Life Insurance Sidesteps Moral Hazards
Thursday, September 4th, 2008
Among the most compelling daily storylines in this financial crisis are the details of the “bailout;” - i.e., who needs (and who will receive) a financial rescue from the Federal government? For politicians and economists, it’s a heated debate as to who is or is not worthy of government assistance. And for some institutions and businesses, receiving immediate financial assistance will be a make-or-break decision.
But even if the specifics don’t directly impact your life, the issues arising from the bailout should provide some interesting financial insight for the individual.
One of the insights is gaining a better understanding the concept of “moral hazard.”
MORAL HAZARD DEFINED
A Moral hazard occurs when a party is insulated from risk, and this “protection” encourages them to behave differently. If an individual or institution can avoid the full consequences of their actions, there is a tendency to act less prudently than they otherwise might. This existence of a moral hazard makes it more likely that negative consequences will result.
MORAL HAZARDS IN THE CURRENT FINANCIAL CRISIS
In regard to current events, the moral hazard issue has surfaced several times. Some commentators have said mortgage lenders over-indulged in risky sub-prime lending because the federal government enabled them to do so by providing assurances that it approved of the efforts to make home ownership more affordable, and was willing to provide some financial back-up in case some sub-prime borrowers defaulted. If this assessment is correct (and many would say it is, particularly in regard to government-sponsored lenders like Fannie Mae and Freddie Mac), the arrangement created a moral hazard. Believing they were covered even if the borrowers defaulted, lenders were more likely to take on bad risks, and more likely to incur losses.
Likewise, Treasury Secretary Henry Paulson has expressed some concern that extending an offer of a government bailout to too many companies would establish a bad precedent. Believing they could always turn to government in case things go awry, businesses in the future might be less diligent in managing their financial affairs.
MORAL HAZARDS ARE EVERYWHERE
Theoretically, there is the presence of a moral hazard in any type of guarantee or insurance. Martha White, writing in a September 19, 2008 Slate article, says “if I
have health insurance, I’m more likely to sky-dive. If I have fire insurance, I’m more likely to burn sandalwood candles in my bedroom.” In the workplace, the guarantee of an hourly wage may create a moral hazard because employees will not work harder than what’s required to hold their position. (”What’s the point in working harder? I’m getting paid the same whether I do five jobs in a day or ten.”)
The presence of moral hazard may also introduce the potential for fraud.
Someone receiving income from a disability insurance claim may be inclined to prolong their disability instead of getting back to work. Both a healthcare provider and a patient may have a motivation to recode a procedure in order to receive insurance reimbursement, as opposed to negotiation a lesser payment from the patient. Because sub-prime lending was profitable (and supposedly risk-free for lenders), there are some indications that verification standards were either loosened or overlooked in order to execute the loans.
USING MORAL HAZARD AS A CRITERIA IN FINANCIAL DECISION-MAKING
For individuals, one of the methods for assessing financial risk might be to determine the moral hazards associated with placing money with a particular institution.
For example, if a mutual fund manager is paid for the size of assets under management, there is certainly an incentive to grow the portfolio by generating higher returns. But this same arrangement also creates an incentive to aggressively market to attract more shareholders; even if the investment results are sub-standard, the manager can earn more money by collecting more deposits. Is this compensation arrangement a moral hazard for existing shareholders? Perhaps, because a manager in down market may decide to focus on attracting new shareholders as opposed to managing the portfolio for the benefit of existing shareholders.
When a mutual fund offers a guarantee that all liquidation requests will be honored immediately, it may force the fund management to sell profitable investments in order to provide the necessary cash. This guarantee of immediate liquidation may create a moral hazard for the remaining shareholders - those who remain invested may now hold shares of lesser value. On a smaller, but much more dramatic scale, this liquidation issue is a major concern for hedge-fund managers and shareholders.
Neither of the above-mentioned issues alone are enough to eliminate mutual funds from consideration as an investment option. But having an idea of the moral hazards associated with a particular investment might be a way to better evaluate the financial risks.
For a long time, mortgage-backed securities were considered a conservative “safe” investment option. However, had more people understood the nature of some of the mortgages lenders were selling to investors, and why these mortgages were initiated, perhaps they would have been evaluated better.
THE UNIQUE STRUCTURE OF CASH VALUE LIFE INSURANCE
Unlike almost any other type of insurance or guarantee, there is minimal moral hazard associated with the establishment of a whole life insurance contract. This is primarily because the guarantees involve life and death - literally.
In general, individuals have a strong motivation to live as long as possible. Likewise, insurance companies have a strong incentive for their policyholders to live as long as possible, because the more premiums they collect before paying a claim, the more profitable they are. Thus, insurance company has a vested interest in correctly evaluating the health of potential policyholders, and encouraging people to live as long as possible.
And while it is not unusual for fraudulent claims to occur with other types of insurance, making a fraudulent death claim is quite difficult. Determining whether someone is alive or dead is a lot more clear-cut than being disabled, or meeting a deductible on an auto accident. Of greater significance, almost no one considers dying “worth it” just to collect the insurance.
But both the insurance company and the individual also know dying is a certainty. In order to collect the insurance benefit, the individual knows he/she must keep the policy in force. The insurance company knows that in order to meet their eventual obligation, they must provide on-going incentives for the policyholder to continue paying premiums. The desires of both parties to sustain the contract are resolved through the cash value features. Over time, policyholders acquire more than an insurance benefit, and the insurance company acquires an on-going stream of capital to weather the fluctuations in claims and market events. This profitability allows the company to charge competitive rates and offer competitive dividends, especially in mutual companies where the policyowners are shareholders.
Considering this alignment of interests and limited exposure to moral hazard, it is no surprise that life insurance companies have, as a group, remained stable and profitable in the midst of a global financial crisis. In his 2006 book Money, Bank Credit, & Economic Cycles, Spanish economist Jesús Huerta de Soto looks at three centuries of capitalism and concludes that life insurance is “a form of perfected savings.” He adds:
“The institution of life insurance has gradually and spontaneously taken shape in the market over the last two hundred years. It is based on a series of technical, actuarial, financial and juridical principles of business behavior which have enabled it to perform its mission perfectly and survive economic crises and recessions which other institutions, especially banking, have been unable to overcome.”
Recent financial events have revealed the potential for great harm when moral hazards are ignored by savers and investors. Among its many intangible benefits, cash value life insurance also presents a limited moral hazard for both policyowners and insurance companies.