Wednesday, October 13, 2010

Put Options, Insurance, and Moral Hazard

If I swallow anything evil
Put your finger down my throat
If I shiver, please give me a blanket
Keep me warm, let me wear your coat
--The Who

A put is an option contract that gives its owner the right, but not the obligation (that's why it's called an 'option'), to sell (or 'put') an asset to someone else at a given price (called the 'strike price').

It's not as complicated as it sounds, and odds are very good that you own one or more put options yourself. For example, insurance policies are put options. You buy a new put option every six months when you pay your auto insurance premium. When you drive accident free over the six month period, the put expires worthless. But in the unfortunate case that you have an accident, and the damage exceeds your deductible (which essentially serves as the strike price), then you will most likely exercise your right to 'put' the problem on you insurance company who is then obligated to cover excess damages.

Puts, therefore, can be viewed as a tool for managing downside risk. They are quite handy when problems arise, but the frustrating thing is that you often must shell out significant upfront money for an option that frequently expires worthless. Wouldn't it be great if you could get that put option for free?

In the public domain, people receive low or no cost put options all the time. Welfare programs such as food stamps, unemployment benefits, and healthcare benefits are often provided to people who have paid little or nothing in terms of upfront premium for such insurance coverage.

Such a situation creates a significant moral hazard problem. Moral hazard, a term that appears to have been coined by the British insurance industry in the 1800s, reflects the human tendency to take more risk when it is perceived that any costs related to the risky behavior will be shouldered by another entity (i.e., the insurer). Thus, people who are out of work may be less inclined to look for a job when they are receiving unemployment benefits. People might engage in poor dietary and exercise habits if they have access to low or no cost health care.

Moral hazard is grounded in basic axioms such as the Law of Parsimmony which, when stretched to its limit, suggests that people are inclined to exploit situations where they can get 'something for nothing.'

The moral hazard condition is in play whenever behavior has been insured. However, the upfront costs that one must pay for put options helps check excessive risk taking. When insurance premiums are lowered below the market price, however, moral hazard is likely to be amplified.

Currently, we may be witnessing moral hazard writ large in financial markets worldwide. We'll examine this in a subsequent post.

position in SH

1 comment:

dgeorge12358 said...

Unemployment insurance is a pre-paid vacation for freeloaders.
~Ronald Reagan