Unit 10 Market successes and failures: The societal effects of private decisions

10.9 Hidden actions and risk: Market failure in insurance and credit markets

Hidden actions are a serious problem in insurance and credit markets because uncertainty and risk play a central role in the outcome from an insurance policy or loan. The chance of a bad outcome for the principal depends on unavoidable risks, but also on the actions of the agent.

You would like to be able to fully insure your car against the risks of theft and damage resulting from an accident. The insurance company is willing to provide insurance if the premium is not less than the amount it expects you will claim over the period of cover. For example, if the value of the car is V, and a policy provides full cover against theft in return for an insurance premium P:

\[\begin{align*} \text{expected pay-off to insurance company} &= P - \text{expected claim} \\ &= P - \text{(probability of theft } \times V) \end{align*}\]

But the probability of theft or damage depends on your own behaviour. If you make a claim, the insurance company (the principal) cannot tell how much you were yourself to blame for the theft or the accident. And buying an insurance policy may make you (the agent) more likely to take exactly the risks that are now insured: you may take less care in driving or locking your car than someone who had not purchased insurance.

Insurers typically place limits on the insurance they sell. For example, coverage may not apply (or may be more expensive) if someone other than the insured is driving, or if the car is usually parked in a place where cars are often stolen. These provisions can be written into an insurance contract.

But the contract is incomplete. The insurer cannot enforce a contract about how fast you drive or whether you always lock your car. These are the hidden actions. Information is asymmetric: you know these facts, but the insurance company does not.

A similar situation arises in the credit market, as described in Section 9.9. A bank (the principal) will be willing to make a loan to a borrower (agent) who wants to finance an investment project, if the bank expects the loan to be repaid in future. If repayment were guaranteed, then for a loan L at interest rate r, the amount repaid would be (1 + r) L. But lending is risky:

\[\begin{align*} \text{expected pay-off to bank} &= \text{expected repayment} - L \\ &= \text{(probability of repayment} \times \text{(1 + } r)L)-L \end{align*}\]

The probability of repayment depends on both unavoidable risks affecting the success of the project, and on prudent use of the funds and hard work by the borrower.

Again, the contract is incomplete. Good behaviour by the borrower cannot be enforced; neither can the bank go to court to enforce repayment if the borrower has no funds left. And—just as an insured person may take less care—borrowers may be less prudent and more inclined to take risks if the bank bears the consequences of failure, compared with how they would behave if they were investing their own wealth.

What can the principal do?

equity

Shares (stocks) in a business are known collectively as equity. The total value of the equity held by the shareholders is equal to the net worth of the business, and an individual shareholder’s equity in the business is the total value of the shares they own. The term equity is also used more generally for a share of ownership of any asset, and for the net worth of any household, business, or project. There is a second entirely different use of the term, meaning fairness, as in ‘an equitable division of the pie’. See also: net worth

collateral

An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.

The problem for both the insurance company and the bank is that the agent’s actions are hidden, and the agent has little incentive to behave prudently. A partial solution is to find a way of providing the incentive. In the similar case of employment effort, this is done by raising the wage so that the employee has something to lose—the rent from a high-paying job. As discussed in Section 9.9, a lender can achieve the same effect by requiring the borrower to invest some of their own wealth (equity) in the project, or to provide collateral (a mortgage contract gives the lender the right to repossess the house in the event of failure to make contractual repayments), bringing the agent’s incentives more in line with those of the principal.

Likewise, an insurance company can ensure that the agent’s incentives are better aligned with its own by providing only partial insurance. (Full insurance would mean that an insured person would be indifferent as to whether their possessions were stolen or not: they would have no incentive at all to take care.) It is common for insurance policies to specify an ‘excess’: an amount that the insured person has to pay themselves in the event of a claim, giving them an incentive to take care.

Hidden actions have external effects

Though seemingly very different, hidden-action problems have an important feature in common with problems, such as pollution and public good provision, which were analysed in earlier sections. Here again, someone makes a decision that has external costs or benefits for someone else. The insured person or borrower (the agent) decides how much care to take. Taking care has an external benefit for the principal, but a private cost for the agent. The result is market failure.

What form does the market failure take? First, people without wealth or collateral are not able to undertake potentially profitable investment projects. And no-one can purchase full insurance. Both of these things would be possible if there were no asymmetries of information.

Second, even with partial mitigations such as equity or an excess, the agent’s incentives will not be fully aligned with those of the principal. The social benefit of care, to the principal and agent jointly, is still greater than the private benefit to the agent. So too little care will be taken. Because the probability of a bad outcome is increased, the principal will raise the price (interest rate or insurance premium). Too little insurance will be purchased; only the less risky investment projects with the highest returns will be financed.

In other words, some potential mutually beneficial transactions will not occur. Compared with the outcome in the absence of information asymmetry, the market allocation will not be Pareto efficient.

With some risks, an insurance market is missing altogether: governments provide cover against unemployment because private firms rarely do so. Getting a low grade in an important exam is a risk facing even the hardest-working student, but you are unlikely to be able to insure yourself against it.

Inequality

In addition, market failure leads to an inequality of outcomes for rich and poor agents. The consequences of being unable to insure yourself against a loss are more serious for those who cannot afford to replace a stolen or damaged item.

Those with little wealth may not be able to get a loan (credit exclusion) or face higher interest rates (credit constraints). even for a project that would have used the resources in a highly productive way—for example, a new business, the cost of a licence to practise a trade, or training. Sometimes a high-quality project from a poor would-be borrower is not funded by the lender, while a rich individual with a middling project gets a loan.

This form of market failure arises particularly when wealth is very unequally distributed. Read Exercise 9.11 for how the Grameen Bank addressed this problem by making groups of borrowers jointly responsible for loan repayment, thereby giving them an incentive to work hard and take prudent decisions without the need for equity or collateral.