Moral hazard

Moral hazard is in Economics some non observable actions or behaviours that can lead to asymmetric information between market participants. It is usually associated with situations where one side of the market can not see the action of the other (see Varian (1990)).

It has been first been analyzed in the insurance industry. Kenneth Arrow (1963) had first introduced Moral Hazard in the literature in a seminal paper. Since then, many researchers have tried to defined it. Buchanan (1964) defines it as "every deviation from correct human behavior that may pose a problem for an insurer".

In the insurance context, it can be defined as the effect of having an insurance and insured's incentives to reduce expected losses.It arise when one market participant do not bear all the full consequence of its actions. Therefore, he will be more inclined to act with more risk or less care than otherwise.

For example, if a car accident cost a person $10.000 but the insurer pays $9.500, the insured person would have less incentive to avoid the accident.

Moral hazard in Insurance

Basically, when completely insured, any benefit of additional precautions will accrue to the insurer rather than to the policyholder. Since insurers understand well that insurance reduces the policyholder's incentives to prevent losses, they have responded to this problem in multiple ways. Moral hazard arise in insurance as one side of the transaction in not able to correctly monitor the other side (or that latter is trying to hide some of his actions).

In most cases, insurance will not offer full coverage. Instead, only some part of the losses will be covered by insurers. To reduce the moral hazard, insured will have to bear some risk.

Another principle used in the insurance industry to mitigate the moral hazard is to rate future premium according to:

• the number and gravity of losses already paid by the insurance

• and to the policyholder's experience (seniority, habits, etc,...).

Holmström (1979) and Shavell (1979) have first studied the impact of moral hazard in insurance. They demontrate that setting deductibles, or a limitation of coverage for small losses is optimal if policyholder's effort can mitigate loss probability.

Similarly, insurers can setup co-payment clauses un which the policyholder will have to pick up some percentage of the loss when there is a claim.

It had been distinguished by Didone and St-Michel (1991) that two different types of moral hazard exist in the insurance context:

• Incentives to not have optimal precaution level to avoid losses (ex-ante)
• Incentives to exaggerate the loss level when incurred (ex-post).

In that framework, one could consider insurance fraud as result of extreme ex-post moral hazard.

For insurers, it is very difficult price premium correctly as too high premiums to cover client with risky behaviour would hurt less-risky client. Hence, nobody would buy that insurance.

Moral hazard in Financial Markets

In finance, Moral Hazard refers to a disposition of individuals or organization to take risky behaviour under the implicit assumption that someone else would bear some part of the losses and consequences if the risk turns out badly.

Usually, it involves the bail-out of the distressed by a governmental body.

The most known examples are the Mexican bailout by the IMF, the Asian bailout, the Long-Term Capital Management bailout, and more recently the bailout of Northern Rock by the Bank of England. In most, if not all, of these situations, excessive risk-takers (countries, banks or even investors) were rescued by a central bank or an international fund.

The case of Deposit Insurance

Deposit insurance can be a source of moral hazard in the banking system. In order to avoid any bank run, a situation where depositors are trying en masse to get their money back, regulators often place deposit insurance in place. Such insurance would ensure that no bank would go insolvent as runs can have a ripple effect and trigger a full-blown contagion. If there were no deposit insurance, even the rumors of a bank at risk (whether the rumors are true or false) could bring people queeing in front of the bank's doors to get deposit back.

In the US, the Federal Deposit Insurance Corporation (FDIC), created in the wake of the Great Depression in 1933, insures deposits at commercial banks up to an amount of 100.000 USD (starting 2011, this amount will be revised every 5 year with indexing to the CPI).

Deposit insurance gives rise to moral hazard as it gives incentives to banks to take more risk as they would capture all the profit but shift the losses to the government. It also reduces the depositors and shareholder's incentives to monitor their bank.

Moral hazard in Corporate Finance

Agency problem (first described by Jensen and Meckling (1976)), or the problem resulting from conflict of interest between company's stakeholders (mainly shareholders, bondholders and managers) is a source of moral hazard.

It had been showed that when shareholders do not have full control of firm's management, the latter has some incentives to take riskier decisions than otherwise.

=> separation stockholders/managers, borrowers taking too much risk, solvency and scale of investments... TBD

References

Arrow, K.J. (1963), «Uncertainty and the Welfare Economics of Medical Care». American Economic Review, 53, December, p. 941-973.

Buchanan, J. (1964), "The Inconsistencies of the National Health Service", Institute of Economic Affairs (Occasional papers n°7), London.

Dionne, G. et P. St-Michel (1991), «Workers compensation and moral hazard». Review of Economics and statistics 83(2), p. 236-244

Holmstrom, B. (1979), "Moral Hazard and Observability", Bell Journal of Economics, 10, p. 74-91

Jensen M.C., Meckling W.H. (1976) "Theory of the Firm : Managerial Behavior, Agency Costs and OwnershipStructure", Journal of Financial Economics, 3, pp. 305-360

Shavell, S. (1979), "Risk-sharing and Incentives in the Principal-Agent Relationship" , Bell Journal of Economics 10, p. 55-73.

Varian, H. R.(1990), "Intermediate Microeconomics: A Modern Approach" , 2nd ed, W W Norton and Co., New York.