just a week after he stood before Congress pressing for a major new health care plan. When U.S. policymakers finally arrive at some type of reform in our health care and financial industries, they we need to consider what motivates all us.

Incentives matter significantly in both these industries. The health care insurance market and financial services industry are subject to an incentive problem called moral hazard.

Moral hazard is the adverse market condition that occurs when individuals, firms, or other organizations take greater risk because they have less incentive to be careful about their losses. Moral hazard would not be much of a problem if financial firms, insurance, banking, or otherwise, could accurately measure and mitigating the risks their client’s take.

After buying car insurance people tend to drive more aggressively than they would if they were fully responsible for all the costs of any accident. But you don’t see your insurance agent following you around to see if you are driving safely.

When lending money, banks cannot always be sure the borrower will use the money as planned and have enough to pay them back. But your banker doesn’t go to work with you everyday to make sure you are earning enough cash.

Since they can’t be everywhere all the time Insurance companies take a number of actions to avoid moral hazard. But they can never monitor all their clients’ behavior and they incur substantial costs to check client health and insure doctors are providing good care.

To cover these costs they charge higher rates. With a mandate to cover all applicants for health insurance, despite all the risks of poor health, insurance companies will raise their rates.

The fact that many in our country choose not to have health insurance even though they know themselves to have low risks of serious health problems is due to the high costs that insurance companies charge because monitoring is so difficult. But individuals without insurance have a strong incentive to take care of themselves. The moral hazard problem will only increase when this group is forced to purchase insurance and their incentive to take care of themselves declines.

In the financial services industry the moral hazard problem becomes worse when investors in financial institutions receive guarantees against loss. Since lenders don’t necessarily incur costs when the borrower does wrong, they take more risk and do less monitoring.

The U.S. has had depositor insurance since the Great Depression. Guarantees against the loss of deposits have greatly reduced the number of bank failures, but at a cost of these banks taking ever-increasing risks.

Over time, regulators have tried to mitigate this moral hazard problem by restricting the types of assets banks can hold, maintaining higher capital requirements, requiring extensive disclosure of bank holdings, and even in some cases, restricting competition.

Before 1994, restrictions on branch banking actually reduced competition but kept many banks smaller, and thus less risky. This restriction increased costs to consumers but kept a lid on the risk bankers could take.

With the restrictions on branch banking gone today, there are still many banks operating, but assets are concentrated in those institutions now thought as too big to fail. These banks know they are such and can therefore take more risk.

Speaking to students at Northwest Nazarene University, Dr. Janet Yellen, president of the Federal Reserve Bank of San Francisco and a member of the Federal Open Market Committee, discussed how a few large banks controlling a high percentage of deposits must now be carefully regulated and monitored. The financial sector’s moral hazard problem grows worse.

Commenting on American Public Media’s Marketplace radio program this week, David Skeel, a professor of corporate law at the University of Pennsylvania, said that after the failure of Lehman Brothers, the moral hazard problem in the financial derivatives market is now even larger. With Lehman gone, competition is reduced, but it is even more likely that the remaining large financial institutions will be bailed out in the future.

Professor Skeel says, “with fewer, but much bigger giants, it will be even harder for regulators to avoid bailing any one of them out if it fails. No matter how badly their managers behave. Before the crisis, four or five of them were probably too big to fail. Now, they all are.”

New regulation will do little to change the incentives in the financial sector. Health care will be just another guarantee from the government. The incentives to take risk continue to grow. Listen to Coach! Motivation determines what we do.

Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.