Moral Hazards: A Bump In The Contract Road

By Tisa Silver AAA

A moral hazard occurs when a party to a transaction has not entered into the contract in good faith. This can occur when a party provides misleading information or has an incentive to take unusual risks. But despite its name, moral hazard doesn't really concern the moral compass or ethics of the parties involved.

Moral hazard has been used in conjunction with concepts such as adverse selection, information asymmetry and the agency problem. In each of these instances, there is a relationship between two parties, one of which may be privy to more information and/or less risk than the other. The problem with such a situation is that when one party in a transaction is insulated from risk, he or she may behave differently (and more carelessly) than expected. Moral hazard can be found in financial, insurance and management circumstances. Here we take a look at this phenomenon and how it affects both parties in a transaction.\(For more on how information asymmetry affects stockholders, check out The Hidden Value Of Intangibles.)

The Moral Hazard Agency Problem
The agency problem involves two parties: the principal and the agent. The agent is hired to act on behalf of (and in the best interests of) the principal. Principal-agent relationships are everywhere. Some examples of this relationship include criminals who retain attorneys to represent them and business owners who hire managers to run day-to-day operations. The agent usually has resources that the principal does not - perhaps extra time or specialized knowledge. This article will explore examples of moral hazard via the agency problem.

Finance: The Borrower Vs. the Lender
The relationship between borrowers and lenders entails a delicate balance of risk and return for both parties. Borrowers seek affordable financing for projects and investments in the hope of using the borrowed money to reap returns well over the cost of financing. On the other hand, lenders need loans of all risk profiles to be repaid. Loan terms must be reasonable enough to attract borrowers, yet worthwhile enough for the lenders to profit from the interest.

For borrowers, the penalty of making losing investments or not repaying their debts is somewhat predictable: either sky-high interest rates on subsequent loans or total inability to obtain additional loans, either of which could lead them to go out of business. But, for lenders, the prospect of going out of business may not be as certain. Banks are linked to central banks, which are often viewed as the "lender of last resort". This extra insurance can create a moral hazard if banks allow the presence of this extra insurance as an incentive to assume more risk. (For more on this, see How To Read Loan And Credit Card Agreements.)

Aside from risky lending, banks can increase their risk through the use of leverage. Many firms use leverage because it magnifies the range of returns, making positives more positive and negatives more negative. Leverage can be good if it is used to purchase return-building assets, but too much leverage can prove detrimental to an entity's stability.

Leverage and risky lending can prove beneficial to a bank's bottom line, but in moderation. Too much risk can lead to loan losses, devaluation of assets, and in some cases, insolvency.

One possible method of decreasing the likelihood of moral hazard is to increase regulation. Through more oversight, regulators can impose and enforce rules to discourage risky behavior. Those rules may include higher capital requirements or heightened transparency. News of more regulation is typically met with opposition, but lack of appropriate supervision can lead to bank failure. If a bank is big enough, its failure could pose a threat to financial markets worldwide. (To learn more, read The Fuel That Fed The Subprime Meltdown.)

Insurance: The Insured Vs. the Insurer
For insurers, the underwriting process is used to assess the risk of potential policyholders and make a decision to provide or deny coverage. Insurers need to grant coverage in order to generate income from insurance premiums, but to be profitable they need to pay as few claims as possible.

Moral hazard can arise in the insurance industry when insured parties behave differently as a result of having insurance. There are two types of moral hazard in insurance: ex ante and ex post.

  • Ex-Ante Moral Hazard - Ed the Aggressive Driver: Ed, a driver with no auto insurance, drives very cautiously because he would be fully responsible for any damages to his vehicle. Ed decides to get auto insurance and, once his policy goes into effect, he begins speeding and making unsafe lane changes. Ed's case is an example of ex-ante moral hazard. As an insured motorist, Ed has taken on more risk than he did without insurance. Ed's choice reflects his new, reduced liability.
  • Ex-Post Moral Hazard - Marie and Her Allergies: Marie has had no health insurance for a few years and develops allergy symptoms each spring. This winter she starts a new job that offers insurance and decides to consult a physician for her problems. Had Marie continued without insurance, she may never have gone to a doctor. But, with insurance, she makes an appointment and is given a prescription for her allergies. This is an example of ex-post moral hazard, because Marie is now using insurance to cover costs she would not have incurred prior to getting insurance.

Insurers try to decrease their exposure by shifting a portion of liability to policyholders in the form of deductibles and co-payments. Both represent the amount of money a policyholder must pay before the insurance company's coverage begins. Policyholders can often opt for lower deductibles and co-payments, but this will raise their insurance premiums.

In Ed's case, if his aggressive driving causes an accident, he will have to pay the deductible before his insurance company pitches in. As for Marie, her health insurer may use co-payments to make her pay for a portion of the charges for doctor's visits and prescriptions. In either situation, the insurer tries to prevent or discourage risky behavior by forcing the insured to bear some of the financial burden associated with any claims.

Management: the Managers vs. the Owners
When owners select managers to run a business, their goals may not always be aligned. Owners seek to maximize their wealth (via higher stock prices), while a manager could seek many things - from a high salary and use of company perks to improving the company or beefing up his or her resume. Without a personal stake in the well-being of a firm, sometimes managers fail to act in the best interest of their shareholders.

Two common conflicts between owners and managers are compensation and project selection. If an executive's contract includes an annual salary and severance pay for departure, they will be paid as long as they are with the firm and after they leave. The unconditional, guaranteed compensation provides no incentive for the executive to avoid risky behavior.

One way for managers to assume risk is through the project evaluation process. New projects should fit with the company's threshold for risk and return. But, the knowledge that owners want profits could cause a manager to take extra risk in order to make those profits. Since their decisions are based on projections, managers might make bad selections and, with no personal penalty for selecting projects that lose money, there is no disincentive for risky behavior.

Some companies have initiated executive compensation packages that are linked to company performance. Performance incentives may come in the form of bonuses, vested benefits, or stock options that will only become profitable if the company's stock rises. Linking pay to performance might cause an executive to think twice before taking on too much risk when part of his or her paycheck is on the line.

Conclusion
Moral hazard has far-reaching implications. From aggressive drivers to central banks, whenever two parties enter into an agreement, there is a chance for moral hazard to appear. (For more on moral hazard in the 2008 liquidity crisis, see The Whens And Whys Of Fed Intervention.)

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