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Life Insurance Sidesteps Moral Hazards
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 Hazard 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 substandard, 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.
Following the GRA trail:
From 401(k) to…?
It was a short sentence buried in the middle of a small
article in an inside section of the November 3, 2008, Wall
Street Journal:
“Some experts are already calling the 401(k) a failed
experiment.”
The article, Financial Crisis Highlights Shortcomings
of 401(k) Plans, focused on several problematic aspects of
401(k)s: people aren’t saving enough, allocation options
are either limited or complex, high fees cut into returns,
and too many invest in company stock.
But who are these “experts” calling the 401(k) a
failure?
An e-mail to writer of the article, Eleanor Laise,
generated no response. Thus, it was time to investigate via
the Internet.
When “401(k) a failed experiment” was typed into
Google, it found the “expert.” Her name is Teresa
Ghilarducci. Ms. Ghilarducci is a professor of economic
policy analysis at the New School for Social Research in
New York, and her statement that the 401(k) was “a failed
experiment” was made in an October 7, 2008
Congressional hearing.
This hearing was called in light of the recent financial
crisis and its negative impact on the account values of
many participants in retirement plans. In the proceedings,
several members of Congress made rumblings about
needing to change the way Americans prepare for
retirement. California Representative George Miller, the
chair of the House Committee on Education and Labor
stated his desire for the hearing was to “conduct muchneeded oversight on behalf of the American people.”
Ms. Ghilarducci was called to speak before the
committee primarily because of a paper she published in
November 2007, titled “Guaranteed Retirement
Accounts.” In her report, Ms. Ghilarducci highlighted the
following flaws with 401(k)s:
The tax breaks are “skewed to the wealthy because it
is easier for them to save,” because the higher one’s
income (and marginal tax bracket), the greater the
deduction for making deductible deposits. Low-income
people, some who pay no income tax, don’t have the
“extra” to save, and don’t have the same incentives. This
format, according to Ghilarducci, “exacerbates income
and wealth inequalities.”
Further, Ghilarducci is of the opinion that individuals
are ill-suited to handle investment risk, as “humans often
lack the foresight, discipline, and investing skills required
to sustain a savings plan.” In light of these shortcomings,
Ghilarducci concludes “Governments, and to a lesser
extent employers, are better suited to bear longevity,
financial, default and inflation risks than individual
workers.”
To rectify these problems, Ghilarducci proposes a
new program: the Guaranteed Retirement Account
(GRA). Designed as a universal retirement plan
administered by the Social Security Administration (or
similar governmental unit), this program would:
–
–
Require all workers to have 5 percent of their
annual pay deducted from their paychecks and
deposited to the GRA account, unless they were
participants in an similar employer-sponsored
defined-benefit pension plan.
Provide a flat $600 tax credit for every worker,
instead of a deduction based on the amount
deposited.
–
–
–
–
Guarantee fixed returns at 3 percent annually by
investing only in conservative investments. (If
actual investment performance exceeded 3
percent, the administrators could elect to exceed
this minimum.)
Convert all existing 401(k) plans to GRAs
Distribute benefits in the form of a monthly
income in retirement. No distributions would be
allowed prior to retirement, and lump-sum
distributions after retirement would be limited to
$10,000 or 10% of the account balance,
whichever is higher.
Limit transfers upon death to heirs to 50 percent
of the account balance if death occurs before
retirement, and 50 percent minus benefits
received if death occurs after retirement age.
These recommendations, if implemented, would
represent a significant change in retirement planning for
Americans. The Federal government and/or employers
would assume most of the responsibility for providing
retirement incomes, while forfeiting the opportunity for
individuals to achieve greater returns through riskier
investment options.
So how likely is it that GRAs will soon
become part of the financial landscape?
The press secretary for the Congressional committee
initially released a statement that committee members
“were listening to all ideas.” And another committee
member said he found the GRA proposal “intriguing” and
“part of the discussion.” But when pressed on a national
news program, Miller backtracked, saying he would not
be in favor of “killing the 401(k).”
From a historical perspective, the Clinton
administration floated a proposal over 10 years ago to
preemptively impose a 15 percent tax assessment on
retirement accounts, assuming the government would be
better served to collect some of the tax immediately
instead of waiting for individuals to retire. The proposal
never made it past the trial-balloon discussion.
On the opposite end of the spectrum, the government
of Argentina announced plans in September to nationalize
all its citizens’ retirement accounts, and implement a
program which in some ways mimics the GRA idea.
Here’s the reality: Because the key features of
government-authorized retirement accounts are controlled
by legislators – and influenced by politics – changes are
inevitable. But while inevitable, changes are very difficult
to predict. For a long-term financial objective like
retirement, this prospect of constant change makes relying
exclusively on government programs a risky option,
particularly for those who desire more than a guaranteed
minimum in retirement.