# Federal Financial Guarantees: Problems and Solutions

Besides insuring bank and thrift deposits, the federal government guarantees a number of other financial transactions, including farm credits, home mortgages, student loans, small business loans, pensions, and export credits (to name a few).

In order to better understand the problems faced by federal financial guarantee programs, consider the conditions which give rise to a well-functioning private insurance market. In private markets, insurers segregate policyholders with similar exposures to risk into separate risk classifications, or pools. As long as the risks of the policyholders are not significantly correlated (that is, all policyholders do not suffer a loss at the same time), pooling reduces the risk of the average loss through the operation of a statistical principle known as the “law of large numbers”. Consequently, an insurer can cover its costs by charging a premium that is roughly proportional to the average loss. Such a premium is said to be actuarially fair.

By limiting membership in a risk pool to policyholders with similar risk exposures, the tendency of higher risk individuals to seek membership in the pool (commonly referred to as adverse selection) is controlled. This makes participation in a risk pool financially attractive to its members. Although an individual with a high chance of loss must consequently pay a higher premium than someone with a low chance of loss, both will insure if they are averse to risk and premiums are actuarially fair. By charging risk-sensitive premiums and limiting coverage through policy provisions such as deductibles, the tendency of individuals to seek greater exposure to risk once they have become insured (commonly referred to as moral hazard) is also controlled.

In contrast, federal financial guarantees often exaggerate the problems of adverse selection and moral hazard. Premiums are typically based upon the average loss of a risk pool whose members’ risk exposures may vary greatly. This makes participation financially unattractive for low risk members who end up subsidizing high risk members if they remain in the pool. In order to prevent low risk members from leaving, the government’s typical response has been to make participation mandatory. However, various avenues exist by which low risk members can leave “mandatory” risk pools. For example, prior to the reorganization of the Federal Savings and Loan Insurance Corporation (FSLIC) as part of the Federal Deposit Insurance Corporation (FDIC) during the savings and loan crisis of the 1980s and 1990s, a number of low risk thrifts became commercial banks. This change in corporate structure enabled these firms to switch insurance coverage to the FDIC, which at the time charged substantially lower premiums than did the FSLIC. Similarly, terminations of overfunded defined benefit pension plans enable firms to redeploy excess pension assets as well as drop out of the pension insurance pool operated by the Pension Benefit Guarantee Corporation (PBGC).

Although financial restructuring makes it possible to leave mandatory insurance pools, the costs of leaving may be sufficiently high for some low risk firms that they will remain. Unfortunately, the only way risk-insensitive insurance can possibly become a “good deal” for remaining members is by increasing exposure to risk; for example, by increasing the riskiness of investments or financial leverage. Furthermore, this problem is even more severe for high risk members of the pool, especially if they are financially distressed. The owners of these firms are entitled to all of the benefits of risky activities, while the insurance mechanism (in conjunction with limited liability if the firm is incorporated) minimizes the extent to which they must bear costs. Consequently, it is tempting to “go for broke” by making very risky investments which have substantial downside risk as well as potential for upside gain. The costs of this largely insurance-induced moral hazard problem can be staggering, both for the firm and the economy as a whole.

Ultimately, the key to restoring the financial viability of deposit insurance and other similarly troubled federal financial guarantee programs is to institute reforms which engender lower adverse selection and moral hazard costs. Policymakers would do well to consider how private insurers, who cannot rely upon taxpayer-financed bailouts, resolve these problems. The most common private market solution typically involves some combination of risk-sensitive premiums and economically meaningful limits on coverage. Federal financial guarantee programs should be similarly designed so that excessively risky behavior is penalized rather than rewarded.

# On the economics of financial guarantees

On pp. 13-19 of the Derivatives Theory, part 3 lecture note and in Problem Set 9, we study how credit enhancement of risky debt works. Examples of credit enhancement in the real world include federal deposit insurance, public and private bond insurance, pension insurance, mortgage insurance, government loan guarantees, etc.; the list goes on.

Most credit enhancement schemes work in the fashion described below. Creditors loan money to “risky” borrowers who are at risk for defaulting on promised payments. Although borrowers promise to pay back $B at t=1, they may default (in whole or in part) and the shortfall to creditors resembles a put option with t=1 payoff of -Max[0, B-F]. Therefore, without credit enhancement, the value of risky debt at t=0 is $V(D) = B{e^{ - r}} - V(Max[0,B - F]).$ However, when credit risk is intermediated by a guarantor (e.g., an insurance company or government agency), credit risk gets transferred to the guarantor, who receives an upfront “premium” worth $V(Max[0,B - F])$ at t=0 in exchange for having to cover a shortfall of $Max[0,B - F]$ that may occur at t=1. If all credit risk is transferred to the guarantor (as shown in the graphic provided below), then from the creditors’ perspective it is as if the borrowers have issued riskless debt. Therefore, creditors charge borrowers the riskless rate of interest and are paid back what was promised from two sources: 1) borrowers pay $D = B - Max[0,B - F]$, and 2) the guarantor pays $Max[0,B - F]$. # Important insights from portfolio and capital market theory The topics covered during the course of the last couple of Finance 4335 class meetings (portfolio and capital market theory) rank among the most important finance topics; after all, the scientific foundations for these topics won Nobel prizes for Markowitz (portfolio theory) and Sharpe (capital market theory). The following outline pretty much summarizes what we covered in class on Tuesday, March 13 and Thursday, March 15: • Portfolio Theory (covered on Tuesday, March 13) 1. Mean-variance efficiency 2. Portfolio Mean-Variance calculations 3. Minimum variance portfolio (n = 2 case) 4. Efficient frontier (n = 2 case under various correlation assumptions) • Capital Market Theory (covered on Thursday, March 15) 1. Efficient frontiers with multiple number (“large” n) of risky assets (aka the “general” case) 2. Portfolio allocation under the general case • degree of risk aversion/risk tolerance determines how steeply sloped indifference curves are • indifference curves for investors with high (low) degrees of risk tolerance (aversion) are less steeply sloped than indifference curves than for investors with low (high) degrees of risk tolerance (aversion)). • Optimal portfolios (i.e., portfolios that maximize expected utility) occur at points of tangency between indifference curves and efficient frontier. 3. Introduction of a risk-free asset simplifies the portfolio selection problem since the efficient frontier is now a straight line rather than an ellipse in $E({r_p}), {\sigma _p}$ space. The same selection principle holds as in the previous point (point 2); i.e., investors determine optimal portfolios by identifying the tangency between their indifference curves and the efficient frontier. The point of tangency occurs on the capital market line (CML) where the Sharpe ratio is maximized; everyone chooses some combination of the risk-free asset and the market portfolio, and risk tolerance determines whether the point of tangency involves either a lending (low risk tolerance) or borrowing (high risk tolerance) allocation strategy. 4. The security market line (SML), aka the CAPM, is deduced by arbitrage arguments. Specifically, it must be the case that all risk-return trade-offs (as measured by the ratio of “excess” return ($E({r_j}) - {r_f}$) from investing in a risky rather than risk-free asset, divided by the risk taken on by the investor (${\sigma _{j,M}}$) are the same. If not, then there will be excess demand for investments with more favorable risk-return trade-offs and excess supply for investments with less favorable risk-return trade-offs). “Equilibrium” occurs when markets clear; i.e., when there is neither excess demand or supply, which is characterized by risk-return ratios being the same for all possible investments. When this occurs, then the CAPM obtains: $E({r_j}) = {r_f} + {\beta _j}(E({r_M}) - {r_f})$. # How differences in correlation produce different minimum variance portfolio weightings Linked below, please find a spreadsheet which showcases how differences in correlation between two risky assets result in different minimum variance portfolio weightings. While we manually performed a similar analysis on the whiteboard in class yesterday, it is also helpful to see this analysis modeled in Excel. Besides determining minimum variance portfolio weightings under different correlation assumptions, the spreadsheet also calculates expected portfolio returns and risks. Furthermore, it decomposes portfolio risks into their component parts – risks related to the variances of the assets which comprise the portfolio, as well as risks which originate from covariance. 4335 mvp.xlsx # A (non-technical) Summary of Portfolio and Capital Market Theory During tomorrow’s Finance 4335 class meeting, I expect to complete our discussion of portfolio and capital market theory. The portfolio theory topic (introduced during yesterday’s class meeting) won Professor Harry Markowitz the Nobel Prize in Economics in 1990, and Professor William F. Sharpe shared the 1990 Nobel Prize with Markowitz for his work on capital market theory (tomorrow’s topic). One of the better non-technical summaries of portfolio theory and capital market theory that I am aware of appears as part of an October 16, 1990 press release put out by The Royal Swedish Academy of Sciences in commemoration of the prizes won by Markowitz and Sharpe (see http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1990/press.html). I have included an appropriately edited version of that press release below (it is important to also note that University of Chicago Finance Professor Merton Miller was cited that same year along with Markowitz and Sharpe for his work on the theory of corporate finance; I include below only the sections of the Royal Swedish Academy press release pertaining to the work by Messrs. Markowitz and Sharpe on the topics of portfolio and capital market theory): ========================== Financial markets serve a key purpose in a modern market economy by allocating productive resources among various areas of production. It is to a large extent through financial markets that saving in different sectors of the economy is transferred to firms for investments in buildings and machines. Financial markets also reflect firms’ expected prospects and risks, which implies that risks can be spread and that savers and investors can acquire valuable information for their investment decisions. The first pioneering contribution in the field of financial economics was made in the 1950s by Harry Markowitz who developed a theory for households’ and firms’ allocation of financial assets under uncertainty, the so-called theory of portfolio choice. This theory analyzes how wealth can be optimally invested in assets which differ in regard to their expected return and risk, and thereby also how risks can be reduced. A second significant contribution to the theory of financial economics occurred during the 1960s when a number of researchers, among whom William Sharpe was the leading figure, used Markowitz’s portfolio theory as a basis for developing a theory of price formation for financial assets, the so-called Capital Asset Pricing Model, or CAPM. Harrv M. Markowitz The contribution for which Harry Markowitz now receives his award was first published in an essay entitled “Portfolio Selection” (1952), and later, more extensively, in his book, Portfolio Selection: Efficient Diversification (1959). The so-called theory of portfolio selection that was developed in this early work was originally a normative theory for investment managers, i.e., a theory for optimal investment of wealth in assets which differ in regard to their expected return and risk. On a general level, of course, investment managers and academic economists have long been aware of the necessity of taking returns as well as risk into account: “all the eggs should not be placed in the same basket”. Markowitz’s primary contribution consisted of developing a rigorously formulated, operational theory for portfolio selection under uncertainty – a theory which evolved into a foundation for further research in financial economics. Markowitz showed that under certain given conditions, an investor’s portfolio choice can be reduced to balancing two dimensions, i.e., the expected return on the portfolio and its variance. Due to the possibility of reducing risk through diversification, the risk of the portfolio, measured as its variance, will depend not only on the individual variances of the return on different assets, but also on the pairwise covariances of all assets. Hence, the essential aspect pertaining to the risk of an asset is not the risk of each asset in isolation, but the contribution of each asset to the risk of the aggregate portfolio. However, the “law of large numbers” is not wholly applicable to the diversification of risks in portfolio choice because the returns on different assets are correlated in practice. Thus, in general, risk cannot be totally eliminated, regardless of how many types of securities are represented in a portfolio. In this way, the complicated and multidimensional problem of portfolio choice with respect to a large number of different assets, each with varying properties, is reduced to a conceptually simple two-dimensional problem – known as mean-variance analysis. In an essay in 1956, Markowitz also showed how the problem of actually calculating the optimal portfolio could be solved. (In technical terms, this means that the analysis is formulated as a quadratic programming problem; the building blocks are a quadratic utility function, expected returns on the different assets, the variance and covariance of the assets and the investor’s budget restrictions.) The model has won wide acclaim due to its algebraic simplicity and suitability for empirical applications. Generally speaking, Markowitz’s work on portfolio theory may be regarded as having established financial micro analysis as a respectable research area in economic analysis. William F. Sharpe With the formulation of the so-called Capital Asset Pricing Model, or CAPM, which used Markowitz’s model as a “positive” (explanatory) theory, the step was taken from micro analysis to market analysis of price formation for financial assets. In the mid-1960s, several researchers – independently of one another – contributed to this development. William Sharpe’s pioneering achievement in this field was contained in his essay entitled, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk (1964). The basis of the CAPM is that an individual investor can choose exposure to risk through a combination of lending-borrowing and a suitably composed (optimal) portfolio of risky securities. According to the CAPM, the composition of this optimal risk portfolio depends on the investor’s assessment of the future prospects of different securities, and not on the investors’ own attitudes towards risk. The latter is reflected solely in the choice of a combination of a risk portfolio and risk-free investment (for instance treasury bills) or borrowing. In the case of an investor who does not have any special information, i.e., better information than other investors, there is no reason to hold a different portfolio of shares than other investors, i.e., a so-called market portfolio of shares. What is known as the “beta value” of a specific share indicates its marginal contribution to the risk of the entire market portfolio of risky securities. Shares with a beta coefficient greater than 1 have an above-average effect on the risk of the aggregate portfolio, whereas shares with a beta coefficient of less than 1 have a lower than average effect on the risk of the aggregate portfolio. According to the CAPM, in an efficient capital market, the risk premium and thus also the expected return on an asset, will vary in direct proportion to the beta value. These relations are generated by equilibrium price formation on efficient capital markets. An important result is that the expected return on an asset is determined by the beta coefficient on the asset, which also measures the covariance between the return on the asset and the return on the market portfolio. The CAPM shows that risks can be shifted to the capital market, where risks can be bought, sold and evaluated. In this way, the prices of risky assets are adjusted so that portfolio decisions become consistent. The CAPM is considered the backbone of modern price theory for financial markets. It is also widely used in empirical analysis, so that the abundance of financial statistical data can be utilized systematically and efficiently. Moreover, the model is applied extensively in practical research and has thus become an important basis for decision-making in different areas. This is related to the fact that such studies require information about firms’ costs of capital, where the risk premium is an essential component. Risk premiums which are specific to an industry can thus be determined using information on the beta value of the industry in question. Important examples of areas where the CAPM and its beta coefficients are used routinely, include calculations of costs of capital associated with investment and takeover decisions (in order to arrive at a discount factor); estimates of costs of capital as a basis for pricing in regulated public utilities; and judicial inquiries related to court decisions regarding compensation to expropriated firms whose shares are not listed on the stock market. The CAPM is also applied in comparative analyses of the success of different investors. Along with Markowitz’ portfolio model, the CAPM has also become the framework in textbooks on financial economics throughout the world. # Rothschild-Stiglitz Numerical Example In class last Thursday, while I explained the logic behind the so-called Rothschild-Stiglitz model (also presented in the last couple of paragraphs of my “Adverse Selection – a definition, some examples, and some solutions” posting and in pp. 22-23 of my “Moral Hazard and Adverse Selection” lecture note), I didn’t quite get around to providing a numerical example, so here it is. Suppose that insurance clients are identical in all respects except for accident risks. Specifically, all such clients have initial wealth of$125, U(W) = W^.5 (i.e., square root utility), and exposed to a loss of $100 when an accident occurs. There are only two possible states – accident and no accident. However, some clients are high risk (i.e., probability of accident is p(h) = .75, whereas other clients are low risk; i.e., p(l) = .25. The insurer’s problem is that he/she cannot determine which clients are high risk and which clients are low risk; consequently, the insurer decides to implement the Rothschild-Stiglitz model so as to induce self selection by clients. Specifically, a high risk contract called Policy A is offered which provides 100% coverage for$75, and a low risk contract called Policy B is offered which provides 10% coverage for $2.50. The following spreadsheet shows that high risk clients will self-select into Policy A, thus earning 0 profit for the insurer, whereas low risk clients will self-select into Policy B, thus earning 0 profit for the insurer: Here, note that high risk and low risk clients prefer policies A and B respectively. Certainly the insurer would like for low risk clients to select Policy A (since this would provide profit to the insurer of$50 per client), but low risk clients rationally select Policy B since it maximizes their expected utilities.  Of course, the objective here is to make sure that Policy B is not attractive to high risk clients by limiting the level of coverage offered under this contract, and indeed, Policy A (which offers 100% coverage at a price that is actuarially fair to high risk clients) is preferred.  Since Policy B offers 10% coverage at a price that is actuarially fair to low risk clients, this high risk clients prefer Policy A; however, if the coinsurance rate on Policy B were, say, 20%, then high risk clients would prefer Policy B and there would be adverse selection (involving a per policy loss due to high risk clients opting into Policy B) of $10 per high risk client. # Adverse Selection – a definition, some examples, and some solutions During yesterday’s Finance 4335 class meeting, I introduced the topic of adverse selection, and we’ll devote tomorrow’s class to further discussion of this topic. Adverse selection is often referred to as the “hidden information” problem. This concept is particularly easy to understand in an insurance market setting; if you are an insurer, you have to be concerned that the worst possible risks are the ones that want to purchase insurance. However, it is important to note that adverse selection occurs in many market settings other than insurance markets. Adverse selection occurs whenever one party to a contract has superior information compared with his or her counter-party. When this occurs, often the party with the information advantage is tempted to take advantage of the uninformed party. In an insurance setting, adverse selection is an issue whenever insurers know less about the actual risk characteristics of their policyholders than the policyholders themselves. In lending markets, banks have limited information about their clients’ willingness and ability to pay back on their loan commitments. In the used car market, the seller of a used car has more information about the car that is for sale than potential buyers. In the labor market, employers typically know less than the worker does about his or her abilities. In product markets, the product’s manufacturer often knows more about product failure rates than the consumer, and so forth… The problem with adverse selection is that if left unchecked, it can undermine the ability of firms and consumers to enter into contractual relationships, and in extreme cases, may even give rise to so-called market failures. For example, in the used car market, since the seller has more information than the buyer about the condition of the vehicle, the buyer cannot help but be naturally suspicious concerning product quality. Consequently, he or she may not be willing to pay as much for the car as it is worth (assuming that it is not a “lemon”). Similarly, insurers may be reticent about selling policies to bad risks, banks may be worried about loaning money to poor credit risks, employers may be concerned about hiring poor quality workers, consumers may be worried about buying poor quality products, and so on… A number of different strategies exist for mitigating adverse selection. In financial services markets, risk classification represents an important strategy. The reason insurers and banks want to know your credit score is because consumers with bad credit not only often lack the willingness and ability to pay their debts, but they also tend to have more accidents than consumers with good credit. Signaling is used in various settings; for example, one solution to the “lemons” problem in the market for used cars is for the seller to “signal” by providing credible third party certification; e.g., by paying for Carfax reports or vehicle inspections by an independent third party. Students “signal” their quality by selecting a high-quality university (e.g., like Baylor! :-)). Here the university provides potential employers with credible third-party certification concerning the quality of human capital. In product markets, if a manufacturer provides a long-term warranty, this may indicate that quality is better than average. Sometimes it’s not possible to fully mitigate adverse selection via the methods described above. Thus, insurers commonly employ pricing and contract design strategies which incentivize policyholders to reveal their actual risk characteristics according to their contract choices. Thus, we obtain what’s commonly referred to as a “separating” (Rothschild-Stiglitz) equilibrium in which high-risk insureds select full coverage “high-risk” contracts whereas low-risk insureds select partial coverage “low risk” contracts: The Rothschild-Stiglitz equilibrium cleverly restricts the menu of available choices in such a way that the insurer induces self-selection. Here, the insurer offers contract L, which involves partial coverage at an actuarially fair price (based upon the loss probability of the low risk insured), and contract H, which provides full coverage at an actuarially fair price (based upon the loss probability of the high risk insured). The differences in the shapes of the indifference curves are due to the different accident probabilities, with a lower accident probability resulting in a more steeply sloped indifference curve. Here, the high-risk policyholder optimally chooses contract H and the low-risk policyholder optimally chooses contract L. The high-risk policyholder prefers H to L because L would represent a point of intersection with a marginally lower indifference curve (here, the Ih curve lies slightly above contract L, which implies that contract H provides the high-risk policyholder with higher expected utility than contract L). The low-risk policyholder will prefer L, but would prefer a full coverage contract at the point of intersection of APl line with the full insurance (45 degrees) line. However, such a contract is not offered since both the low and high-risk policyholders would choose it, and this would cause the insurer to lose money. Thus, one of the inefficiencies related to adverse selection is that insurance opportunities available to low-risk policyholders are limited compared with the world where there is no adverse selection. There is a very practical implication of this model. If you are a good risk, then you owe it to yourself to select high-deductible insurance, since insurers price low-deductible insurance with the expectation that high-risk policyholders will be the primary purchasers of such coverage (and therefore, low-deductible policies will be more costly per dollar of coverage than high-deductible policies. # Analytic and Numerical Proofs of the Bernoulli Principle and Mossin’s Theorem Last week, we discussed two particularly important insurance economics concepts: 1) the Bernoulli Principle, and 2) Mossin’s Theorem. The Bernoulli Principle states that if an actuarially fair full coverage insurance policy is offered, then an arbitrarily risk averse individual will purchase it, and Mossin’s Theorem states that if insurance is actuarially unfair, then an arbitrarily risk averse individual will prefer partial insurance coverage over full insurance coverage. The Bernoulli Principle is graphically illustrated in the following figure (taken from p. 4 in the Insurance Economics lecture note): Here, the consumer has initial wealth of$120 and there is a 25% chance that a fire will occur which (in the absence of insurance) will reduce her wealth from $120 to$20. The expected loss is E(L) = .25(100) = $25, which is the actuarially fair price for a full coverage insurance policy. Thus if she remained uninsured, she would have E(W) = .25(20) + .75(120) =$95, and her utility would be EU. Note that the (95, EU) wealth/utility pair corresponds to point C in the figure above. Now suppose the consumer purchases an actuarially fair full coverage insurance policy. Since she is fully insured, she is no longer exposed to any risk; her net worth is $95 irrespective of whether the loss occurs, her utility is U(95), and her wealth/utility pair is located at point D in the figure above. Since U(95) > EU, she will fully insure. More generally, since this decision is optimal for an arbitrarily risk averse consumer, it is also optimal for all risk averse consumers, irrespective of the degree to which they are risk averse. Next, we introduced coinsurance. A coinsurance contract calls for proportional risk sharing between the consumer and the insurer. The consumer selects a coinsurance rate $\alpha$, where $\alpha$ represents the proportion of loss covered by the insurer. By definition, $\alpha$ is bounded from below at 0 and from above at 1. Thus, if the consumer selects $\alpha$ = 0, this means that she does not purchase any insurance (i.e., she self-insures). If she selects $\alpha$ = 1, this implies that she obtains full coverage. Furthermore, the price of a coinsurance contract is equal to the price of a full coverage insurance contract (P) multiplied by $\alpha$. On pp. 6-7 of the Insurance Economics lecture note, I analytically (via the calculus) confirm the Bernoulli principle by showing that if the consumer’s utility is U = W.5 and insurance is actuarially fair, then the value for $\alpha$ which maximizes expected utility is $\alpha$ = 1. An Excel spreadsheet called the “Bernoulli and Mossin Spreadsheet” is available from the course website which enables students to work this same problem using Solver. I recommend that you download this spreadsheet and use Solver in order to validate the results for a premium loading percentage (β) equal to 0 (which implies a full coverage (actuarially fair) premium P = E(L)(1+β) =$25 x (1+0) = $25) and β = 0.6 (which implies an actuarially unfair premium of$40, the analytic solution for which is presented on p. 8 in the Insurance Economics lecture note).

Let’s use Solver to determine what the optimal coinsurance rate ($\alpha$) is for U = W.5 when β = 0 (i.e., when insurance is actuarially fair and full coverage can be purchased for the actuarially fair premium of $25). To do this, open up the Bernoulli and Mossin Spreadsheet and invoke Solver by selecting “Data – Solver”; here’s how your screen will look at this point: This spreadsheet is based upon the so-called “power utility” function U = Wn, where is 0 < n < 1. Since we are interested in determining the optimal coinsurance rate for a consumer with U = W.5, we set cell B2 (labeled “exponent value”) equal to 0.500. With no insurance coverage (i.e., when $\alpha$ = 0) , we find that E(W) =$95 and E(U(W)) = 9.334. Furthermore, the standard deviation (σ) of wealth is $43.30. This makes sense since the only source of risk in the model is the risk related to the potentially insurable loss. Since we are interested in finding the value for $\alpha$ which maximizes E(U(W)), Solver’s “Set Objective” field must be set to cell B1 (which is a cell in which the calculated value for E(U(W)) gets stored) and Solver’s “By Changing Variable Cells” field must be set to cell B3 (which is the cell in which the coinsurance rate $\alpha$ gets stored). Since insurance is actuarially fair (β = 0 in cell B4), the Bernoulli Principle implies that the optimal value for $\alpha$ is 1.0. You can confirm this by clicking on Solver’s “Solve” button: Not only is $\alpha$ = 1.0, but we also find that E(W) =$95, σ = 0 and E(U(W)) = 9.75. Utility is higher because this risk averse individual receives the same expected value of wealth as before ($95) without having to bear any risk (since σ = 0 when $\alpha$ = 1.0). Next, let’s determine what the optimal coinsurance rate ($\alpha$) is for U = W.5 when β = 0.60 (i.e., when insurance is actuarially unfair). As noted earlier, this implies that the insurance premium for a full coverage policy is$25(1.60) = $40. Furthermore, the insurance premium for partial coverage is$ $\alpha$40. Reset $\alpha$ ’s value in cell B3 back to 0, β’s value in cell B4 equal to 0.60, and invoke Solver once again:

On p. 8 in the Insurance Economics lecture note, we showed analytically that the optimal coinsurance rate is 1/7, and this value for $\alpha$ is indicated by clicking on the “Solve” button:

Since $\alpha$ = 1/7, this implies that the insurance premium is (1/7)40 = $5.71 and the uninsured loss in the Fire state is (6/7)(100) =$85.71. Thus in the Fire state, state contingent wealth is equal to initial wealth of $120 minus$5.71 for the insurance premium minus for $85.71 for the uninsured loss, or$28.57, and in the No Fire state, state contingent wealth is equal to initial wealth of $120 minus$5.71 for the insurance premium, or \$114.29. Since insurance has become very expensive, this diminishes the benefit of insurance in a utility sense, so in this case only a very limited amount of coverage is demanded. Note that E(U(W)) = 9.354 compared with E(U(W)) = 9.334 if no insurance is purchased (as an exercise, try increasing β to 100%; you’ll find in that case that no insurance is demanded (i.e., $\alpha$ = 0).

I highly recommend that students conduct sensitivity analysis by making the consumer poorer or richer (by reducing or increasing cell B5 from its initial value of 120) and more or less risk averse (by lowering or increasing cell B2 from its initial value of 0.500). Other obvious candidates for sensitivity analysis include changing the probability of Fire (note: I have coded the spreadsheet so that any changes in the probability of Fire are also automatically reflected by corresponding changes in the probability of No Fire) as well as experimenting with changes in loss severity (by changing cell C8).

# Moral Hazard

During tomorrow’s class meeting, we will discuss the concept of moral hazard. In finance, the moral hazard problem is commonly referred to as the “agency” problem. Many, if not most real-world contracts involve two parties – a “principal” and an “agent”. Contracts formed by principals and agents also usually have two key features: 1) the principal delegates some decision-making authority to the agent and 2) the principal and agent decide upon the extent to which they share risk.

The principal has good reason to be concerned whether the agent is likely to take actions that may not be in her best interests. Consequently, the principal has strong incentives to monitor the agent’s actions. However, since it is costly to closely monitor and enforce contracts, some actions can be “hidden” from the principal in the sense that she is not willing to expend the resources necessary to discover them since the costs of discovery may exceed the benefits of obtaining this information. Thus moral hazard is often described as a problem of “hidden action”.

Since it is not economically feasible to perfectly monitor all of the agent’s actions, the principal needs to be concerned about whether the agent’s incentives line up, or are compatible with the principal’s objectives. This concern quickly becomes reflected in the contract terms defining the formal relationship between the principal and the agent. A contract is said to be incentive compatible if it causes principal and agent incentives to coincide. In other words, actions taken by the agent usually also benefit the principal. In practice, contracts typically scale agent compensation to the benefit received by the principal. Thus in insurance markets, insurers are not willing to offer full coverage contracts; instead, they offer partial insurance coverage which exposes policyholders to some of the risk that they wish to transfer. In turn, partial coverage reinforces incentives for policyholders to prevent/mitigate loss.

Similarly, in a completely different setting, consider the principal/agent relationship which exists between the owner and manager of a business.  If the manager’s effort level is high, then the owner may earn higher profits compared with when the manager’s effort level is low.  However, if managerial pay consists of a fixed salary and lacks any form of incentive compensation (e.g., bonuses based upon meeting or beating specific earning targets), then the manager may be inclined to not exert extra effort, which results in less corporate profit.   Thus, compensation contracts can be made more incentive compatible by including performance-based pay in addition to a fixed salary.  This way,  the owner and manager are both better off because incentives are better aligned.

# On the Determinants of Risk Aversion

Four years ago, The Economist published a particularly interesting article about the determinants of risk aversion, entitled “Risk off: Why some people are more cautious with their finances than others”. Here are some key takeaways from this article:

1. Economists have long known that people are risk-averse; yet the willingness to run risks varies enormously among individuals and over time.

2. Genetics explains a third of the difference in risk-taking; e.g., a Swedish study of twins finds that identical twins had “… a closer propensity to invest in shares” than fraternal ones.

3. Upbringing, environment and experience also matter; e.g., . “…the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons”.

4. People’s financial history has a strong impact on their taste for risk; e.g., “… people who experienced high (low) returns on the stock market earlier in life were, years later, likelier to report a higher (lower) tolerance for risk, to own (not own) shares and to invest a bigger (smaller) slice of their assets in shares.”

5. “Exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses.” Furthermore, a low tolerance for risk is linked to past emotional trauma.