Moral hazard occurs when an individual knows more about his or her own actions than other people do. This leads to a distortion of incentives to take care or to exert effort when someone else bears the costs of the lack of care or effort.

A deductible in an insurance policy is a sum that the insured individual must pay before being compensated for a claim.

When Americans go out for a quick meal, they often end up at one of the fast-food chains—McDonald’s, Pizza Hut, Wendy’s, and so on. Because these are large corporations, most customers probably imagine that the people who serve them are themselves employees of large corporations. But usually they aren’t. Most fast-food restaurants—for example, 85% of McDonald’s outlets—are franchises. That is, some individual has paid the parent company for the right to operate a restaurant selling its product; he or she may look like an arm of a giant company but is in fact a small-business owner.

Becoming a franchisee is not a guarantee of success. You must put up a large amount of money, both to buy the license and to set up the restaurant itself. For example, in 2014 it cost between $1.1 and $2.2 million to open a McDonald’s franchise. And although McDonald’s takes care that its franchises are not too close to each other, they often face stiff competition from rival chains and even from a few truly independent restaurants. Becoming a franchise owner, in other words, involves taking on a lot of risk.

But why should people be willing to take these risks? Didn’t we just learn that it is better to diversify, to spread your wealth among many investments?

The logic of diversification would seem to say that it’s better for someone with $1.7 million to invest in a wide range of stocks rather than put it all into one Taco Bell. This implies that Taco Bell would find it hard to attract franchisees: nobody would be willing to be a franchisee unless they expected to earn considerably more than they would as a simple hired manager with their wealth invested in a diversified portfolio of stocks. So wouldn’t it be more profitable for Pizza Hut or Taco Bell simply to hire managers to run their restaurants?

It turns out that it isn’t, because the success of a restaurant depends a lot on how hard the manager works, on the effort he or she puts into choosing the right employees, on keeping the place clean and attractive to customers, and so on. The problem is moral hazard: the manager knows whether he or she is really putting 100% into the job; but company headquarters, which bears the costs of a poorly run restaurant, does not. So a salaried manager, who gets paid even without doing everything possible to make the restaurant a success, does not have the incentive to do that extra bit—an incentive the owner does have because he or she has a substantial personal stake in the restaurant’s success.

In other words, there is a moral hazard problem when a salaried manager runs a Pizza Hut, where the private information is how hard the manager works. Franchising solves this problem. A franchisee, whose wealth is tied up in the business and who stands to profit personally from its success, has every incentive to work extremely hard.

The result is that fast-food chains rely mainly on franchisees to operate their restaurants, even though the contracts with these owner-managers allow the franchisees on average to make much more than it would have cost the companies to employ store managers. The higher earnings of franchisees compensate them for the risk they accept, and the companies are compensated by higher sales that lead to higher license fees.

In addition, franchisees are forbidden by the licensing agreement with the company from reducing their risk by taking actions such as selling shares of the franchise to outside investors and using the proceeds to diversify. It’s an illustration of the fact that moral hazard prevents the elimination of risk through diversification.

Solutions appear at back of book.

AIG (American International Group) was once the largest insurance company in the United States, known for insuring millions of homes and businesses and managing the pension plans of millions of workers. But in September 2008, AIG was at the epicenter of the crisis sweeping global financial markets because major commercial and investment banks faced potentially devastating losses through their transactions with AIG. Fearful that a chaotic bankruptcy of AIG would panic the already distressed financial markets, the Federal Reserve stepped in and orchestrated a $182 billion corporate bailout of AIG, the largest in U.S. history. In return, American taxpayers became owners of nearly 80% of AIG. How did things go so wrong?

AIG’s problems originated not in its main businesses—property insurance and pension management—but in its smaller Financial Products Division, which sold credit-default swaps, or CDS. A CDS is like an insurance policy for an investor who buys a bond. A bond is simply an IOU—a promise to repay on the part of the person or company that issued the bond. But any IOU carries the possibility that the borrower will default on the loan. So bond investors who wish to protect themselves against the risk of default purchases a CDS from a company like AIG. If the borrower defaults, bond investors collect an amount equal to their losses from the company that issued the CDS.

In the mid-2000s, Joseph Cassano, the head of AIG’s Financial Products Division, sold hundreds of billions of dollars worth of CDSs to investors in mortgage-backed securities—bonds created by combining thousands of American home mortgages. Sales of CDSs made the Financial Products Division AIG’s most profitable department. And there were virtually no costs involved because mortgage defaults were low and the Financial Products Division was located in London, meaning that AIG was not required to abide by U.S. insurance regulations to set aside capital to cover potential losses—despite the fact that AIG, the parent company, was headquartered in the United States. As Cassano stated in 2007, “It is hard for us … to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.” Cassano was so confident in his strategy and fearful of outside meddling that he prevented auditors from inspecting his books, leaving AIG’s management and shareholders in the dark about the risks they faced.

Yet the hard-to-see scenario appeared in 2008 when the U.S. housing market crashed. As mortgage defaults surged, investors in mortgage-backed securities incurred huge losses and turned to AIG to collect. But with no capital to cover claims, AIG faced bankruptcy until the U.S. government stepped in.

Banks such as Goldman Sachs, had made huge profits by putting together low-quality mortgage-backed securities with high likelihoods of default and then insuring them with AIG. Despite an outcry, Goldman’s claims were paid in full by the government because their transaction with AIG was entirely legal.

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