Moral Hazard - The true cost of being immoral

Moral hazard is one of the most intriguing concepts in the field of behavioural economics and risk management. Though the term was coined almost three centuries ago when it was predominantly studied in the context of the insurance sector, through the course of time we have applied this theory to various other sectors also. The popularity of the theory must be credited to its explanation of the contradictory behaviour of humans. The theory illustrates that an individual increases his exposure to risk when he is insured. For example, a product is handled more aggressively during its warranty period than when such a period expires, or that a driver is less cautious while driving an insured car than one without insurance. It goes to explain how we, in a way have the incentive to increase our exposure to risk when we do not have to bear the full cost of the consequence of such risk.

This behaviour is pervasive and can be seen both at micro and macro levels. While the examples at the micro-level are innumerable, the government bailout during the 2008 financial crisis is a classic example of moral hazard that the U.S government faced at a macro level. In the Indian context, the Yes Bank bailout by PSU posed a significant moral hazard to the government coupled with increasing NPAs in the industry. Moral Hazard was also a strong argument put forth by economists who opposed the idea of bailing out IL&FS through LIC.

However today I confine my views to the other part of the equation and analyse the transaction from the other end. While theoretically, a moral hazard to one party may look like a clear gain to the other party, and businesses in the shoes of the other party may take it as an incentive to increase their risk exposure (i.e., behave immorally in our context), nevertheless in a practical sense it is not such a simple and straightforward rule. In commercial contracts, the cost of primary consequences of risk is often transferred, however, the cost of ancillary consequences is often retained within the business. Managers who fail to consider the secondary consequences, inadvertently subscribe to risks that are outside their risk appetite. Listed below are some of the major risks that a business retains despite the transfer of the cost of primary impact or consequence. 

Compliance Risk

Compliance risk is the risk of incurring legal and financial penalties or prosecution that may arise on account of failure to comply with laws and regulations of the land. For example, a business may have active insurance in place that covers employee hospitalisation costs and other costs in case of accidents, which seem to make the business owners immune against factory accidents. However, the business should not stop investing in occupational health and safety controls as, despite active insurance, regulators may hold business owners responsible for negligent business practices.

Operational Risk

Operational Risk refers to the risk incurred on account of failed processes, systems, or people. For example, AMCs (annual maintenance contract) have become a standard norm in manufacturing industries that deploy sophisticated machinery. AMCs usually cover preventive as well as break-down maintenance. However, the business should not stop investing in a workmen training program that educates workmen with respect to machine handling and minor maintenance, as the business has only transferred the cost of repairs and not the cost incurred on account of line disruptions which is significantly high in comparison to just the repair cost.

Liquidity Risk

Liquidity risk is the risk that the business may not be able to meet its current obligations. For example, in case of a natural calamity, with the insurance claims piling up, the insurer may take significant time to approve and settle insurance claims. In such cases, an extended lead time may expose the organisation to liquidity risk.

Business Continuity Risk

Business continuity risk is the risk that certain factors or events such as fires, floods, civil war, etc., may affect business operations to an extent that significant questions may be raised on the very existence of the business itself. For example, businesses often get insurance against fire in order to transfer the cost of assets damage to the insurer, however, the business should continue investing in fire-fighting and fire safety equipment and regularly conduct fire drills with its employees, as the business has only transferred the cost of the asset and in a rare case, the revenue damage to the business, but fire accidents at a large scale may significantly increase the business continuity risk of the organisation.

Reputation Risk

Reputation Risk is the risk of events and transactions that may incur negative publicity for the organisation and may affect the company’s reputation or brand value. In all the above examples it can be seen that such events may raise questions on the business as a reliable participant in the supply chain which can largely affect a company’s reputation.

If one is still not satisfied, then he must ask himself whether is it justified to handle a mobile phone aggressively just because it has a protective case on it. To summarise, exploiting the benefits of information asymmetry and creating a moral hazard to the other party is like trying to cross the ocean just because u have a rowboat at hand, it is therefore important that the business ensures that it also has a ship and that it uses the rowboat only to complement its goal.

Author,

Manish Solanky