One thing I’ve known abstractly for a little while, but only just made concrete, is that you can only get insurance on something in which you have an “insurable interest.” This is to prevent the dread “moral hazard”: if I get insured against your house burning down, then I have an interest in burning down your house to collect the insurance money. Likewise if I take out an insurance policy on you. Whereas I presumably don’t have an interest in killing myself so that my beneficiaries will get my life-insurance money; my spouse is also assumed to prefer Live Steve to Dead Steve.

I knew all this, and I knew that a CDS — “insurance” against a mortgage default — was not subject to the same insurable-interest regulation. What I didn’t realize, until Matt Taibbi pointed it out, is that AIG was writing lots of CDSes on a single mortgage-backed security. Lots of people could bet on my defaulting on my mortgage, and not one of those bettors had to have an interest in my solvency.

That adds another wrinkle to this that for some reason I hadn’t had clear in my head: many speculators who owned CDSes had an interest in seeing mortgages default. This wouldn’t be so if finance companies had only been using CDSes to hedge their exposure to the mortgage-backed-securities market; in that case, most every CDS would be matched against a mortgage-backed security, so the investor wouldn’t really care which way the market went — he’d make money, or at least not lose too much money, either way.

Indeed, hedging is what the theory is supposedly all about. You construct synthetic securities from more-real assets (mortgages, credit-card payments, corporate debt); the synthetic securities are supposed to have precisely-known risk properties. If I’m reading everything right, hedging is supposed to be a perpetual-motion machine for the finance industry: everyone can take risky bets to his heart’s content, so long as he’s taking offsetting bets in the other direction. Companies like AIG are supposed to have vast, diversified portfolios: if any one mortgage defaults, they don’t care; they have plenty of other bets that will go up, and the Central Limit Theorem — or something like it — gives them a high probability of making money overall.

The AIGs were supposed to gather up risk from the world’s financial marketplace, mix it around, denature it, and render it harmless. I can’t tolerate much risk — I’m risk-averse, like everyone else — but AIG can. A diverse portfolio allows them this freedom. Of course it didn’t work out this way.

But back to mortgages. How does the law — or how do insurance companies — guarantee that I only have one homeowner’s-insurance policy? Suppose I own a $300,000 home, and somehow trick four insurance companies into insuring me against fire. Each of them is trying to limit moral hazard, so it insures me for something less than the appraised value of the house; let’s say I get $280,000 from each in the event of an all-consuming fire. Four $280,000 policies means $1.1 million in coverage on this house. I now have a very strong interest in seeing it burn.

Of course the insurance companies are aware of this possibility, and they must prevent it somehow. The obvious solution would be to have a central registrar of insured properties: every time I buy a policy on a house, a clerk somewhere staples my policy to my mortgage and files it away. Maybe there’s even a legal component: just like car insurance, I’m required to insure my house, and the state keeps track of it.

Does anyone know if that’s how it works?

Adam Rosi-Kessel and I recently got into a discussion about this topic, so I did a little googling and found a few interesting nuggets. E.g.,

An Insurance Research Council study indicates that only 14 percent of arson suspects are motivated by a desire to defraud an insurance company, but other studies find the percentage is higher. Between 20 and 25 percent of arson fires are drug-related.

So says the Insurance Information Institute.

Second, it occurred to me that when property values are declining, moral hazard becomes a more serious problem: if your property isn’t reassessed very often, and values are collapsing, it may be in your interest to burn the building down now and collect the cash. I wonder whether that explains the 330 arsons in Detroit from January to June of 2008 and the 231 in Baltimore. Or maybe those are drug-related. (I’ve watched The Wire. I know things.)

Finally: are you guilty of arson when you burn down your own house? A faint memory told me, and the Wikipedia affirms, that arson is the burning of someone else‘s home, not one’s own. If I burn down my own home, am I only guilty of insurance fraud?