Case studies of how (poorly designed) insurance creates moral hazard

In my moral hazard lecture, I discuss how contract designs and pricing strategies can “fix” the moral hazard that insurance might otherwise create. Insurance is socially valuable if it enables firms and individuals to manage properly the risks that they face. However, insurance can also have a potential “dark side.” The dark side is that too much insurance and/or incorrectly priced insurance can create moral hazard by insulating firms and individuals from the financial consequences of their decision-making. Thus, in real-world insurance markets, we commonly observe partial rather than full insurance coverage. Partial insurance ensures that policyholders have incentives to mitigate risk. Real-world insurance markets are characterized by pricing strategies such as loss-sensitive premiums (commonly referred to as “experience-rated” premiums), and premiums that are contingent upon the extent to which policyholders invest in safety.

In competitively structured private insurance markets, we expect that the market price for insurance will (on average) be greater than or equal to its actuarially fair value. Under normal circumstances, one does not expect to observe negative premium loadings in the real world. Negative premium loadings are incompatible with the survival of a private insurance market since this would imply that insurers cannot cover capital costs and would, therefore, have incentives not to supply such a market.

This brings us to the National Flood Insurance Program (NFIP). The NFIP is a federal government insurance program managed by the Federal Emergency Management Agency (also known as “FEMA”). According to Cato senior fellow Doug Bandow’s (admittedly dated, but still quite accurate) blog posting entitled “Congress against Budget Reform: Voting to Hike Subsidies for People Who Build in Flood Plains”,

“… the federal government keeps insurance premiums low for people who choose to build where they otherwise wouldn’t. The Congressional Research Service figured that the government charges about one-third of the market rate for flood insurance. The second cost is environmental: Washington essentially pays participants to build on environmentally fragile lands that tend to flood.”

Thus, the NFIP provides a fascinating case study concerning how subsidized flood insurance exacerbates rather than mitigates moral hazard. It does this by encouraging property owners to take risks (in this case, building on environmentally fragile lands with high flood risk) which they otherwise would not be inclined to take if they had to pay the full expected cost of such risks.

There are many other examples of moral hazard created by insurance subsidies. Consider the case of crop insurance provided to farmers by the U.S. Department of Agriculture. The effective premium loading on federally provided crop insurance is typically quite negative (often -60% or more), thus putting crop insurance on a similar footing to flood insurance in terms of cost compared with actuarially fair value. Just as mis-priced flood insurance effectively encourages property owners to build in floodplains, mis-priced crop insurance motivates farmers to cultivate acreage which may not even be all that fertile.

I could go on (probably for several hundred more pages–there are many other egregious examples which I could cite), but I think I will stop for now…

Moral Hazard Class Problem and Solution

The “Moral Hazard Lecture–March 9, 2021” video features a class problem that carefully examines how to go about designing a so-called “incentive-compatible” contract between a corporate owner (the principal) and manager (the agent). The key insight is that moral hazard can be mitigated by ensuring that both the principal and the agent have “skin in the game”.  In this class problem, this is accomplished by offering the corporate manager an incentive compensation scheme involving a cut in salary that is supplemented by a bonus if certain profit targets are met.

The class problem is available at http://risk.garven.com/wp-content/uploads/2020/10/Moral-Hazard-Class-Problem.pdf, and its solution is available at http://fin4335.garven.com/spring2021/moralhazardsolutions.pdf.

The Next Topic in Finance 4335: Moral Hazard

The next two lectures in Finance 4335 are devoted to the discussion of two important problems related to asymmetric informationmoral hazard and adverse selection.

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 risks 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 earnings 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.

Important announcement: Asynchronous delivery of the Moral Hazard lecture scheduled for tomorrow

Finance 4335 (Risk Management) will not meet synchronously tomorrow, March 9, on Zoom. Furthermore, I have rescheduled tomorrow’s 3:30-4:30 pm CT office hour for 3:30-4:30 pm today (Monday, March 8).  We will resume meeting synchronously on Thursday, March 11.

A pre-recorded version of the Moral Hazard lecture (labeled “Moral Hazard Lecture – March 9, 2021”) is available for viewing in the Media Gallery on Canvas.  Although we will not meet synchronously for class tomorrow, attendance credit will be assessed on the basis of whether students view the Moral Hazard lecture in its entirety at any time prior to 11:59 pm CT on Wednesday, March 10.

I will look forward to seeing everyone in the class this coming Thursday at the regularly scheduled (2-3:15 pm CT) time on Zoom, at which time we will delve into the topic of adverse selection.

Grading policy pertaining to the use of Excel spreadsheet templates

As tempting as it might be to knock off the answers for part E of Problem Set 5 by performing a handful of minor edits on the Coinsurance, Deductibles, and Upper Limits Spreadsheet (such as I did for the Insurance Economics Class Problem earlier today), let me remind you about my policy concerning the use of Excel for problem sets and exams.

In Finance 4335, I assign grades solely on how well you explain and support the answers you provide in the PDF documents which you upload to Canvas. In order to earn credit, I expect students to show their work by providing logical explanations of how they get their answers, using properly formed English grammar, coupled with references to the appropriate theoretical concepts.  While I am fine with using spreadsheet templates such as the one referenced here to validate your answers, I do not accept spreadsheets for credit in lieu of well-written, coherent explanations of solutions for the problems that appear on problem sets or exams.

A (potentially) productive use of (thoroughly vetted) spreadsheets such as the ones that I post to the course website would be to study the logical structure of the coding; this can help clarify course-related concepts.

Midterm 1 and Current Course Grades in Finance 4335

I just uploaded the midterm 1 grades, along with attendance, quiz, problem set, and current Finance 4335 course grades to Canvas.

As stated in the course syllabus, final numeric course grades will be determined according to the following equation:

Final Course Numeric Grade =.10(Attendance and Participation) +.10(Quizzes) +.20(Problem Sets) + Max{.20(Midterm Exam 1) +.20(Midterm Exam 2) +.20(Final Exam),.20(Midterm Exam 1) +.40(Final Exam),.20(Midterm Exam 2) +.40(Final Exam)}

As I noted in my February 1st blog posting entitled “Finance 4335 Grades on Canvas”, as the spring semester progresses and I continue to collect grades in the attendance, quiz, problem set, and exam categories, then the course grade listed on Canvas will dynamically incorporate that information on a timely basis for each student; now that we have Midterm 1 Exam grades, the equation that I am now using (until Midterm 2) is as follows:

Course Numeric Grade after Midterm 1 = (.10(Attendance and Participation) +.10(Quizzes) +.20(Problem Sets) +.20(Midterm 1))/.6

There are n = 33 students enrolled in Finance 4335. Here are the current grade statistics:

As you can see from this table, over 50% of students have the mean or higher in each category (since in all cases, the median is higher than the mean). I base the GPA calculation on comparing each student’s current course grade to the course letter grade schedule that also appears on the syllabus:

If you are disappointed by your performance so far in Finance 4335, keep in mind that the final exam grade automatically double counts in place of a lower midterm exam grade. In case if both midterm exam grades are lower than the final exam grade, then the final exam grade replaces the lower of the two midterm exam grades. If any of you would like to have a chat with me about your grades, by all means, then set up a Zoom appointment with me.

Stanford study into “Zoom Fatigue” explains why video chats are so tiring

Fascinating article on the science of so-called “Zoom Fatigue”…
A new study from Stanford University communications expert Jeremy Bailenson is investigating the very modern phenomenon of “Zoom Fatigue.” Bailenson suggests there are four key factors that make videoconferencing so uniquely tiring, and he recommends some simple solutions to reduce exhaustion.