Moral Hazard

12 Key excerpts on "Moral Hazard"

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  Facts, Values and Objectivity in Economics

  • José Castro Caldas, Vítor Neves(Authors)
  • 2012(Publication Date)
  • Routledge

    (Publisher)

  This concept arguably poses the most interesting questions for economic discourse. Mainstream economic discourse normally avoids discussions of morals as being outside the purview of economics. Akerlof and Shiller depart from this approach by bringing the moral concept of fairness into the discourse. Nevertheless, they maintain the strict division between rationality and morals. But Moral Hazard is a concept which is employed in mainstream analysis which focuses on rational behaviour, usually with respect to information asymmetry. It is opportunistic behaviour, i.e. behaviour which takes advantage of an opportunity for personal benefit even if it is at the expense of others. 2 But is it immoral? The ambiguity of Moral Hazard as a concept arises from the possibility that it can be captured as rational behaviour. As a case study of how moral sentiments are treated in economic theory, we will explore the concept of Moral Hazard in relation to the financial crisis and show how that affects the nature of the policy response. Concern with Moral Hazard was central to the way in which the authorities responded initially to the onset of crisis. But first we set out the much broader context of the relation between morals, ethics and economics, exploring how far they can in fact be kept separate. We explore the background to the history of economics as a moral science. There is an extensive literature about (moral) values in economic theory (see e.g. Brennan and Waterman 1994; Peil and van Staveren 2009). Morals can be identified in economics at a variety of levels, but the way in which they appear in economic theory depends on the methodological framework: the closed-system rational-choice framework or any of the open-system political economy frameworks. As a result, the literature has involved a significant amount of talking at cross purposes, not least because of the different meanings attached to terms in the different frameworks

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  When All Else Fails

  Government as the Ultimate Risk Manager

  • David A. Moss(Author)
  • 2004(Publication Date)
  • Harvard University Press

    (Publisher)

  To combat the preva-lent perception of insurance as a vehicle for evading personal respon-sibility, insurers insisted that Moral Hazard could be distinguished from other, more natural hazards. They also maintained that it could be screened out altogether. For these insurers, identification of moral haz-ard was a necessary first step toward eliminating it, which was in turn a prerequisite for legitimizing their industry in the eyes of the public. 43 In other contexts, however, practitioners—and especially government policymakers—have viewed Moral Hazard as an almost inevitable by-product of risk shifting, tempting even the most virtuous of citizens. Whenever someone retains control of an activity after having shed the downside risk (by shifting it to an insurer, for example), he has a strong incentive to try to increase the overall riskiness of the activity. After all, he will reap all the gains, while the other party (the insurer) will have to bear the losses. This is essentially how economists conceive of A Primer on Risk and Its History 37 Moral Hazard today, though the original sense of moral outrage has been largely abandoned. 44 Back in 1841, when federal lawmakers were debating whether to es-tablish a discharge in bankruptcy (which would erase a bankrupt’s for-mer debts at the end of the legal process), many congressmen worried about Moral Hazard, though without exactly using the term. One repre-sentative suggested that with a discharge in place, the debtor “was a man above all men exposed and tried. His morals were at stake. By passing such a bill Congress exposed him to such a temptation as ought never voluntarily to be encountered by man .

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  Gambling on Humanitarian Intervention

  • Alan Kuperman, Timothy Crawford(Authors)
  • 2014(Publication Date)
  • Taylor & Francis

    (Publisher)

  How the two strands of meaning in these terms carry over to the concept of Moral Hazard should now be obvious. The first strand comes from the nouns (incentive, precedent), which denote some influence upon the behaviour of actors. The second strand comes from the adjectives (perverse, negative) which indicate that the resulting behaviour is undesirable. That it is undesirable suggests that it is not anticipated, although, as we shall see, this need not always be the case. In the discussion which follows, we will delve deeper into this question of unintended consequences and the role it plays in the Moral Hazard concept.

  Specifications

  Now we must delineate the essential elements of our concept of Moral Hazard. The Oxford English Dictionary defines Moral Hazard as “the lack of incentive to avoid risk where there is protection against its consequences”. If we substitute antonyms for the terms ‘lack’ and ‘avoid’ we come close to the causal-core of the concept—the presence of incentives to take risk where there is protection (or the expectation of protection) against its consequences.

  Where do these incentives come from? Not from thin air, but sooner or later, from the actions of others. Moral Hazard is not immaculately conceived: it is fathered by earthly potentates. Moral Hazard is thus a ‘relational’ concept which denotes “a relationship of interaction”—more or less direct—between actors (Oppenheim, 1975, p. 287). That relationship involves influence, exercised by those who create Moral Hazard incentives, over the behaviour of those who respond to them. In this way, the concept of Moral Hazard forwards a potentially valid causal explanation of the behaviour of political actors exposed to such perverse incentives.

  Thus, for Dane Rowlands and David Carment, the Moral Hazard of intervention occurs when “the intervener’s own actions cause the combatants to prefer conflict escalation to moderation”. The intervenor’s actions create “incentive structures” which lead the antagonists “to reduce their effort to avoid calamity” (1998, p. 271). Similarly, Robert Rauchhaus has argued that something akin to Moral Hazard occurs “when a third party, through actions or promises to act, creates an incentive structure that encourages others to take risks or actions that they otherwise would avoid” (Rauchhaus, 2003).5 Thus the impetus for the rebels’ action derives from incentives in their strategic context (created by an inter-venor) rather than from changes in the substance of their goals. That is, intervention or the prospect of it does not transform a contented minority into malcontents, but rather, changes the environment in which, and the means by which, malcontents pursue political change. Moral Hazard emboldens malcontents, it does not create them.6

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  New Financial Ethics

  A Normative Approach

  • Aloy Soppe(Author)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  Moral Hazard is a form of opportunistic behaviour in which an agent seeks to strengthen their self-interest at the expense of another party. Usually, Moral Hazard starts with an information asymmetry in a specific process. Practice shows that Moral Hazard particularly occurs when a person or group of persons do not bear the full risk of their financial acting. In this case, the risk – partly – belongs to another party through, for example, warranties or other legal positions. When actors themselves do not carry all risk involved in a financial act or process, Moral Hazard readily arises leading to, for example, individuals or investors taking excessive risks. 2 Examples include banks that are ‘too big to fail’, and are therefore expected to be rescued by the government when things go wrong, such as has happened in financial crises. The same applies to the deposit insurance system for banks. Careful selection of banks becomes less important for customers when the government safeguards them through deposit insurance – see, for example, the European Icesave affair in 2008. Moral Hazards readily lead to a paradox. On the one hand (financial), markets need protection and warranties to ensure their effective operation. On the other hand, these safeguards should not exceed a certain threshold otherwise those very warranties create Moral Hazard that leads to imbalances that may cause a crash. An important manifestation of Moral Hazard is so-called adverse selection. Adverse selection is the problem where one party has an informational advantage over the other party prior to the transaction. In this situation, rationally acting agents can easily misuse information that the other party does not yet possess. Take, for example, the purchase of a travel insurance policy. Careless people will probably be more inclined to purchase a travel insurance policy than those who are very careful and better protect their belongings when travelling

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  The Soulful Science

  What Economists Really Do and Why It Matters - Revised Edition

  • Diane Coyle(Author)
  • 2009(Publication Date)
  • Princeton University Press

    (Publisher)

  There is a mirror problem which arises with regard to behavior after the transaction. We might start out with the same information but afterwards there’s an asymmetry arising from the fact that I can’t monitor your behavior. This is known as Moral Hazard. Moral Hazard describes a divergence in incentives between the two parties to a transaction. In the case of insurance, buying cover for your household goods might make you careless about taking care of them. Insurers respond by charging a lower premium for people willing to accept a larger “excess,” the amount of loss they must cover for themselves before making a claim on the policy. Countries which know the IMF will bail them out of a financial crisis might be less careful about running stable macroeconomic policies. Banks that know they will be bailed out by the government, in order to protect depositors, will have an incentive to make too many risky loans: in fact, far, far too many, so that the resulting losses will be large enough to induce a bailout rather than so small that they can be covered by a reduced dividend to shareholders. 5 Moral Hazard can also operate in employment relationships when an employer pays a worker or contractor an hourly wage but is unable to check how much effort they put into the task—for example, should new software take a contractor two weeks or two months or two years to write and instal? There’s every incentive for the contractor to take life at an easy pace and spin the work out for as long as possible. By definition, what can’t be observed or monitored can’t be included in the terms of the contract

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  Reactive Risk and Rational Action

  Managing Moral Hazard in Insurance Contracts

  • Carol A. Heimer(Author)
  • 2023(Publication Date)
  • University of California Press

    (Publisher)

  2 Insurers' Analyses of Moral Hazard Moral Hazard and Reactive Risk The problem of incentives shifting once insurance is pur- chased is usually discussed in both insurance and economics as the problem of Moral Hazard (Denenberg et al. 1964; Arrow 1971; and Pauly 1974). In order to show more clearly the connection between Moral Hazard and decision-making problems, I am going to discuss exactly where Moral Hazard enters the chain of causation leading to insurance losses. Insurers usually think of Moral Hazard as an inde- pendent factor affecting insurance losses at a single point in the causal chain; this assumption leads them to emphasize careful under- writing as a solution. I will argue that Moral Hazard is the result of an interaction between character and economic incentives, and that in- surers must always combine underwriting to eliminate the worst characters with incentive structures to motivate loss prevention and deter insurance crime. Neither tactic will work alone. Generally speaking, insurance covers losses from a particular peril or set of perils. A peril, such as fire, lightning, wind, a liability judgment, or theft, is simply a source of loss. In theory, the insurer can calculate, largely from past experience, the likelihood that a policyholder in a particular category will experience a loss from a given peril. If this were all that were involved, prices could be set according to expected losses, and insurance could be bought and sold in a market with no further adjustments. Unfortunately, certain conditions, some of which the policyholder controls, modify the probability of loss. In insurance terminology, M O R A L H A Z A R D 2 9 these are hazards, conditions that increase the probability of loss.

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  Bankruptcy

  The Case for Relief in an Economy of Debt

  • Joseph Spooner(Author)
  • 2019(Publication Date)
  • Cambridge University Press

    (Publisher)

  The classic concept of Moral Hazard refers to the ‘tendency for insurance against loss to reduce incentives to prevent or minimise the cost of loss’. 61 Reduced incentives to prevent the loss arising are conceptualised as ex ante Moral Hazard, while ex post Moral Hazard is the theoretical tendency for insurance to reduce incentives to minimise costs of recovering from loss. 62 Applied to personal insolvency law, Moral Hazard concerns firstly arise as to the extent to which the discharge, by relieving the debtor of over-indebtedness, creates incentives (at the ex post stage) for the debtor to enter an insolvency procedure at the first sign of financial difficulty without a true need for debt relief. At the ex ante stage, similar concerns arise regarding debt relief’s tendency to create incentives for consumers to over-borrow in the first place. 63 For neo- classical economic theorists, the law must take serious account of both of these sets of incentives. Behavioural economists and socio-legal research- ers are more concerned only with the ex post incentives, 64 as they argue that assumptions of Moral Hazard theory required to generate ex ante concerns do not hold in consumer over-indebtedness’s empirical reality (see Part 7.5 below). The assumptions of Moral Hazard theory include: 1) Money (the reduction in a debtor’s liability in the case of personal insolvency law) compensates for loss; 2) People are rational economic actors (including rational loss minimisers); 3) Taking care to prevent loss requires effort; 4) Taking care is effective; 5) The insured has control over herself, her property and her financial circumstances; and 60 Personal insolvency policy is but one of many issues which, through insurance theory, ‘can best be understood as an institutional adaptation to the problems of risks and incentives’.

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  Microeconomic Foundations II

  Imperfect Competition, Information, and Strategic Interaction

  • David M. Kreps(Author)
  • 2023(Publication Date)
  • Princeton University Press

    (Publisher)

  Hidden action versus Moral Hazard Economists prefer to avoid value judgments in their professional capacity. 1 Hence, in the economics literature, alternatives to the value-laden term Moral Hazard are sought. Many economists take the position that Bob, responding in a fashion that is personally optimal for himself given the circumstances in which he finds himself, is not acting immorally. If Bob misbehaves, the fault is Alice’s for not structuring Bob’s incentives properly. (This generally doesn’t extend to breaking the law; and Bob breaking a promise that he gave freely is gray-area behavior.) So, in place of Moral Hazard, the term hidden action is used: Bob takes actions that are consequential to Alice but are hidden from her. This term doesn’t quite capture the full dimensions of the general issue. There are cases in which Bob’s actions are not hidden from Alice, but still, Bob’s actions are uncontractible : 2 Alice cannot craft a legally enforceable arrangement that prevents 1 A more accurate statement is that they like to pretend that they avoid value judgments. Notwith- standing any such pretense, the fundamental structure of orthodox economics is based on some fairly controversial value judgments. 2 Economists have a penchant for abusing the English language, turning nouns—Alice signed a con- tract with Bob—into verbs—Alice contracted with Bob—and then manufacturing adjectival forms for the new verbs. According to dictionaries, manifolds are contractible, while diseases are contractable, so economists have a choice between “ible” and “able.” I took a quick survey of colleagues: A majority, but not a strong majority, voted for “ible.” Chapter Nineteen. Moral Hazard and Incentives 37 Bob from certain actions, whether she observes them or not. 3 Bottom line: When you see the terms Moral Hazard and hidden action, they both connote imperfectly the collection of issues and models that are explored in this chapter.

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  Corporate Risk Management

  Theories and Applications

  • Georges Dionne(Author)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  Obviously, entrepreneurs who finance 100% of a project have very strong incentives to maximize the expected profits and to reduce the default probability. In contrast, when a project is financed by third parties with partial guarantees, incentives may be weaker, particularly when the managers' actions are not perfectly observable by creditors. This incentive problem is called ex ante Moral Hazard. Moral Hazard is present when the prevention actions of one party (business, individual, worker, or agent) are not observable by another party associated with the risks of a contract (bank, insurance company, employer, or principal), but may suffer the financial consequences associated with these risks. Moral Hazard is often present in debt contracts, insurance contracts, and in the relationship between the board of a company and the officers. Moral Hazard was present in securitization activities of banks before and during the financial crisis because banks had no incentives to monitor the credit risk of loans, particularly that of mortgage subprime loans (Dionne and Malekan, 2017; Dionne and Harchaoui, 2008; Malekan and Dionne, 2014; Keys et al, 2009, 2010; Keys, Seru, and Vig, 2012; Bubb and Kaufman, 2014).

  In investment projects, the entrepreneur's action or effort may move the revenue frequency to the right, or the revenue distribution function downward. As Figures 10.1 and 10.2 illustrate, the agent increases the expected value of revenues by exerting more effort, which can be represented by instead of .

  FIGURE 10.1

  Movement of revenue frequency to the right by making more effort (e) to obtain higher expected revenues conditional on higher effort.

  FIGURE 10.2

  Downward movement of the revenue distribution function by making more effort (e).

  The lender's problem is to write a loan contract that maximizes the entrepreneur's incentive to make the greatest effort. This is because if the project or the business fails, both parties will lose.

  We are not addressing the question of collateral although it is very important. In general, for commercial loans, the collateral requested may reach a large percentage of the loan amount. It is clear that when the collateral is 100%, the problem of incentives no longer arises. But incentives are generally less than those under full information with a lower collateral under Moral Hazard.

  10.1 OPTIMAL FINANCIAL CONTRACTS AND Moral Hazard

  Suppose that the stakeholders are risk neutral. We are interested in financial contracts in the presence of information asymmetry. The agent (borrower) may influence the result of the project by actions that cannot be observed by the principal (lender). A more detailed description of the contracts studied is presented in Appendix A

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  Moral Hazard

  A Financial, Legal, and Economic Perspective

  • Juan Flores Zendejas, Norbert Gaillard, Rick Michalek, Juan Flores Zendejas, Norbert Gaillard, Rick J. Michalek, Rick Michalek, Juan Flores Zendejas, Norbert Gaillard, Rick J. Michalek(Authors)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  Chapter 9 of this volume).

  Section 6 Conclusion

  This chapter has investigated the moral nature of Moral Hazard. My analysis supports the idea first suggested by Kenneth Arrow that increasing one’s exposure to risk in the face of insurance can be immoral. However, it does so by addressing the important argument made in the ethical literature by Ben Hale: insurance schemes are socially beneficial exactly because they allow people to increase their risks. The way out of this conundrum is to recognize that there is a socially optimal level of risk-taking, which is not the maximal level. When insured persons fail to target their behavior sufficiently closely to this optimal level, they exploit the other members in the insured pool. When doing so, they fail to behave as good fiduciaries toward the others in the pool, thereby disincentivizing reflexive fiduciary behavior from such others.

  This logic can become widespread, as illustrated by the financial crisis. If people start to exploit insurance schemes, such behavior may be infectious, i.e., others may be encouraged to do so too. This raises premiums for all and decreases the viability of the insurance pool itself. In the end, the insurance scheme will collapse. What is needed if we want to maintain insurance for all, especially in public policy contexts, is a strategy of what I have called “internalizing sufficientarianism”, which regulates the behavior of the individual insured persons with the goal of reducing if not eliminating exploitative risk-taking. This will maintain the viability of the insurance pool, without asking others to pay the price.

  Acknowledgment

  I would like to thank Txai de Almeida Brito, Michael Bennett, Huub Brouwer, and Yara al Salman for their feedback and discussion. I thank Norbert Gaillard, Xavier Landes, and Maurits de Jongh for their extensive comments on an earlier draft. This work is part of the research program “Private Property and Political Power”, with project number 360-20-390, which is financed by the Dutch Research Council (NWO).

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  Game Theory and Society

  • Weiying Zhang(Author)
  • 2017(Publication Date)
  • Taylor & Francis

    (Publisher)

  11Moral Hazard and corruption

  The most basic reason corruption occurs is asymmetric information about relevant actions. Theoretical research on asymmetric information of actions is called “principal-agent theory” or Moral Hazard theory.

  In Economics, any relationship where the behavior of one person influences the interests of another person can be called a principal-agent relationship. The person with private information is called the agent, and the person without private information is called the principal.

  There are four causes of the principal-agent issue: (1) A conflict exists between the interest of the principal and the agent; (2) there is asymmetric information and the principal has difficulty observing the agent’s behavior; (3) the agent is risk-averse; or (4) the agent’s capacity for liability is limited.

  Conflicts of interest alone might not be sufficient to cause the principal-agent problem. If the principal can fully observe the agent’s behavior, the agent is risk-neutral, or the agent’s capacity for responsibility is not limited, then the principal-agent problem can also easily be resolved.

  The primary issue in principal-agent theory research is the design of incentive contracts for the agent. Incentive contracts face a dilemma between incentives and insurance. The optimal contract must balance incentives and insurance.

  The optimal intensity of incentives is determined by four factors: (1) The degree output depending on the agent’s effort; (2) the degree of output uncertainty; (3) the degree of the agent’s risk aversion; and (4) the agent’s responsiveness to incentives.

  Comparisons of relative performance improve incentive contracts, but might also lead to agents colluding with or undermining each other.

  The contradiction between performance-based rewards and meritocracy means that incentive methods must be diversified. The “official standard” was actually homogenization of incentives. Not only did it severely distort resource allocation, it also harmed social harmony.

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  Insurable Interest and the Law

  • Franziska Arnold-Dwyer(Author)
  • 2020(Publication Date)
  • Taylor & Francis

    (Publisher)

  The Moral Hazard justification for the doctrine of insurable interest derives from the idea that an insured without any interest would stand to benefit from the destruction of, or damage to, the insured subject-matter without any personal loss or detriment which, in turn, might tempt him to bring about its destruction in order to gain the benefit of insurance. This Chapter examines the criticisms of the Moral Hazard justification drawing on empirical data, doctrinal legal analysis and case studies. In relation to property insurance, it will be argued that the relationship between insurable interest and Moral Hazard can be better understood if insurable interest is seen as a mechanism for aligning the interests of the insured and the insurer in keeping the insured subject-matter safe. The example of the US STOLI schemes highlights that Moral Hazard is a real concern in life insurance.

  Historical background and economic analysis

  In Sadlers’ Company v Badcock Lord Hardwicke summarized the Moral Hazard issue as follows: “…if any person may insure, whether he has property or not, it may be a temptation to burn houses, to receive the benefit of the policy”, and “… the temptation to [destroy ships] has arisen from interest and no interest inserted in policies”.1 Similarly, it was thought that insuring the life of another person in whose life the insured had no interest could lead to the temptation to kill that person.2 From the Preamble of the MIA 1746 it is clear that one of the main mischiefs the Act sought to address was the deliberate destruction of insured ships and cargo by insureds without any interest:

  1 (1743) 2 Atk 554 (Ch) 556.

  2 R Merkin, ‘Gambling by Insurance – A Study of the Life Assurance Act 1774 ’ (1980) 9 Anglo-Am L R 331, 331–333.

  … the making of assurances, interest or no interest, or without further proof of interest than the policy, hath been productive of many pernicious practices, whereby a great number of ships, with their cargoes, have either been fraudulently lost and destroyed …

  (Emphasis added)

  Conversely, by limiting the application of s.1 of the MIA 1746 to British vessels and cargo, Parliament pursued a strategy of encouraging Moral Hazard in relation to foreign vessels: permitting wager policies on foreign vessels would encourage fraud and aggression against enemy ships as it would make such ships, if insured against capture by British subjects, attractive targets for ‘friendly’ British privateers.3

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