History of The Term "Moral Hazard" Author(s) - David Rowell and Luke B. Connelly

A History of the Term "Moral Hazard"
Author(s): David Rowell and Luke B. Connelly

Source: The Journal of Risk and Insurance, Vol. 79, No. 4 (December 2012), pp. 1051-1075
Published by: American Risk and Insurance Association
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© The Journal of Risk and Insurance, 2012, Vol. 79, No. 4,1051-1075
DOI: 10.1111/j.l539-6975.2011.01448.x
A History of the Term "Moral Hazard"

David Rowell
Luke B. Connelly
Abstract
The term "moral hazard" when interpreted literally has a strong rhetorical
tone, which has been used by stakeholders to influence public attitudes to
insurance. In contrast, economists have treated moral hazard as an idiom
that has little, if anything, to do with morality. This article traces the genesis
of moral hazard, by identifying salient changes in economic thought, which
are identified within the medieval theological and probability literatures. The
focus then shifts to compare and contrast the predominantly, normative con
ception of moral hazard found within the insurance-industry literature with
the largely positive interpretations found within the economic literature.
Introduction
The term "moral hazard" originated in the insurance literature. Its modern use in
economics is understood—by economists—to describe loss-increasing behavior that
arises under insurance. As Pauly argued
... the problem of "moral hazard" in insurance has, in fact, little to do with
morality but can be analyzed with orthodox economic tools. (Pauly, 1968,
p. 531)
Some economic definitions focus on ex ante behavior: moral hazard is defined as

the "... impact of insurance on the incentives to reduce risk" (Winter, 2000, p. 155).
Similarly, the contemporary text Intermediate Microeconomics simply states that in the
context of insurance the ".. lack of incentive to take care is called moral hazard"
(Varian, 2010, p. 724). More formally, if the expected loss from an insured event is
defined as E(L) = pL, where p is the probability of the event and L is the loss, the
foregoing definitions restrict moral hazard to the impacts of insurance on p.
David Rowell is at the Australian Centre for Economic Research on Health (ACERH UQ),
and The School of Economics, The University of Queensland, Australia. Luke B. Connelly
is at the Australian Centre for Economic Research on Health (ACERH UQ), and Centre of
National Research on Disability and Rehabilitation Medicine (CONROD). David Rowell can
be contacted via e-mail: d.rowell@uq.edu.au. Rowell acknowledges financial support from the
Australian Centre for Economic Research on Health (ACERH) and the Brian Gray scholarship
program, which is jointly funded by the Australian Prudential Regulation Authority (APRA)
and the Reserve Bank of Australia (RBA).
1051
1052 The Journal of Risk and Insurance
Moral hazard is also manifested when the behavior of insureds affects L, per the
following definition:
Ex post moral hazard concerns the effects of incentives on claiming actual

losses (Abbring, Chiappori and Zavadil, 2007, p. 1)
whereas more catholic definitions of the term encapsulate both types of moral hazard.
For example, in The Economics of Agency, Arrow (1985, p. 38) simply defined moral
hazard as "hidden action" by the agent. In each of the foregoing cases, it is clear that (1)
moral hazard is defined as a positive concept and (2) that the two words form an idiom,
that is, "[... a] group of words established by usage as having a meaning not deducible
from those of the individual words" (Oxford English Dictionary [OED], 2008). The
English language contains many idioms: clearly, not all "teething problems" require
a dentist and not all "free trade" is free.
The concept of moral hazard has been used by economists to analyze a "wide variety of
public policy scenarios, from unemployment insurance, corporate bailouts, to natural
resource policy" (Hale, 2009, p. 3). For example, when discussing the management of
the Global Financial Crisis, Ben Bernanke, the Chairman of U.S. Federal Reserve, was
quoted in Time as saying:
Certainly, all the interventions created moral hazard, sending a perverse

message that "too big to fail" financial firms will be rescued no matter how
badly they screw up, encouraging Wall Street traders to start gorging on
risk again. (Grunwald, 2009, p. 44)
However, the phrase moral hazard has obvious and powerful rhetorical capabilities
to moderate social attitudes towards insurance. As the term "moral hazard" made the
transition from the confines of the insurance and economic literatures to the public
domain, social scientists writing in the noneconomic literature have questioned the
normative implications of the term. Some of these authors have been strident in their
criticism of economics, economists, and the real or imagined policy consequences of
moral hazard. A remarkable example is as follows:
Today, moral hazard signifies the perverse consequence of the well

intentioned efforts to share the burdens of life, and it also helps deny
that refusing to share those burdens is mean-spirited or self-interested. In
deed using the economics of moral hazard, it is but a short step to claim, in
one economist-politician's memorable word, that "[s]ocial responsibility
is a euphemism for individual irresponsibility." By "proving" that helping
people has harmful consequences, the economics of moral hazard justify
the abandonment of legal rules and social policies that try and help the
less fortunate... (Baker, 1996, pp. 239-240)
Other critics have been somewhat more circumspect but have expressed concern
about the normative overtones of this economic idiom:
A History of the Term "Moral Hazard" 1053
... the concept of moral hazard is widely used and deeply entrenched in the
practice of economics that little attention is paid to the underlying ethical
and moralistic notions suggested by the use of that particular expression
(Dembe and Boden, 2000, p. 258) and
[o]ne thing that should be clear about the terminology of "moral hazard"
is that the language invokes a normative notion. It suggests that there is
a moral danger, a moral problem, associated with the over provision (or
overprovision) of insurance. (Hale, 2009, p. 2)
Finally, pejorative uses of the term moral hazard are also now found within popular
culture. For example, when asked to explain moral hazard, the fictitious New York
banker Gordon Gekko simply said "[i]t means they can steal your money and no one
is responsible" (Wall Street: Money Never Sleeps, 2010).
This article traces the origins of the term "moral hazard" by going back in time
to consider the earliest known developments of insurance as well as touching on
a range of literatures as diverse as the theological and probability literatures and,
latterly, the economics literature. Not surprisingly, we find that the concept of moral
hazard developed with insurance markets. More importantly, we also show that the
use of the term in the early insurance industry literature was ambiguous and, viewed
from the vantage point of the modern economist, was used to describe not only moral
hazard—as that term is understood by economists—but also the distinct phenomenon
of adverse selection.
The article is arranged as follows. The next section provides a brief overview of some
of the earliest-known examples of insurance and of the historical characterization
of risk, in which theology played a central role. Then, relevant developments of
the probability literature, insurance-industry literature, and economics literatures are
described, followed by our conclusion.
Historical and Theological Literatures
Some authors (Hale, 2009; Pearson, 2002) have appeared to suggest that the concept
of moral hazard has developed symbiotically with insurance.
Talk of moral hazards has been around since at least as long as the modern
insurance industry, which some date as far back as 1662. (Hale, 2009, p. 3)
Yet, the term "moral hazard" did not appear until the late nineteenth century (Baker,
1996), which suggests that the concept of moral hazard and the creation of the idiom
did not idly evolve with the development of insurance.
It has been recognized that, as long ago as 7000 B.C. (Hart, Buchanan, and Howe, 2007),
Chinese merchants employed elementary risk management techniques whereby mer
chants would disperse their cargo across several ships to spread the risk of a loss
(Vaughan, 1997). One of the oldest documented examples of a financial instrument
being used to provide insurance against risk can be found in The Hammurabi Code,
which was written in Babylon in 1790 B.C. Law 48, offered a rudimentary form of
agricultural insurance and states:
If a man owe a debt, and the god Adad has flooded his field, or the harvest
has been destroyed, or the corn has not grown through lack of water, then
in that year he shall not pay corn to his creditor. He shall dip his tablet in
water, and the interest of that year he shall not pay. (Edwards, 1921, p. 20)
Later, Greek and Roman merchants used a similar technique known as "bottomry"
loans to transfer their risk to moneylenders, by borrowing money with a contractual
clause, which annulled the debt if the ship or cargo was lost at sea (Hart, Buchanan,
and Howe, 2007).
The earliest known European contracts were underwritten in Genoa in 1343

(Ceccarelli, 2001) and the oldest preserved English contract was dated 1547 (Hart,
Buchanan, and Howe, 2007). The Great Fire of London in 1666 provided an impetus
for the development of fire insurance. Lloyd's of London was established in 1688 to
enable slave merchants to defray the cost of a sunken ship. Risk takers would signal
their willingness to accept liability for some proportion of the loss, in exchange for
a premium, by writing their name under the line; hence the origin of the term "un
derwriter" (Bernstein, 1996). Later, the industrial revolution saw the development of
other lines of insurance including life insurance (Pearson, 2002).
The French historian Febvre (Febvre, 1956) claimed:
... that a proper history of insurance should not only cope with econ
omy but also with conceptions of religion and nature. (English translation
provided by Ceccarelli, 2001, p. 607).
In the Middle Ages, the Church considered random events to be outcomes of divine
will and hence events that are not to be anticipated. Simony was condemned because
it was viewed as the sale of Christ's charisma and usury was condemned because it
was the sale of God's time. In 1234, Pope Gregory IX issued the decretal Naviganti,
which stated that insurance was illicit (Ceccarelli, 2001).
As commercial insurance grew, so did the debate that surrounded it. The early theo
logical discourse tended to focus on the insurer rather than the insured. Debate was
centered on whether insurance was a licit remedy for the commercial costs ensuing
from acts of God. Theologians who supported the Naviganti, such as the Portuguese
Carmelite Joäo Sobrinho [1400-1475], argued that the insurer was selling something
that was not rightfully theirs to sell and that the safety of a venture proceeds only from
God's will. Similarly, the fifteenth-century French theologian Peter Tartaret argued
that the insurer should not profit from human presumption of safety since safety can
only be granted by God (Ceccarelli, 2001).
Two lines of counterargument, sometimes proposed by theologians with close family

ties to merchant traders, can be found within Ceccarelli's anthology of canonical
thought on insurance in the Middle Ages. The first, initially proposed by Thomas
Aquinas [1225-1274] argued that since insurance did not affect ownership, it was
not usury. The second line of argument followed from Franciscan scholars such as
Barnardo of Siena [1380-1444] who stated that the possession and use of money could
be separated. These premises enabled insurance to be justified on the basis of social

usefulness. For example, Domingo Soto [1495-1560] argued that risk was an economic
object and that insurance shared the risk between merchant and insurer. Assecuratio
must be licit because insurance enables licit business to prosper (Ceccarelli, 2001).
By the sixteenth century, mercantile apologists had succeeded in differentiating in

surance from usury and had employed social welfare arguments to justify insurance.
Yet no concept of moral hazard was identified within this literature. Theologians
from both sides of the debate stated a belief that chance events, such as the sinking
of a ship, were a product of God's will. For example, John Major [1496-1550], a Scot
tish theologian who argued that insurance was licit, still accepted that the forces of
nature were so mighty that usually human skill could do nothing to prevent ship
wrecks or other accidents (Ceccarelli, 2001). If statements such as these are accepted as
prima facie evidence of a fundamental belief in providence, then the concept of moral
hazard, which posits that individual behavior can affect chance events, could not
develop.
Febvre (1956) argued that as insurance grew in response to the economy's need
for commercial security, the perception of nature changed. Future events were no
longer solely attributed to the will of God. Individual behavior was recognized as
a co-determinant. De iustitia et iure1 published by Leonardus Lessius [1554-1623] in
1605 was the first theological work cited in Ceccarelli's anthology of theological and
canonical thought on insurance, to explicitly recognize an individual's ability to affect
future events. When discussing a just price for insurance, Lessius (1605) argued that
even when the underwriter benefits from asymmetric information, the market price
is still just.
In the case of the insurer having professional skill (i.e., has received relevant
news by mail) or experience having with natural phenomena (i.e., he is
aware that the weather will be good), who knows that the real value
venture risks are less than what the current market place estimates and who
does not reveal it to the other party, still the market price is to be considered
just, because probable profits derive from his professional ability. (Lessius
1605, as quoted in Ceccarelli, 2001, p. 627)
The recognition by Lessius that probable profits were derived from professional ability
and not solely from God's will, was an early example of the change in the perception
of nature that was identified by Febvre (1956). This transformation was a necessary
precursor to the eventual development of a theory of moral hazard.
Probability Literature
The theory of probability is sometimes attributed to correspondence between the

French mathematicians Pascal [1623-1662] and Fermât [1601-1665], published in
1654, in which they analyzed the fair division of stakes from an incomplete game of
points (a medieval game of dice) (Daston, 1983). The Pascal-Fermat correspondence
1 The English translation is On Justice and Law
motivated Huygens [1629-1695] to publish On Reasoning in Games of Chance in 1657

(preceding the publication of the Pascal-Fermat correspondence in 1679), and was
followed by The Art of Conjecturing by Jakob Bernoulli in 1713 and the Analytical Theory
of Probability by Laplace in 1812. Although this probability literature made no explicit
reference to moral hazard, ex post it is possible to identify some important develop
ments in the theory of risk, which contributed to the eventual development of moral
hazard.
Daston (1983) has argued that during the seventeenth century mathematical prob
abilists such as Huygens originally couched probability in terms of expectations
because games of chance were perceived as a subset of aleatory contracts, which
were any agreement involving an element of risk (e.g., annuities, partnerships, in
surance and "cast of a net" fish contracts). These contracts embodied two qualitative
notions of expectation. The first, from law, was the concept of equity. The second, from
economics, was the concept of prudence. Both equity and prudence moderated math
ematical probability with enlighted views of moral rationality and expectation. When
explaining uncertainties, under the influence of individual behavior, mathematicians
were obliged:
... to adapt and amend the theory of probability to tally with reigning
conceptions in the moral sciences, in particular that of an archetypal "rea
sonable man." (Daston 1983, p. 58)
The notion of expectation introduced a normative judgment upon individual behav

ior, which could affect uncertain outcomes. The probability of an uncertain event
would depend on the "reasonableness" of the individual. This recognition of the
archetypal "reasonable man" also implicitly recognized the existence of the "unrea
sonable man." Although Lessius (1605) had recognized that individuals could use
their professional ability to affect an outcome, "reasonableness" injected a new pejo
rative tone into the analysis of risk. That decisions made under Locke's "twilight of
probabilities" could reflect the goodness of the individual was a notion that persists,
but is certainly not universally accepted (see Pauly, 1968), in conceptions of moral
hazard to this day.
Not only did the probability literature posit that individual characteristics could
affect the likelihood of an uncertain event but this literature also developed a theory
to value risk, which incorporated a nonpejorative use of the word "moral" into its
lexicon. Daston (1983) has argued that eighteenth-century moral scientists, of whom
classical probabilitists considered themselves a subset, studied the deliberations and
behavior of groups of individuals designated as rational with a view to deriving
explicit rules to guide behavior. In 1708, Nicholas Bernoulli [1695-1726] proposed
the following paradox in a letter to the French mathematician Pierre Raymond de
Montmort [1678-1719]:
Peter tosses a coin and continues to do so until it should land "heads"

when it comes to the ground. He agrees to give Paul one ducat if he gets
"heads" on the very first throw, two ducats if he gets it on the second, four
if on the third, eight if on the fourth, and so on, so that with each additional
throw the number of ducats he must pay is doubled. Suppose we seek to

determine the value of Paul's expectation, (Montmort 1708, in Bernoulli,
1954, p. 31)2
In 1738, Daniel Bernoulli [1700-1782], Nicholas Bernoulli's cousin, resolved the para
dox by identifying two notions of expectation, one "mathematical" and the other
"moral." Mathematical expectation ignored the individual characteristics of the risk
takers and equated outcome value with price. Moral expectation was considered the
utility of the mathematical expectation. Here Bernoulli's use of the phrase "moral ex
pectation" in fact communicates to his contemporaries an assumption of rationality,
rather than a presumption of any ethical expectation. Bernoulli argues his point as
follows:
Somehow a very poor fellow obtains a lottery ticket that will yield with
equal probability either nothing or twenty thousand ducats. Will this man
evaluate his chance of winning at ten thousand ducats? Would he not be
ill-advised to sell this lottery ticket for nine thousand ducats? To me it
seems that the answer is in the negative. On the other hand I am inclined
to believe that a rich man would be ill-advised to refuse to buy the lottery
ticket for nine thousand ducats. If I am not wrong then it seems clear that
all men cannot use the same rule to evaluate the gamble. (Bernoulli, 1954,
p. 24)
Bernoulli proposed that moral expectation (mean utility) was logarithmically related
to wealth. He constructs the following numerical example drawn from marine insur
ance to illustrate that individuals with different wealth endowments will value set
risks differently Caius, a Petersburg merchant, can sell commodities purchased in
Amsterdam for 10,000 rubles if they can be shipped to Petersburg. However, five in
every 100 ships are lost at sea. Actuarially unfair insurance is available at 800 rubles
per cargo. Bernoulli asks:
The question is, therefore, how much wealth must Caius possess apart
from the goods under consideration in order that it be sensible for him to
abstain from insuring them? (Bernoulli, 1954, p. 30)
By setting the expected value of the insured loss equal to the uninsured loss, Bernoulli
calculated that if Caius had an initial wealth greater than 5,043 rubles, he should not
buy insurance. The mathematician Jean Rond d'Alembert [1717-1783] argued that
these calculations were an oversimplification of behavior but he accepted the basic
premise that
2 Specimen Theoriae Novae de Mensura Sortis (Bernoulli, 1738) was translated from Latin into
English by Dr. Sommer for Econometrica in 1954.
... moral considerations, relative, either to the fortune of the players, or to

their state, or to their situation, to their same strength (when it concerns
some games of commerce), & thus of the rest. (d'Alembert, 1754)3
Bernoulli's [1738] assertion that risks of equal mathematical expectation could have
a different moral expectation depending on "the particular circumstance of the per
son making the estimate" (Bernoulli, 1954, p. 24) made a seminal contribution to the
theory of risk. This conceptual milestone made an important contribution to the even
tual development of a theory of moral hazard. The theory of moral hazard predicts
changes in individual behavior following the purchase of insurance. When preventive
effort cannot be observed, an individual may choose to invest less preventive effort
than otherwise to avoid the insured outcome (Shavell, 1979). However, to develop a
theory of behavior it is first necessary to develop a theory of value. Bernoulli's [1738]
paradigm does this. Utilizing the language of Bernoulli's paper, the purchase of actu
arially fair insurance could be defined as the trading of risks of equal mathematical
expectation, such that risks of low moral expectation (the uninsured state) are traded
for risks of high moral expectation (the insured state). The trading of the uninsured
for insured state increases the individual's level of utility (moral expectation). Cru
cially, it is this increase in utility that generates the conditions and incentives for moral
hazard to transpire. It would, however, be another 127 years before the causal link
between insurance and decreased preventative effort would be explicitly identified.
Insurance-Industry Literature
Despite the growth of the medieval insurance industry, there was little evidence of
data collection or evaluation by insurers (Daston, 1988). It was not until 1660 that
the first serious empirical study of shipping losses was conducted (Franklin, 2001).
Pearson (2002) has claimed that although, in principle, insurers in the eighteenth
century differentiated between physical and moral risks, the absence of an actuarial
science meant that this distinction remained theoretical rather than empirical. At
tributions such as character, probity, temperance, ethnicity and class were used to
assess both physical and moral risks. English insurers, for example, identified Irish
and Jewish populations as being morally suspect (Pearson, 2002).
Pearson (2002) has argued that the objective measurement of physical hazards re
mained crude. For example, the mutual society, Amicable, established in 1706, charged
the same membership fee irrespective of age. Life insurers used the pseudo-science
of physiognomy4 to assess the health status of prospective policyholders. The insurer
Royal Exchange sold life assurance policies without medical review until 1838. The
fire insurers, London Assurance and Royal Exchange relied on just three risk classi
fications (common, hazardous and doubly hazardous) to underwrite fire insurance
until the second half of the nineteenth century (Pearson, 2002). The absence of the
3 Translation provided by Richard J. Pulskamp, Department of Mathematics and Com

puter Science, Xavier University Cincinnati, Ohio. http://www.cs.xu.edu/math/Sources/
Dalembert/croix_ou_pile.pdf
4 The Oxford English Dictionary defines physiognomy as the study of the features of the face,
or of the form of the body generally, as being supposedly indicative of character; the art of
judging character from such study.
empirical tools to quantify risk would appear to be an obvious constraint on the iden
tification of moral hazard, which required that the probability of an insurable event
be differentiated between insured and uninsured individuals.
Pearson (2002), however, has argued that eighteenth-century insurers recognized the
concept of moral hazard and implemented measures to control it.
In fact, no clear definition [of moral hazard] was in use by insurance offices
before 1850, and it is not known when the term itself came into vogue.
The concept it embodied, however, was widely recognized, namely the
possibility of unfavourable features of a risk arising from the character of
the insured. (Pearson, 2002, p. 6)
The accuracy of this claim is questionable. Both moral hazard and adverse selection
result in a correlation between insurance and claim; however, the direction of cau
sation is opposite. The distinction is subtle: whereas moral hazard posits that the
purchase of insurance will induce individuals to invest less preventive effort, adverse
selection posits that high-risk individuals (including individuals with fraudulent in
tent) will purchase more insurance. Moral hazard is not "unfavourable features of a
risk arising from the character of the insured," but rather the "unfavourable features
of risk" arising from the purchase of insurance. The phenomenon described in the
quote above seems to be an amorphous conception of behavior under insurance that
includes both adverse selection and moral hazard, without distinction.
This misconception is also reflected in the discussion of the insurance industry's

response to "moral hazard." Pearson (2002) states that eighteenth-century English
insurers controlled for moral hazard in the Irish life assurance market by verifying
the subject's age and establishing an "insurable interest."5 However, moral hazard
is not generally considered a significant problem in markets for life assurance since
insured parties may rarely be prepared to trade their longevity for the financial
gain of a nominated benefactor. Undoubtedly, the insured subjects were not dying
prematurely due to incentives associated with insurance. Rather, speculating Irish
policyholders were exploiting private information they held about the health status
of third parties to adversely, with respect to their insurer, select lives for insurance.
It would not be until the mid-nineteenth century that the concept and term "moral
hazard" appeared in the insurance-industry literature.
The genesis of an idiom is an ill-defined process that pairs concept with phrase.
The use of language by the early probability literature appears to have made an es
oteric contribution to the development of this idiom. The contemporary definition
of hazard is "risk of loss or harm, peril, jeopardy" OED (2008). However, the word
hazard ("hassard" or "hasart"), which has French origins, first entered the English
language in 1167 to describe a game of dice. It was not until 1618 that the word "haz
ardous" in the sense of "perilous" appeared in the English language (Harper, 2010).
5 There was no requirement under Irish law for an "insurable interest/' such as kinship, to be
demonstrated by the party taking out the policy on the life of another. This created scope
for gambling and speculation on lives and made underwriting on "other interest" policies
hazardous (Pearson, 2002).
Pascal and Fermât developed probability theory to analyze the division of stakes
from an incomplete game of dice or points. Thus, from its inception, the probability
literature had analyzed games of hazard which, as Baker (1996) pointed out, Victorian
England had considered morally questionable.
During the Middle Ages, two senses of the word moral existed. The first recorded use
of the word "moral," within the English language, appeared in 1387-1395 in Chaucer's
[1343-1400] The Canterbury Tales as, "Sownynge in moral vertu was his speche" (OED,
2008). The word "moral" in this context is consistent with the contemporary meaning
of moral as "excellence of character or disposition, as distinguished from intellectual
excellence, or from the theological virtues of faith, hope, and charity" (OED, 2008).
However, a second interpretation of the word moral also existed. Philosophical and
scientific thought of the Middle Ages was often initially written in Latin and subse
quently translated into English. Although Latin defines the word mörälis as "... of
or belonging to manners or morals, moral" (Lewis and Short, 1879) the etymology
of mörälis comes from the word mos (Daston, 1983), which is defined as "... manner,
custom, way, usage, practice, wont, as determined not by the laws, but by men's will
and pleasure, humor, self-will, caprice" (Lewis and Short, 1879).
The medieval use of the word "moral" often retained its Latin sense, which did not
project the pejorative overtones associated with its English origins. For example, in
the eighteenth century, "moral scientists" studied the behavior of rational individu
als in the hope of establishing rules to guide the broader community (Daston, 1983).
Mathematicians, most notably Daniel Bernoulli, used the concept of "moral expec
tation" to describe the subjective value placed on a probable gain by an individual
(Dembe and Boden, 2000).
It was not until the mid-nineteenth century that concept of moral hazard was rec
ognized and the idiom first appeared within the insurance-industry literature. In
1850, a former attorney-general of Pennsylvania, Horace Binney [1780-1875] gave
an address in which he spoke "... of moral as well as of physical phenomena" (Bin
ney, 1888, supra note, at p. 393 in Baker, 1996, p. 252) to distinguish those events
attributable to the behavior of people from those attributable to nature. In 1853 the
London Bankers Magazine, wrote "risk of a moral as well as a mathematical character"
(J. Smith Homans 1853, as cited in Baker, 1996, p. 249). Then in 1865, the first recorded
use of the idiom moral hazard appeared in The Practice of Fire Underwriting, wherein
moral hazard was defined as:
... the danger proceeding from motives to destroy property by fire,

or permit its destruction. (Ducat, 1865, pp. 164-165 in Baker, 1996,
p. 249)
Baker (1996) contends that the creation of "moral hazard" suited the times; from
"hazard" with its moral overtones of danger; and from "moral," referring to the
moral scientists who made chaste use of the odds.
What combination of words could better signify the serious, scientific and
highly proper—indeed moral—grounding of the insurance enterprise?
(Baker, 1996, p. 248)
The idiom resonated and soon became entrenched within the insurance-industry
literature. Baker, (1996) has argued that in 1867 the Aetna Guide to Fire Insurance
Handbook soon developed a dual conception of moral hazard. The first was a moral
hazard, due to character:
Consider first the moral hazard What is the general character borne by
the applicant? Are his habits good? Is he an old resident, or a stranger and
an itinerant? Is he effecting insurance hastily, or for the first time? Have
threats been uttered against him? Is he peaceable or quarrelsome -popular
or disliked? Is his business profitable or otherwise? Has he been trying to
sell out? Is he pecuniarily embarrassed? Is the stock reasonably fresh and
new, or old, shopworn and unsalable? When was the inventory last taken?
Is the amount of insurance asked for, fully justified by the amount and
value of the stock? Is a set of books systematically kept? (Aetna Insurance
Co., 1867, p. 21 in Baker, 1996, p. 250)
The second conception was moral hazard, due to temptation:
Heavy insurance also increases the moral hazard, by developing motive

for crime, where otherwise no temptation existed, and wrong was in no
way contemplated. (Aetna Insurance Co., 1867, p. 159 in Baker, 1996, p.
251)
The essential idea was that the purchase of insurance encouraged moral hazard which
could manifest as either (1) a deliberate act of fraud or (2) an act of carelessness. The
former behavior was considered immoral and the latter was not. This dual conception
of moral hazard embodied both a pejorative English sense of the word moral and its
more positive, Latin meaning.
It is important when reviewing these historical texts not to inappropriately attribute

a modern conception of moral hazard to the authors' meaning. It appears that the
phrase moral hazard was used to describe both moral hazard in the modern sense as
a change in behavior in response to incentives, and as a related concept of adverse
selection. Whereas moral hazard was developed within the fire insurance literature,
the related concept of adverse selection was developed within the life insurance
industry literature. The earliest identified references to discuss adverse selection were
"On the Effects of Selection" (McClintock, 1892) and "A Statistical Study in Life In
surance" (Dawson, 1894). Both publications consider the propensity of individuals
in poor health to maintain life insurance policies as compared to individuals in good
health. It was not until 1922 that the article "Supervening Impossibility of Performing
Conditions in Insurance Polices" (Patterson, 1922) included references to both moral
hazard and adverse selection, in an examination of the legal and economic implica
tions of default on life insurance premiums. Thus, the concept of moral hazard may
have preceded adverse selection by some 30 years. It is possible that this delayed
development of the term "adverse selection" may explain why the phrase "moral
hazard" was initially used to describe both phenomena.
Reconsider Baker's (1996, p. 250) quote from the Aetna Guide above "Consider first
the moral hazard..." Only the penultimate sentence, which refers to the amount of
insurance requested, addresses an issue pertaining to moral hazard. The dominant
focus of this quote is the identification of preexisting personal characteristics, which
are supposedly correlated with the individual's propensity to engage in fraud. Thus,
the statement in fact addresses adverse selection rather than moral hazard. Baker's
following sentence, by implication, supports this conclusion:
Character, or the individual predisposition for fraud or loss, is a dominant

concern here. (Baker, 1996, p. 250)
When character is a predisposition, which precedes the purchase of insurance, adverse

selection rather than moral hazard is the phenomenon being analyzed. This notion of
adverse selection posits that individuals with a criminal intent will purchase insurance
with a view to commit fraud whereas moral hazard posits that insurance per se will
persuade otherwise law-abiding individuals to engage in fraud. The following two
quotes illustrate that the phrase moral hazard was sometimes used to identify adverse
selection rather than moral hazard as understood in the contemporary sense.
If the moral hazard is not good, there are no considerations that would
induce the company to accept the risk... (Tiffany, 1882, p. 24 in Baker, 1996,
p. 253)
Moral Hazard- The character of the applicant is usually of the first impor
tance; and where this is not satisfactory, the applicant should be dismissed
at once. (Aetna Insurance Co., 1867, p. 13 in Baker, 1996, p. 253)
Clearly, however, when Ducat (1865) asserted that insurance can offer "a direct incen
tive to crime" (Ducat, 1865, pp. 11-12 in Baker, 1996, p. 251) a contemporary notion
of moral hazard was also understood.
Grammar can be a useful tool to differentiate the alternate meanings of moral hazard.
When "moral hazard" was used as a singular, abstract noun, it described a moral
hazard in the contemporary sense as a response to incentives. Alternatively, when the
phrase was used as a collective noun, moral hazard[s], it described individuals with a
predisposition to file a claim (i.e., adverse selection). The following quote, albeit from
a secondary source, illustrates this point nicely.
They [nineteenth century insurers] would refuse to insure "moral hazards"

—that is, people with bad characters. And they would structure the insur
ance contract so that it does not create a "moral hazard"—that is, so that
insurance did not encourage the wicked to apply or tempt good people to
do wrong. (Baker, 1996, pp. 240-241)
That initially moral hazard was a flexible concept that was also used to describe
adverse selection is obtusely supported by the following statement: "[f]or nineteenth
century insurers, moral hazard was a label that applied to people and situations"
(Baker, 1996, p. 240). Although Baker used this terminology, the parallel should be
clear. During the nineteenth century when moral hazard was applied to situations, it
embodied moral hazard in the modern sense, that is, a response to incentives. When
moral hazard was applied to people, it reflected an alternative meaning of moral
hazard as de facto, a process of adverse selection.
In 1905, Everett Crosby, the General Agent for the North British and Mercantile
Insurance Company published the following definition of moral hazard in The Annals
of the American Academy of Political and Social Science.
First, we have "direct moral hazard" where a property is fired by the

owner for gain. Second, the "indirect moral hazard" where the owner may
not be prospering or permanently located, and has little or no incentive
for safekeeping hazard, keeping premises in repair and maintaining fire
appliances, thus allowing the physical hazard to become abnormally high.
(Crosby, 1905, pp. 225-226)
Although Crosby's definition of moral hazard did include illegal acts such as arson,
the focus of the analysis was on the incentives which produced the conduct rather
than an ex ante identification of individuals likely to file a claim. Crosby's "modern"
definition of moral hazard was unambiguous, and did not imply adverse selection.
Furthermore his treatment of moral hazard was, prima facie, nonprejudicial with re
spect to social minorities, as the following quote illustrates:
The record of fire losses has clearly shown that moral hazard is frequently
found among assured of means and of high social standing or with excel
lent mercantile ratings. (Crosby, 1905, p. 226)
Several authors have outlined a rationale for the insurance industry to embrace a
public role. The political scientist Deborah Stone (2002), for example, has argued that
insurance is a social institution, which defines norms and values in political culture
and ultimately shapes the way citizens think about issues of membership, community,
responsibility, and moral obligations. Community attitudes to risk aversion, fraud,
propensity to claim and preventive effort can affect the viability of insurance. Thus,
there is an incentive for insurers to engage in social discourse to shape and define
social norms, which promote individual and mutual responsibility with a view to
maximize commercial prosperity. Pearson (2002) has argued the insurance industry
accepted and promoted the idea that public resources should be committed to the
amelioration of "moral hazard" (and/or adverse selection).
In an imperfect market, however, where costs and benefits were not pre
cisely known, and in a society in which moral precepts dictated that prop
erty should be protected from fraud, theft, and arson whatever the cost,
insurers may have felt that the allocation of both private and public re
sources to combating moral hazard should not be based on economic
factors alone. (Pearson, 2002, p. 8)
Arrow (1963) has also asserted that there is a rationale for insurers to enter the
public sphere to shape community norms. Analyzing insurance and the market for
medical care, he said "[i]n the absence of ideal insurance, there arise institutions
which offer some sort of substitute guarantees" (Arrow, 1963, p. 965). He argued that
to limit physician incentives to overtreat insured patients (i.e., ex post moral hazard)
society has developed norms, in the form of ethical expectations, to guide physician
treatments.
In 1907, H.P. Blunt wrote in the Journal of the Insurance Institute that it was a joint
public duty of the insurance industry and the State to deter moral hazard.
As regards the low-class alien population so much in evidence now-adays

in our crowded centres, the rigid exclusion of these from their books is
held by first-class offices to be a duty owing not only to their shareholders
but also to the State, seeing that a policy in such hands is likely to be an
incentive to crime. (Blunt, 1907 in Pearson, 2002, p. 35)
As the insurance industry grew so did its willingness and capacity to engage in public
discourse to influence social norms through rhetorical argument. The insurance
industry literature from the early twentieth century is replete with many examples of
the idiom moral hazard used normatively. For example, in a book entitled A Study of
Accidents and Accident Insurance, moral hazard is described as "[m]en who steal or lie
[or] magnify a slight injury, or be dilatory in resuming work when they are able to do
so" (McNeill, 1900 in Dembe and Boden, 2000, p. 259). Similarly, in the monograph
Insurance and Crime moral hazard is defined "misrepresentation and negligence"
(Campbell, 1902 in Dembe and Boden, 2000, p. 259).
Ethnocentric and class-specific formations of moral hazard were also used to moderate
social attitudes toward claims and claiming. Under the entry "moral hazard abroad,"
the Dictionary of Fire Insurance states that
[c]ertain features affect moral hazard abroad which are fortunately absent
in Great Britain. For instance, Central America has long been recognised
as a hotbed of serious moral hazard A type known as Assyrians do
not hesitate to adopt any means or make any statements so as to secure
payment of policy moneys in full. (Remington and Hurren, 1935, p. 328)
Furthermore, other prejudicial references linking moral hazard to other marginalized

minorities were used to frame public attitudes to claims and claimers.
Moral hazard was typically attributed to the (immoral) personal charac

teristics of individual, but some authorities claimed that it was more likely
among certain ethnic and social groups like ... drug addicts and homosex
uals. (Rupprecht, 1940; Shepherd and Webster, 1957 in Dembe and Boden,
2000, p. 259)
Economic Literature
In contrast, the economic literature has focused on moral hazard as a consequence

of incentives rather than as a product of criminality. The analysis of moral haz
ard was not widespread within the economic literature of the nineteenth century.
For example, Marshall's widely acclaimed economic text, Principles of Economics,

which was first published in 1890 provides only a cursory treatment of insurance
and without explicit reference to moral hazard. However, the capacity of insurance
to induce carelessness and fraud was recognized.
Even as regards losses by fire and sea, insurance companies have to allow
for possible carelessness and fraud; and must therefore, independently of
all allowances for their own expenses and profits, charge premiums con
siderably higher than the true equivalent of the risks run by the buildings
or the ships of those who manage their affairs well. (Marshall, 1920, p. 231)
The first identified economist to analyze explicitly moral hazard was Haynes, (1895)
who published an article entitled "Risk as an Economic Factor" in The Quarterly
Journal of Economics. Generally, the treatment of moral hazard by economists did not
utilize the same degree of emotive language that was evidently in use in the insurance
industry . Moral hazard was viewed as a positive rather than normative concept. For
example, Haynes, (1895) introduces the concept of moral hazard as follows:
Lack of moral character gives rise to a class of risks known by insurance

men as moral hazards. The most familiar example of this class of risks is
the danger of incendiary fires. Dishonest failures, bad debts etc. would
fall into this class, as well as all forms of danger from the criminal classes.
(Haynes, 1895, p. 412 )
Note, first, the pluralization of moral hazard[s] and second that this quote contains
no bellwether reference to incentives to identify moral hazard. In this quote, the
term "moral hazards" has embodied the notion of adverse selection, which was, as
discussed above, often evident in the insurance-industry literature. However, when
outlining the disadvantages of technical insurance, Haynes (1895) does identify a
central role for incentives.
Security [technical insurance] is good, but security as well as hazard may

have an unfavourable effect upon industry.
(a) Intensity of effort is diminished...
(b) Carelessness is encouraged by insurance...
(c) The greatest disadvantage of technical insurance is the encouragement

it gives to dishonesty. (Haynes, 1895, p. 445)
When drawing the reader's attention to a form of moral hazard that would now be
referred to as ex post moral hazard, the role of incentives is again emphasized.
There would still remain the moral hazard of excessive estimates of loss
where there was no dishonesty in the origin of the fire. (Haynes, 1895,
p. 445)
The decision to focus on incentives was not surprising since the study of incentives
was an established area of investigation for economists. Some 120 years earlier Adam
Smith demonstrated an intuitive understanding of moral hazard and the role that it
played in a commercial setting, when he wrote
The directors of such companies, however, being the managers rather of

other peoples' money than of their own, it cannot well be expected, that
they should watch over it with the same anxious vigilance with which
the partners in a private copartnery frequently watch over their own ...
Negligence and profusion, therefore, must always prevail, more or less,
in the management of the affairs of such a company (Smith 1937 [1776],
p. 700)
Thus, from its earliest appearances within the economic literature, the concept of
moral hazard was not limited to the analysis of private markets for insurance. For
example, Rubinow [1875-1936], who was trained as a physician and then as an
economist, argued that the concept of insurance could be extended to include a vari
ety of compulsory state schemes (Rubinow, 1904). The implications of moral hazard
in this form of insurance were implicitly recognized.
The one great objection most frequently raised against compulsory state
insurance, either sickness or for accidents is that workingmen abuse the
system, which leads, of course to greater expenditures. (Rubinow, 1904,
P- 371)
However, it was not until the publication of his major work Social Insurance 9 years
later, that this phenomenon was explicitly recognized as [moral] hazard in this ex
panded conceptualization of insurance.
But the most damaging argument in the opinion of many is the charge
that social insurance not only increases hazard, but vastly more stimulates
the simulation of accidents or disease or unemployment; and that encour
ages the professional mendicant, demoralizes the entire working class by
furnishing an easy reward for malingery. (Rubinow, 1913, p. 496)
The application of the moral hazard grew beyond simply markets for private and
social insurance. In Risk, Uncertainty and Profit, Knight (1921) considered the feasibility
of insuring commercial losses. He argued that where the insurer is unable to observe
manager effort, moral hazard would preclude the insurance of commercial profits.
On account of the "moral hazard" and practical difficulties, it is neces

sary to restrict the amount of insurance to the "direct loss or damage" or
even to a part of that, while of course there are usually large indirect losses
due to the interruption of business and dislocation of business plans which
are entirely unprovided for. (Knight, 1921, p. 129)
Knight (1921) also used the concept of moral hazard to analyze the structure and
efficacy of commercial partnerships. He argued that moral hazard placed a constraint
on the size of partnerships.
The fact which limits the application of insurance principle to business

risks generally is not their inherent uniqueness alone Furthermore, the
classification or grouping can only to a limited extent be carried out by
any agency outside the person himself who makes the decisions, because
of the peculiarly obstinate connection of a moral hazard with this sort of
risk. (Knight, 1921, p. 130)
On the other hand, it is the inefficiency of organization, the failure to secure

effective unity of interest, and the consequent large risk due to moral
hazard when a partnership grows to considerable size, which in turn limit
its extension to still larger magnitudes and bring about the substitution of
the corporate form of organization. (Knight, 1921, p. 131)
In "Uncertainty and the Welfare Economics of Medical Care," Arrow (1963) trans
formed the ethical topography surrounding moral hazard. Whereas Rubinow (1913)
made a normative case for social insurance, which saw moral hazard as phenomena
that might need to be managed, Arrow (1963) outlined an efficiency argument for
public intervention due to moral hazard. Arrow stated that
[t]he welfare case for insurance policies of all sorts is overwhelming. It

follows that the government should undertake insurance in those cases
where this market, for whatever reason [e.g., moral hazard], has failed to
emerge. (Arrow, 1963, p. 961)
In markets for medical insurance, ex post moral hazard may occur if the physician and
patient engage in "medical care not completely determined by the illness" (Arrow,
1963, p. 961). Thus, Arrow argues that public intervention in the form of either (1)
public insurance for medical care or (2) the establishment of professional norms may
be warranted to control the worst excess of ex post moral hazard. Pauly (1968) instead
argued that given a zero price for medical care, ex post moral hazard would result in an
increase of the actuarially fair premium, such that some individuals may prefer to self
insure rather than be co-opted into a public insurance scheme. In a rejoinder, Arrow
(1968) reintroduces morality to the discussion by arguing that Pauly's (1968) inference
that "rational economic behavior" and "moral perfidy" are mutually exclusive is not
necessarily correct. He states that ex post moral hazard in the market for medical care
"will certainly not be socially optimal" (Arrow, 1968, p. 538) and that an intervention
such as rationing may be warranted.
Whereas the initial Arrow-Pauly dialogue analyzed the implications of an ex post

moral hazard in a market for medical insurance much of the ensuing theoretical anal
ysis that followed (Pauly, 1974; Shavell, 1979; Holmstrom, 1979) was more focused
on analyzing ex ante moral hazard in markets for insurance.6 Moral hazard was now
seen as one manifestation of asymmetric information (Arrow, 1971; Pauly, 1974) and
6 We thank an anonymous reviewer for drawing our attention to this point.
occurred when the principal (insurer) could not observe, or found it too expensive
to observe, the effort invested by the agent (insured) to avoid a claim (Holmstrom,
1979; Shavell, 1979; Marshall, 1976). However, the evolving concept of moral hazard
had now irrevocably left the narrow analytical confines of the markets for private
insurance. The idiom moral hazard was used to analyze and discuss an increasingly
diverse range of issues of broad public interest, including unemployment (Foster and
Rosenzweig, 1994), worker's compensation (Butler and Worrall, 1983), and disability
benefits (Chelius and Kavanaugh, 1988), share copping (Cheung, 1969), the stock mar
ket (Diamond, 1967), and family behavior in traditional societies (Becker, 1981). There
is scarcely an area of economic study where consideration of asymmetric information
and consequent incentives do not play a role (Coyle, 2007).
Yet within the discipline of economics, this idiom remained largely free of strong moral
overtones. Dembe and Boden (2000) argued that it was unlikely that the use of the
term "moral hazard" by economists such as Arrow (1951) or Drèze (1987) carried the
same ethical overtones that were evident in the overtly moralistic insurance-industry
literature. During the mid-twentieth century, the economic literature had revisited
Bernoulli [1738] to develop further a theory of utility. The concept of "moral expecta
tion" was central to the development of this new literature. Contributions from von
Neumann and Morgenstern (1953), Friedman and Savage (1948), and Stigler (1950)
would ensure that "moral" as subjective expectation rather than ethical judgment con
tinued to influence the currency of the phrase "moral hazard" within the economic
literature (Dembe and Boden, 2000).
The prejudicial language, which was sometimes used by the insurance-industry lit
erature to describe moral hazard during the first half of the twentieth century, has
since abated for social and cultural reasons. Dembe and Boden (2000) have said that
from about 1940 to 1980 insurance texts drew a distinction between moral hazard
and morale hazard. For example, the insurance text Risk Management Vaughan (1997)
states:
Moral hazard: refers to the increase in probability of loss associated which

results from evil tendencies in the character of the insured person —
Morale hazard: not to be confused with moral hazard, results from the
insured person's careless attitude towards the occurrence of losses. The
purchase of insurance may create a morale hazard, since the realization
that the insurance company will bear the loss... (Vaughan, 1997, p. 12)
This taxonomy, although not frequently used, may also be confusing. What insur
ers evidently have called morale hazard, "carelessness due to incentives," is what
economists such as Pauly (1974), Shavell (1979), and others have continued to call
moral hazard. What the insurance-industry literature has termed "moral hazard," that
is, "evil tendencies," the authors of this article have called "adverse selection," with
the following caveat. The concept of asymmetric information is central to the economic
concepts of moral hazard and adverse selection. If the "evil tendencies" were unob
servable to the insurer then any unobserved self-selection by potential policyholders
will result in a process of adverse selection. If the "evil tendencies" were observable
then the insurers will risk rate their policyholders accordingly and no process of
adverse selection will occur.
It can be seen therefore that the contemporary insurance texts continue to advance
definitions of moral hazard that embody self-selection. For example, moral hazard
has been variously defined as:
... an imputed subjective characteristic of the insured that increases the

probability of loss (Mehr and Cammack, 1976, p. 23) and
moral hazards, such as dishonesty, carelessness, and lack of concern

(Hart, Buchanan, and Howe, 2007, p. 1)
as opposed to those definitions found within economics literature (e.g., Mas-Colell,

Whinston, and Green-Jerry, 1995; Varian, 2010), which focus on the role of incentives.
Pindyck and Rubinfeld (1989), for example, simply stated that the problem of moral
hazard is that
... behaviour may change after the insurance has been purchased.
(Pindyck and Rubinfeld, 1989, p. 620)
These interdisciplinary differences no doubt contribute to the ambiguity that contin

ues to surround the use of this term in the wider public domain.
The importance of a clear distinction between moral hazard and adverse selection is
not an idle one. Following the theoretical analysis of moral hazard in the 1960s and 70s,
a number of economists were subsequently motivated to estimate the moral hazard
effect empirically in an assortment of markets for insurance, for example, automobile
insurance (Abbring, Chiappori, and Pinquet, 2003; Chiappori and Salanie, 2000) or
physician services (Chiappori, Durand, and Geoffard 1998; Koc, 2011). For a review
of the empirical literature of tests for moral hazard and adverse selection in insurance
markets, see the excellent review by Cohen and Siegelman (2010). One of the primary
challenges that must be addressed in investigations of this nature is to distill the effects
of moral hazard from adverse selection. Both phenomena can induce a correlation
between insurance and the probability distribution of the insured event, but the
underlying data-generating processes are distinct. Clearly, a sound appreciation of
these differences is germane to any empirical investigation of moral hazard in an
insurance setting.
Conclusion
The phrase "moral hazard" was initially developed within insurance-industry lit
erature 150 years ago to describe a positive correlation between the possession of
insurance and incidence of the insured event. The incorporation of the word "moral"
in the phrase "moral hazard" has a powerful rhetorical character, which has been
used by a variety of interests, most notably insurers, to influence the public's attitude
to claims and claimers. The discipline of economics has since assimilated the term
"moral hazard" within its own literature to consider the role of incentives in a broad
range of principal-agent relationships. As the idiom has entered the public domain,
contributors to a growing noneconomic literature that has analyzed moral hazard

have sought to diffuse the rhetorical capacity embodied in this term by challenging
the notion, purportedly propagated by economics, that moral hazard describes im
moral behavior. This discourse, however, has in fact almost exclusively consisted of
a monologue by noneconomists: influential economists such as Pauly (1968, p. 531)
have clearly stated that "... moral hazard has in fact little to do with morality..."
and hence, it may be argued that there is little claim to answer.
The claim has been made by some authors that moral hazard developed naturally
with insurance (Hale, 2009; Pearson, 2002), when clearly the existence of insurance in
Europe can be seen to predate the creation of the term "moral hazard" by almost five
centuries. Two principal impediments to the conceptual development of a theory of
moral hazard were identified. The first constraint was theoretical. The early theolog
ical debate, which surrounded the liceity of insurance, suggests that a fundamental
view of providence prevailed in the Middle Ages. If this view is accepted as evidence
of a widespread "belief," these theological documents imply that although ever ran
dom events such as the sinking of a ship were solely attributable to the will of God,
the concept of moral hazard, which posits that that individuals can affect the prob
ability of an event, could not evolve. Febvre's (1956) supporting argument—which
states that as the insurance industry grew in the Middle Ages the perceptions of
nature changed—had implications for the development of a concept of moral hazard
as the capacity of the individual to affect future events was incorporated into our
understanding of risk.
The second constraint was an empirical one. It was not until the beginning of the
seventeenth century that the science of probability commenced development. Fur
thermore, the application of these new empirical tools was slowly embraced by the
insurance industry. Pearson (2002) has argued that it was not until the nineteenth
century that insurers began to fully incorporate these actuarial techniques into their
commercial practice. The identification of moral hazard required sufficient actuarial
acumen to differentiate the probability of an insured and uninsured adverse event.
It is not surprising, therefore, that it was not until 1865 that Ducat first identified
a correlation between insurance and the occurrence of the insured event, which he
called "moral hazard."
The creation of an idiom, which matches a meaning with a set of words, is an imprecise
process. Several intriguing historical coincidences may have contributed to varying
degrees to the creation of this ambiguous idiom. The science of probability began ana
lyzing games of hazard (dice). Although the English meaning of moral as "excellence
of character..." was subjective, the Latin meanings of mörälis "belonging to man
ners" (Lewis and Short, 1879) and its root mos "manner and custom... determined
... by men's will and pleasure" (Lewis and Short, 1879) saw a less deprecatory use
of the term "moral" by medieval scholars. For example, eighteenth-century "moral
scientists" studied the behavior of rational individuals and probabilists coined the
term "moral expectation" (utility) to evaluate risk. The notion of expectation and the
"reasonable man" embraced by the early probabilists reflects a normative concep
tion of chance events. It is speculative to quantify the net contribution of any single
root influence, however, taken en masse; they reflect the ambiguity that continues to
surround the use of this idiom today.
The modern conception of moral hazard implies more than correlation; it involves
causation: that insurance changes behavior and induces claims. Initially, moral haz
ard was sometimes used to describe the actuarial process of adverse selection. At the
turn of the twentieth century the principal contributors to the academic literature 7
expressed a positive concept of moral hazard (i.e., insurance changes behavior) that
could be unambiguously distinguished to the evolving notion of adverse selection
(i.e., high-risk individuals are more likely to buy insurance and/or to buy more insur
ance) (Dawson, 1894; McClintock, 1892). However, the insurance-industry literature
was to adopt a different perspective.
Several authors (Arrow, 1963; Pearson, 2002; Stone, 2002) have outlined theoretical
reasons as to why they believed there was a public role for the insurance industry.
Documentation from the turn of the century confirms that the insurance industry also
perceived a public role for itself (Blunt, 1907). Several examples of the normative ap
plication of the phrase moral hazard by contributors to the early insurance-industry
literature have been cited (Campbell, 1902; McNeill, 1900; Remington and Hurren,
1935; Rupprecht, 1940; Shepherd and Webster, 1957). Although the normative and
emotive treatment of moral hazard abated through the course of the twentieth cen
tury, the insurance-industry literature continues to conceive of and define the phe
nomenon of moral hazard in moral terms (Hart, Buchanan, and Howe, 2007; Mehr
and Cammack, 1976). This normative conception of moral hazard can also be found
within other fields. For example, legal scholars such as Baker (1996) and philosophers
such as Hale (2009) have attempted to address and refute the ethical arguments that
the term "moral hazard" may imply.
In contrast, the theoretical treatment of moral hazard within the economics litera
ture has differed in two important ways. First, economists (e.g., Smith [1776]) have,
from the outset, explored and analyzed the effect of incentives. Thus, it is perhaps
not surprising that the early analysis of moral hazard (Haynes, 1895; Knight, 1921;
Rubinow, 1913) was focused on incentives. Dembe and Boden (2000) have argued that
the focus on a theory of utility and the resulting use of Bernoulli's [1738] phrase "moral
expectation" contributed to a value-neutral concept of moral hazard by economists.
Second, economists have expanded the application of the term moral hazard. First,
Knight (1921) considered the implications of moral hazard for corporate structure.
Arrow (1963,1968) and Pauly (1968) debated the extent to which moral hazard jus
tified publicly funded medical insurance. The Arrow-Pauly debate ensured that the
concept of moral hazard would be seen as not only interesting to economists but also
of importance to the wider public.
This article offers at least three useful insights. First, two contrasting treatments of
moral hazard by the economic and insurance-industry literatures sowed the seeds
for an energetic public debate. The economic literature has applied a "value-neutral"
idiom, which has been used pejoratively within the confines of the insurance-industry
7 The principal contributors to the moral hazard literature were the economists Haynes (1895),
Rubinow (1913), and the General Agent North British and Mercantile Insurance Company
Evert U. Crosby (1905) who was published in The Annals of the American Academy of Political
and Social Science.
literature, to an expanding range of topics of social interest. McCloskey has argued

that economists:
... want to persuade audiences, too, and therefore exercise wordcraft, in

no dishonourable sense. (McCloskey, 1994, p. 51)
The phrase "moral hazard" has the potential to alienate readers from noneconomics
backrounds and there is an attendant potential for the use of the term to obfuscate
the positive message that economists mean to convey with the idiom. Second, other
social scientists interested in the history of moral hazard and insurance could consider
the context in which the phrase moral hazard appears in the economics literature
by seeking to understand the clear distinction that economists make between the
concepts of moral hazard and adverse selection. Sometimes what at first appears
to be a discussion—in the noneconomics literature, or in popular usage—of moral
hazard is, on closer inspection more appropriately viewed as a discussion of adverse
selection. Third, to this day definitions of moral hazard found within the insurance
industry literature also do not always correspond with the concept as it is used
by economists. The insurance industry may also benefit in breaking from historical
practice and adopting the clear distinction that economists make between moral
hazard (whereby insurance contracting moderates insured behavior) and adverse
selection (whereby insurance type moderates insurance contracting).
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History of The Term "Moral Hazard" Author(s) - David Rowell and Luke B. Connelly

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A History of the Term "Moral Hazard"

Author(s): David Rowell and Luke B. Connelly

A History of the Term "Moral Hazard"

Some economic definitions focus on ex ante behavior: moral hazard is defined as

Ex post moral hazard concerns the effects of incentives on claiming actual

Certainly, all the interventions created moral hazard, sending a perverse

Today, moral hazard signifies the perverse consequence of the well

Historical and Theological Literatures

The earliest known European contracts were underwritten in Genoa in 1343

Two lines of counterargument, sometimes proposed by theologians with close family

be separated. These premises enabled insurance to be justified on the basis of social

By the sixteenth century, mercantile apologists had succeeded in differentiating in

The theory of probability is sometimes attributed to correspondence between the

1 The English translation is On Justice and Law

motivated Huygens [1629-1695] to publish On Reasoning in Games of Chance in 1657

The notion of expectation introduced a normative judgment upon individual behav

Peter tosses a coin and continues to do so until it should land "heads"

throw the number of ducats he must pay is doubled. Suppose we seek to

... moral considerations, relative, either to the fortune of the players, or to

3 Translation provided by Richard J. Pulskamp, Department of Mathematics and Com

This misconception is also reflected in the discussion of the insurance industry's

... the danger proceeding from motives to destroy property by fire,

The second conception was moral hazard, due to temptation:

Heavy insurance also increases the moral hazard, by developing motive

It is important when reviewing these historical texts not to inappropriately attribute

Character, or the individual predisposition for fraud or loss, is a dominant

When character is a predisposition, which precedes the purchase of insurance, adverse

They [nineteenth century insurers] would refuse to insure "moral hazards"

First, we have "direct moral hazard" where a property is fired by the

As regards the low-class alien population so much in evidence now-adays

Furthermore, other prejudicial references linking moral hazard to other marginalized

Moral hazard was typically attributed to the (immoral) personal charac

In contrast, the economic literature has focused on moral hazard as a consequence

For example, Marshall's widely acclaimed economic text, Principles of Economics,

Lack of moral character gives rise to a class of risks known by insurance

Security [technical insurance] is good, but security as well as hazard may

(a) Intensity of effort is diminished...

(b) Carelessness is encouraged by insurance...

(c) The greatest disadvantage of technical insurance is the encouragement

The directors of such companies, however, being the managers rather of

On account of the "moral hazard" and practical difficulties, it is neces

The fact which limits the application of insurance principle to business

On the other hand, it is the inefficiency of organization, the failure to secure

[t]he welfare case for insurance policies of all sorts is overwhelming. It

Whereas the initial Arrow-Pauly dialogue analyzed the implications of an ex post

6 We thank an anonymous reviewer for drawing our attention to this point.

Moral hazard: refers to the increase in probability of loss associated which

... an imputed subjective characteristic of the insured that increases the

moral hazards, such as dishonesty, carelessness, and lack of concern

as opposed to those definitions found within economics literature (e.g., Mas-Colell,

These interdisciplinary differences no doubt contribute to the ambiguity that contin

contributors to a growing noneconomic literature that has analyzed moral hazard

literature, to an expanding range of topics of social interest. McCloskey has argued

... want to persuade audiences, too, and therefore exercise wordcraft, in

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