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“Moral hazard” is a term that dates back to the 1600s. Until recent times its use has been mostly confined to the insurance industry to refer to behaviour that responds to changes in perceived risk.

The industry has noticed that people who have contents insurance are less careful about locking up. It has also noticed that drivers of cars with ABS brakes (superior brakes) did not have fewer accidents – they had different accidents – accidents consistent with high-performance cars, which is what they had become.

Why “moral” hazard? Clearly the insurance industry was disconcerted by behaviour that upset the calculations of its actuaries. Such behaviour had to be wrong – immoral. But such behaviour is universal. Risk management is an exercise that involves striking a balance between the potential rewards and losses of decisions made in the face of uncertainty. A less judgmental term to describe this phenomenon is risk compensation. Legislators and regulators routinely ignore it.

Britain is suffering simultaneously from under-regulation and over-regulation. The deregulation of the financial markets under Margaret Thatcher gave a relatively small number of bankers free rein to contrive incentive structures that paid them fabulous rewards for taking risks with other people’s money. Meanwhile other spheres of activity are being suffocated by an excess of regulation, the most egregious example being the Independent Safeguarding Authority. This new bureaucracy, created as a response to the murder of two young girls in Soham, is charged with vetting an estimated 11.3 million people before they will be permitted to work, or volunteer with, children or vulnerable adults. The vetting involves a Criminal Records Bureau check on all 11.3 million after which “we will decide on a case-by-case basis whether each person is suited to this work”.

Leaving aside the mind-boggling expense and bureaucracy required to perform this feat, its effect is almost certain to be perverse. A CRB check will be seen as an insurance policy; behaviour that might previously have aroused suspicion is now less likely to be questioned because some superior authority has certified the suspect as “safe”.

After the Thatcherite deregulation, under New Labour we have had the Better Regulation Commission, the Better Regulation Executive, the Better Regulation Advisory Council and now BERR – the Department for Business, Enterprise and Regulatory Reform. All these attempts at reform have explicitly acknowledged the damage caused by excessive regulation and have been powerless to resist it. Fundamental to this failure is a blindness to risk compensation.

Every perceptible safety measure that does not make the people want to be safer will provoke offsetting behaviour. The effect can be seen wherever one looks – from protective equipment on the sports field, to the settlement of flood plains protected by higher levees, to bailed out banks. It can be found on the road and in the bed – condoms are seat belts for sex concludes one study that invokes risk compensation to explain the failure of both safety measures to deliver the protection they promised.

Which takes me to my final point. The College of Emergency Medicine is leading a campaign to make cycle helmets compulsory. If successful it will result in a significant decline in cycling with a loss of attendant social, environmental and health benefits with no life saving benefit. It will kill off London’s new cycle hire scheme. In support of their campaign they cite the “success” of the seat belt law. But the law has failed and should be repealed. The Parliamentary Advisory Council of Transport Safety resolutely refuses to acknowledge evidence of this failure (click here, here and here). In its blindness to risk compensation and its consequences it risks helping to create a new, genuine, moral hazard.

PS    The Manifesto Club campaigns against the hyperregulation of everyday life. It has a refreshing website - http://www.manifestoclub.com/.

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Martin Parkinson raises an interesting question (comment on previous post): what should be the reaction to an accident that, a priori, was an extremely low probability event? He suggests that “any attempt to reverse the counterproductive aspects of ‘health and safety culture’ is doomed to failure”. After an accident he argues that most people will say, “well that tragic accident which just occurred could have been easily avoided – it would be unthinkable not to make the obvious small change which would avoid a repetition”. Further, he adds, “the accident might have been freakish and unforeseen, but if there is a seemingly easy and cheap “fix”, then no responsibly-minded person would fail to make that fix …there is no logical point at which you can say your environment has “just the right amount of apparent danger”.

This is an issue that I probed in a recent essay “Dangerous trees?”. See the section entitled “Fault trees, event trees and trees”.

Britain’s Health and Safety Executive declares risks of death of less than 1:1,000,000 to be “acceptable” – defined as “generally regarded as insignificant and adequately controlled”. But how should such risks be calculated? If one divides the number of people killed by trees in Britain every year by the population, the risk works out at about 1:10,000,000. Acceptable? Only until someone is killed.

After the event it is usually possible to identify the cause and the person(s) responsible. A risk worth taking becomes culpable negligence. Hindsight transforms an “acceptable” risk with a probability of 1:10,000,000 into one with a probability of 1:1.

The fear of becoming the legally-liable victim of such a transformation, assisted by no-win-no-fee lawyers, is perhaps the main driver of the excessive risk aversion that bans hanging flower baskets and forbids conkers without goggles. For most institutional risk managers, outside hedge funds, there are no rewards for taking risks, only costs for failure. For them, one accident is one too many. No set of circumstances for which they might be held responsible can be too safe.

Escape from the suffocating safety culture that such reasoning produces can be sought in a “blame-free” culture. After a low-probability “freakish” accident, emphasis should be placed not on establishing guilt and punishment, but on lessons to be learned. Judges, juries and the Health and Safety Executive have important roles to play. Reconstructed foresight, not 20/20 hindsight, should be the standard against which culpability for freakish accidents should be judged.

Thanks Martin for your highly pertinent comments.

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“Moral hazard” is a term used in the insurance industry to refer to the way in which behaviour alters when people acquire insurance. People with house contents insurance are less careful about locking up. Such behaviour in the eyes of insurers is “immoral”. The term stigmatizes human nature. We all adjust our behaviour in response to our perception of hazard – we all slow down when we come to a sharp bend in the road.

The term is now enjoying unprecedented popular exposure in discussions of the Bank of England’s rescue of banks and building societies. Might rescuing them from the consequences of foolish decisions encourage more foolishness? A good question but not sufficiently sharply focussed.

It is not the banks, and all their clerks, depositors and shareholders, who have been foolish. It is particular individuals, whose culpability is strongly correlated with the size of their salaries and bonuses during the boom years. Their behaviour merits the label immoral because they have been reaping their enormous, risk-free rewards in a system rigged in their favour.

The economy has come to a sharp bend in the road. Those responsible are still in their hummers, with bull bars, air bags and seat belts. Why should they care? Why should they behave differently in the future? Unless the rescue operation confronts the incentives to immorality built into the current system, they are unlikely to slow down.

Published in abbreviated form in The Guardian 24 April 2008