Adverse selection and moral hazard in contract law


A contract is an agreement under which two parties perform corresponding duties with respect to their conduct, being a “bilateral coordination agreement”. This formulation addresses the legal idea of ​​the contract but also rises above it. Over the past thirty years, the ‘contract’ has become a central idea in monetary analysis, providing access to three central fields of study: ‘the driving forces’,’ fragmented contracts’ and ‘the costs of transaction “.

This article will focus on the subject of adverse selection and moral hazard in contract law. While adverse selection is an antagonistic choice and a hidden data problem, it reveals an ex-stake, moral hazard, a problem involving masked activity, reveals an ex-post phenomenon. Both suggest negative impacts on contractual competence and costs and touch on one or the other field of study: driving forces, fragmented contracts and transaction costs.

The negative impacts, for example, the impact on transaction costs and in addition the impact of deficient contracts will be discussed in this article. Legally binding and financial solutions, for example, reporting, deductibles and indemnities and valued contracts with a specific final objective of limiting or maintaining a strategic distance from both adverse selection and moral hazard are considered from there.

By definition, a contract is a promise or set of promises made by one party to another. If there should be a breach of contract, the law provides a remedy. The promise or guarantees may be communicated in writing or orally or may be suggested on the basis of circumstantial conditions. When an agreement is a solitary association between the parties, contract law is the segment of the common law which translates the written agreements between the parties and resolves the debate between them as a rule.

Contract law itself has a few purposes for accomplishing the jurisdiction in the same way, for example, to allow individuals to participate in turning the hijackings with an unhelpful arrangement into a pleasurable arrangement and, therefore, to achieve results. effective. The ideal sense of duty in enforcement and securing an ideal dependency are different reasons in contract law which should guarantee a productive result. Contract law further provides default terms that should be effective in limiting the transaction costs of negotiating contracts, and the law can adjust advertising deceptions by dictating the terms of an agreement.

If an agreement would be complete and effective, without flaws or disappointments, then contract law would not be essential, at least not in the sense of settling disputes in court. Either way, a global contract actualizes that every conceivable possibility is expected, the associated dangers or risks are effectively dispensed and all relevant data has been transmitted. In all cases, this would induce enormous transaction costs and would therefore run up against the raison d’être of contract law, which is to limit these expenses for the sake of efficiency.

Asymmetric information or backwards data or data asymmetry describes circumstances in which one party to a contract has better data than the other party – or in similar terms: one party knows more than the other. It basically depicts the disappointment of the parties to communicate to each other all the important data, required for both parties in the agreement or contract. Either way, data asymmetries also occur when data is deliberately masked or masked (masked data). These asymmetries therefore encourage ineffective behavior, being the reason for an “unfavorable selection or choice”.

Adverse selection in its place is a term of re-establishing economic or financial matters and assigns a condition in which undesirable results are acquired. Moral hazard is the name given to the risk that one party to an agreement may change its conduct to the detriment of the other party once an agreement has been reached ex post.

Moral hazard is a matter of concealed activity, supported by asymmetries of data virtually equivalent to unfavorable determination. For example, for a faulty arrangement, the principal’s expenses may fall below the agent’s expenses to fulfill the contract. In any event, the risk of moral hazard only arises when it is difficult for the principal to supervise the agent.

The negative impacts mentioned do not emerge only from the presence of adverse selection or moral hazard in general, but also from the fact that the former and the latter create spillover effects if they are to be avoided.

Antiselection, determined or caused by asymmetric information, can be kept at a strategic distance through the collection of additional data, if the other party to the agreement is unwilling to provide that data itself. However, sourcing data comes with additional costs called transaction costs in contract law.

As a rule, it is said that forgetting (not getting more data) makes sense when the expense to get more data exceeds the normal benefit of getting it, hence the buyer, hinting at the main main concept -agent, should and source more data as long as the recovery costs are lower than the misfortune or loss distribution costs.

In any event, these costs, referred to as transaction costs in contract law, undermine efficiency and could hamper the execution of contracts. Contracts or their satisfaction involve risks. While some risks are unequivocally named, others may remain silent, implying that they are not expressly specified. In the event that an agreement is silent on a danger, the agreement is said to have a “hole”. The holes can be in an agreement, in light of the fact that the probability of a specific hazard is not predicted, these holes are called “accessory holes”. In the case where the probability of a hazard is somewhat remote, then the hole not covering this hazard is called a “deliberate hole”. In both cases, the agreement is said to be “fragmented or incomplete”.

In the event that the parties agree to express risk allocation conditions, they bear a specific transaction cost contrasting with the exchange costs with a positive probability in the event that they leave a hole. The example of moral hazard calls into question contracts from various angles. From the outset, moral hazard is a posteriori problem and occurs after an agreement has been reached at this stage. In addition, moral hazard arises from masked activity and is therefore not predictable for the other party to the agreement. Third, the activity masked by moral hazard is largely intentional in the sense that the party committing a covert action is unlikely to disclose information to the other party about an event.

The problem is that “filling the holes” would involve generating more data. This way, alluding to the principal-agent aspect, where the principal cannot filter the agent, the principal would need more data on the agent. This may be on the whole unrealistic, since the agent neutralizes by revealing his objectives. In addition, the search for more data is a significant factor in transaction costs. However, the principal will collect more data as long as the cost of the additional data is lower than the cost of distributing the normal misfortune or expected loss.

But how do you limit these effects without reducing the extent of coverage?

Incentives to Avoid Adverse Selection and Moral Hazard: There are economic as well as purely legal incentives to avoid or at least reduce adverse selection and moral hazard. Reporting or flagging, deductibles as well as indemnification and assessed contracts are the four possibilities to deal with the problem.

To conclude, this article demonstrates that adverse selection and moral hazard are a phenomenon, where adverse selection prevents the parties from concluding an even effective contract, caused by a judicious choice under asymmetric information, moral hazard is the objective but corrupt objective of one party to an agreement for ex-post to change its position to have an advantage but to the detriment of the other party.

In contract law, adverse selection and moral hazard thwart contracting and pose difficulties for contract law with a specific end goal of limiting or avoiding negative stretching. There are a few methodologies in the fields of economic, monetary or legal studies to stop moral hazard and maintain a strategic distance from adverse selection. All of them suggest impacts on transaction costs but aim to achieve a pareto-efficient outcome and to achieve efficiency in general, although this is not always the case, as the example of signaling shows.

On the whole, we can say that a redistribution of risks or misfortunes towards the agent (the promisor) surely imposes a positive effect on the reduction of the incentive of moral hazard but also on adverse selection.

The references

Cutter, R. & Ulen, T. (2000). Law and economics. Third edition. Addison-Wesley. pages 225-328.

Dionne, G., Michaud, PC & Dahchour. M. (2004). Separating Moral Hazard from Adverse Selection in Automobile Insurance: Longitudinal Evidence from France.

Grundl, H. (2005). Organizations and Entscheidungstheorie. Dr. Wolfgang Schieren-Lehrstuhl fur Versicherungs und Risikomanagement. Humboldt, University of Berlin.

Journal of Insurance Matters. (2005). Vol. 28. N ° 1. pp. 1-13.

McGraw-Hill, Irwin. (2004). Insurability of risks, contractual provisions and legal doctrines. Ch: 10.

Petrick, N. (2005). Contract law. Economic analysis of law, Higher Schools of Economics, Russia.

Working paper (2004-05). Canada Research Chair in Risk Management, HEC Montréal.

Zinnes. CF (2004). Moral risk and unfavorable selection. Institutions, Governance and Economic Development. University of Maryland-College Park.

Dr. VVLN Sastry is Legal Counsel at Lex India Juris.

[The opinions expressed in this article are the personal opinions of the author. The facts and opinions appearing in the article do not reflect the views of LiveLaw and LiveLaw does not assume any responsibility or liability for the same]


Martin E. Berry

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