Articles from the New Yorker

The Moral Hazard Myth

Articles from the New Yorker, The Moral Hazard Myth, August 29, 2005

Dept. of Public Policy

The bad idea behind our failed health-care system.

America's health-care mess is, in part, simply an accident of history. The fact that there have been six attempts at universal health coverage in the last century suggests that there has long been support for the idea. But politics has always got in the way. In both Europe and the United States, for example, the push for health insurance was led, in large part, by organized labor. But in Europe the unions worked through the political system, fighting for coverage for all citizens. From the start, health insurance in Europe was public and universal, and that created powerful political support for any attempt to expand benefits. In the United States, by contrast, the unions worked through the collective-bargaining system and, as a result, could win health benefits only for their own members. Health insurance here has always been private and selective, and every attempt to expand benefits has resulted in a paralyzing political battle over who would be added to insurance rolls and who ought to pay for those additions.

Policy is driven by more than politics, however. It is equally driven by ideas, and in the past few decades a particular idea has taken hold among prominent American economists which has also been a powerful impediment to the expansion of health insurance. The idea is known as "moral hazard." Health economists in other Western nations do not share this obsession. Nor do most Americans. But moral hazard has profoundly shaped the way think tanks formulate policy and the way experts argue and the way health insurers structure their plans and the way legislation and regulations have been written. The health-care mess isn't merely the unintentional result of political dysfunction, in other words. It is also the deliberate consequence of the way in which American policymakers have come to think about insurance.

"Moral hazard" is the term economists use to describe the fact that insurance can change the behavior of the person being insured. If your office gives you and your co-workers all the free Pepsi you want—if your employer, in effect, offers universal Pepsi insurance—you'll drink more Pepsi than you would have otherwise. If you have a no-deductible fire-insurance policy, you may be a little less diligent in clearing the brush away from your house. The savings-and-loan crisis of the nineteen-eighties was created, in large part, by the fact that the federal government insured savings deposits of up to a hundred thousand dollars, and so the newly deregulated S. & L.s made far riskier investments than they would have otherwise. Insurance can have the paradoxical effect of producing risky and wasteful behavior. Economists spend a great deal of time thinking about such moral hazard for good reason. Insurance is an attempt to make human life safer and more secure. But, if those efforts can backfire and produce riskier behavior, providing insurance becomes a much more complicated and problematic endeavor.

In 1968, the economist Mark Pauly argued that moral hazard played an enormous role in medicine, and, as John Nyman writes in his book "The Theory of the Demand for Health Insurance," Pauly's paper has become the "single most influential article in the health economics literature." Nyman, an economist at the University of Minnesota, says that the fear of moral hazard lies behind the thicket of co-payments and deductibles and utilization reviews which characterizes the American health-insurance system. Fear of moral hazard, Nyman writes, also explains "the general lack of enthusiasm by U.S. health economists for the expansion of health insurance coverage (for example, national health insurance or expanded Medicare benefits) in the U.S."

What Nyman is saying is that when your insurance company requires that you make a twenty-dollar co-payment for a visit to the doctor, or when your plan includes an annual five-hundred-dollar or thousand-dollar deductible, it's not simply an attempt to get you to pick up a larger share of your health costs. It is an attempt to make your use of the health-care system more efficient. Making you responsible for a share of the costs, the argument runs, will reduce moral hazard: you'll no longer grab one of those free Pepsis when you aren't really thirsty. That's also why Nyman says that the notion of moral hazard is behind the "lack of enthusiasm" for expansion of health insurance. If you think of insurance as producing wasteful consumption of medical services, then the fact that there are forty-five million Americans without health insurance is no longer an immediate cause for alarm. After all, it's not as if the uninsured never go to the doctor. They spend, on average, $934 a year on medical care. A moral-hazard theorist would say that they go to the doctor when they really have to. Those of us with private insurance, by contrast, consume $2,347 worth of health care a year. If a lot of that extra $1,413 is waste, then maybe the uninsured person is the truly efficient consumer of health care.

The issue about what to do with the health-care system is sometimes presented as a technical argument about the merits of one kind of coverage over another or as an ideological argument about socialized versus private medicine. It is, instead, about a few very simple questions. Do you think that this kind of redistribution of risk is a good idea? Do you think that people whose genes predispose them to depression or cancer, or whose poverty complicates asthma or diabetes, or who get hit by a drunk driver, or who have to keep their mouths closed because their teeth are rotting ought to bear a greater share of the costs of their health care than those of us who are lucky enough to escape such misfortunes? In the rest of the industrialized world, it is assumed that the more equally and widely the burdens of illness are shared, the better off the population as a whole is likely to be. The reason the United States has forty-five million people without coverage is that its health-care policy is in the hands of people who disagree, and who regard health insurance not as the solution but as the problem.

Comprehensive auto insurance: balancing moral hazard and risk

Comprehensive automobile insurance covers loss or damage to a car arising from all causes, including fire and theft. The likelihood of theft depends on the driver’s behavior: taking care to park in secure, well-lighted places; using a steering lock; and activating the car alarm. Short of hiring a full-time private detective, it is difficult for an insurer to monitor the driver’s behavior completely.

A driver who has comprehensive automobile insurance, however, may take fewer precautions. For instance, the driver may sometimes neglect to engage the steering lock or park in dark alley. While the driver personally bears all the costs of precautions, a large part of the benefit in terms of reduced likelihood of theft accrues to the insurer.

Many insurers offer comprehensive automobile insurance only with a minimum deductible. Such policies provide compensation only to the extent that the loss exceeds the deductible. A driver will benefit from precautions against loss to the extent of her or his deductible. Accordingly, the deductible helps to resolve the driver’s moral hazard.

The deductible, however, imposes risk on the driver. Drivers buy insurance because they are averse to risk. Ironically, the insurer must limit the extent of insurance to resolve the problem of moral hazard.

Evaluating managerial performance

A common way of evaluating the performance of company management is through the stock price. AT&T is a leading international telecommunications provider. AT&T common shares rose by 44% between 1993-98. Should investors have cheered?

Not if they considered their alternatives. Figure 13.4 shows the cumulative total shareholder returns from investments in AT&T shares as compared with the Standard & Poor’s Telephone Index, which is an index of shares of major telecommunications providers. An investment in the Telephone Index would have been much more profitable.

This example suggests that a more reasonable way of evaluating managers is to measure their performance against that of other companies in the same industry. Relative performance evaluation cancels out background factors over which managers have no control. This yields a more accurate measure of management’s performance.

An example of a telecommunications company that uses such a measurement scheme is Level 3 Communications. It rewards its managers by issuing stock options linked to the market as a whole (measured by the S&P 500). Thus, it claims to perfectly align the interests of its managers and its owners – its managers only receive bonuses if it outperforms the market as a whole.

Sources: AT&T, proxy statement pursuant to Section 14A of the Securities Exchange Act of 1934 (March 25, 1999); www.level3.com/press/1826.html.

Balancing multiple responsibilities: Teaching to the test

Teachers are expected to pursue multiple objectives: helping students learn basics, helping students achieve their potential, and addressing student moral development are among the most important three. Efforts to improve school performance frequently involve standardized testing and rewarding teachers and schools on the basis of (improvement in) test scores. The “No Child Left Behind” legislation in the U.S. is a notable example.

Critics of these developments often point to the potential substitution of the more easily measured test performance for more difficult-to-measure goals, such as moral development. These concerns are compounded by the troubling evidence that the easily measured test performance is itself innacurate, due to cheating. In fact, one study report that cheating may have occurred in 3.4% - 5.6% of all classrooms where “high stakes” testing was being used.

The study points out that this cheating by teachers, test administrators, and/or principals can be easily prevented through better testing procedures, but that “the challenge for educators and policymakers will be to develop a system that captures the obvious benefits of high-stakes testing as a means of providing incentives while minimizing the possible distortions that these measures induce.”

Source: “Rotten Apples: An Investigation of the Prevalence and Predictors of Teacher Cheating” Brian A. Jacob and Steven D. Levitt, 2004, www.educationnext.org/unabridged/20041/68.html.

Performance Pay for Teachers

The teachers that are given bonuses for helping students achieve higher test scores definitely needs more evaluation and regulation. One pilot program in Little Rock Ark. shows the most positive results, but the program admits to teaching the test instead of teaching the regular subject material. Teachers driven by these professional bonuses may only be teaching our children how to be good test takers, they might not even be teaching the subject material.

"If there is a positive effect, it is going to be very small," said Kevin Booker (a researcher with Mathematics Policy Research in Princeton, N.J.) about improving test results.

“In North Carolina, researchers found that a program that rewards bonuses of $1,500 to teachers in schools that show test-score gains above a specified threshold could have resulted in higher rates of teacher turnover in low-performing schools.”

If you wanted a $1,500 bonus why would you teach in a low-performing school? Teachers are attracted to teach at the high performing schools. To solve some of the performance based pay issues many states are using multiple measures to gauge teachers contribution to students overall learning and growth, not just testing results.

Source: "Performance-Pay Studies Show Few Achievement Gains" H. Vaishali, Education Week; 3/12/2008, Vol. 27 Issue 27, p7-7, 2/3p, 2c

CEO Compensation Survey (A Special Report); Poorer Relations: When it comes to CEO pay, why are the British so different?

Abstract (Summary)

The typical British CEO earns a little more than half what his or her U.S. counterpart makes, according to a Towers Perrin study completed this year that compared compensation packages for executives in 26 countries. The typical CEO at a large U.S. company receives almost $2.2 million a year, whereas a British CEO earns nearly $1.2 million, the Stamford, Conn., consulting firm reports. Bonuses and long-term incentives for the U.S. CEO also make up a larger proportion of the typical pay package, 62%, than they do in any other country in the study; in Britain, bonuses and long-term incentives make up 35% of the typical package.

More shares are in fewer hands in Britain -- mostly the hands of pension funds and other large institutions -- which makes it easier to hold consultations with shareholders on executive pay. In Britain, a much smaller equity market than the U.S., "the top 10 shareholders will usually be about 50% of your company," says Mr. Stephen Cahill. And even at the 100 largest companies, the top 10 shareholders might own 20% to 25% of the shares. For smaller companies, it's not unusual for one shareholder to own 10% or more.

Finally, differences in performance incentives in U.S. and U.K. pay packages can be revealing as well. For instance, while the Towers Perrin study points out that bonuses, stock grants and other long-term incentives tend to make up a smaller part of a British CEO's compensation than that of an American, such rewards for the British CEO are also more likely to depend on his or her performance. And performance standards in the U.K. can be far more demanding than in the U.S. For example, often a British company's shares will have to perform above the median share performance for its industry in order for executives' options or restricted shares to vest.

Source: Joanna L. Ossinger. Wall Street Journal. (Eastern edition). New York, N.Y.: Apr 10, 2006. pg. R.6

Moral hazard and the subprime mortgage

An article on Bankrate.com suggests moral hazard has played a role in the subprime mortgage crisis. Over the years mortgage standards have become lax while at the same time profits have risen.

More and more risky loans have been made and the assumption of risk has been passed on down the chain. Lenders were selling loans to investors. The investors were selling mortgage-backed securities in the market. Everyone was out to make a profit and many thought they were protected from much of the risk.

In the end it is the government who steps in to soften the impact on the economy. The aid does help out the homeowner, but it also helps those who were trying to pass the buck.

Source: http://www.bankrate.com/brm/news/mortgages/20070418_subprime_mortgage_morality_a1.asp?caret=3c

Denali - The Alaska Gas Pipeline

According to a recent press release, BP and ConocoPhillips have teamed together to create a new company in order to compete for the development and construction of a new gas pipeline in Alaska. The press release states, "BP and ConocoPhillips... have combined resources to start Denali - the Alaska Gas Pipeline. The pipeline will move approximately 4 billion cubic feet of natural gas per day to markets, and will be the largest private sector construction project ever build in North America." The release goes on to say this combination of mega-companies will combine their resources to spend $600 million (sunk costs) to reach just the first project milestone by 2010. If successful, the newly formed company will transport the gas to market. Who will ultimately own the pipeline could still be up for negotiations (State of Alaska, producers, other private investors, etc.). Does this organizational structure create a verticle integration if the gas is being produced and treated by BP and ConocoPhillips, transported through "their" pipe and potentially sold at stations they own (BP). Furthermore, with potentially other partners coming to the table in order to transport the gas through Canada, what is the potential for holdup? As Alaskans know far too well (good and bad), the price of oil and gas in the U.S. is at a premium, not to mention the global demand for product. Political climates may favor this project but that may soon change with a new administration in 2009. Whereas producers are incentivized to act now, will other projects across the globe become more attractive if this window closes? This new venture is the latest attempt to motivate the State to keep producers in the game. Residents are split on big oil interests and whether or not they're sincere in their motives. When 90% of State revenues are based on oil, Alaska can't afford to scare off this golden goose - maybe the producers can't afford to pass it up either.

Source: www.denali-thealaskagaspipeline.com

Amazon Toying with Vertical Integration

April 25, 2008

Sramana Mitra

Amazon.com (AMZN) has been pursuing growth at all costs. Its recently announced Q1 2008 results are a testament to that drive. It reported the quarter’s revenue at $4.13 billion, meeting analyst expectations and reporting a 37% increase over the previous year. Its earnings for the quarter at $0.34 were marginally higher than the market’s expectation of $0.32, and are 30% higher than previous year earnings.

Media revenue increased by 28% over the previous year to $2.54 billion while Electronics and other General Merchandise EGM revenue increased by 56% over the period to $1.48 billion.

Region-wise, North America contributed $2.13 billion recording a 31% growth. The rest of the world revenues grew by 44% to $2.01 billion.

Going forward, for Q2, it expects net sales of between $3.875-$4.075 billion, which is a growth of 34%-41% with GAAP operating income of $0.12-$0.16 billion. For the year 2008, it expects net sales between $19.1-$20 billion, a growth of 29%-35% with GAAP operating income of $0.74-$0.94 billion.

I have repeatedly mentioned that Amazon needs to expand its margins. The management however, continues to follow the low-price strategy to drive up sales. It attributes its sales growth for the quarter to “low prices and millions of in-stock items available for immediate shipment”. Its operating margin continues at 5.8% for the quarter, despite addition of new categories even in the international segment.

Amazon’s competitor, eBay (EBAY) recently announced its results, and unlike Amazon, eBay continues to give higher margins.

The management does not give a more detailed breakdown of revenue contributors. So, Kindle revenues are still not available to analysts. It has increased the content to 115,000 titles from the 90,000 titles at launch, which is indicative of at least some commitment.

The most interesting move I saw this quarter from Amazon, however, is the news that it will only sell print-on-demand books printed by its own POD provider, Booksurge. In fact, the book publishing business is ready for a complete overhaul, and who is better positioned than Amazon to pull this off? With Booksurge, Amazon is offering 35% royalties to authors, promotion opportunities on Amazon (e.g. cobranding with best-sellers for $1000 a month), etc.

When you contrast this with the 10-15% royalty that major publishers offer their authors, and virtually no marketing (except in the case of a few titles), Amazon is starting to address the two most important issues in the book industry. I can’t wait to see what Amazon would do to turn this around. The vertical integration basically takes out all intermediaries except the Author (35%) and Amazon (65%), and can become a compelling option for 90% of the authors.

Amazon’s stock reported an increase of 1.8% during the day on Wednesday, but in the after hours session, it fell by 4.8% to close of $77.10. Yesterday, it was trading in the $77-79 range.