Moral hazards of risk management

Risk management is a balancing act in which the potential rewards of an action are weighed against possible losses. There is a view in the insurance industry that this act ought not to be influenced by insurance. An introductory insurance textbook insists that "the insured should never be influenced in any way by the existence of his insurance policyI he should always act as if uninsured". The possibility that behaviour will be influenced by insurance - such as being less careful about locking up if you have burglary insurance - is referred to as "moral hazard". There is a lot of it about and, as this book shows, the belief that it ought not to exist is naive. Insurance alters the potential consequences of a course of action and, thereby, alters behaviour.

Virginia Haufler charts the role of insurance in promoting the growth of international trade. She traces the growing involvement of governments in insuring international commerce, to the point where government insurance for trade, credit and foreign investment now exceeds that provided by the private sector by a factor of more than 1,000. Besides direct insurance, governments insure commerce in other ways, ranging from naval protection and the negotiation of treaties to a readiness to adjust interest rates and intervene in exchange rates. Haufler says: "We cannot understand the institutions of production and exchange apart from the institutions we have designed to protect them. In turn, the character of protection affects the institutions of production and exchange. It is doubtful whether the globalisation of trade and production could have progressed so far without the availability of protection, both by the state and, when that fails, by private sector services."

She contrasts today's circumstances with those of previous centuries, citing Karl Polanyi: "In the past the organisation of trade had been military and warlike, it was an adjunct of the pirate, the rover, the armed caravan, 'the sword-bearing merchant, the armed burgesses of the towns, the adventurers and explorers, the planters and conquistado res'."

She concludes that insurance is a benign force for progress and prosperity:

"The private networks of international insurance may tie trade with peace more closely than ever before as the socialisation of risk moves forward." All this she argues convincingly. Yet the more she piles up evidence in support of her thesis, the more preoccupied I become with a significant exception: the drugs trade. It is a trade conducted by planters, pirates and sword-bearing merchants, and a trade that governments seek to obstruct with anti-insurance. The institutions of production and exchange of drugs encounter institutions designed not to protect them but to eliminate them. Does the drugs trade thrive despite the institutions designed to eliminate it or because of them? It appears to be a trade that thrives on risk; the greater the risks in production and distribution, the greater the potential profits and, if enough drugs get through, the actual profits. The volume of trade may be diminished by efforts to obstruct it, but the substantial profits have created vast criminal empires.

The book also provides examples of business, encouraged by insurance, that ought to have been left undone. "When a firm believes there is an unacceptable risk on a prospective transaction, it has a number of options other than buying insurance, including abandoning the project - an alternative chosen by many commercial banks with regard to Latin American debtor states." But she glosses over the extent to which the debt crisis was a product of lenders' faith in insurance - in the form of their governments' ability and willingness to help defaulting debtors or cushion losses. Insurance alters terms of trade. In trying to anticipate its consequences one must look for its probable impacts on the rewards and costs of an action. Its consequences are not always benign. It can encourage carelessness. Its absence can encourage vigilance. Haufler offers an example: "The lack of insurance or its high cost may also prompt more effective environmental protection to prevent losses from occurring."

This informative book tells an interesting story, but the evidence it presents demands a more ambivalent conclusion. Insurance is a two-edged sword.

John Adams is professor ofgeography, University College London.