Moral Hazard Vs Adverse Selection

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In this paper, we discuss that “moral hazard is more widespread than adverse selection in a company, but tackling moral hazard is one of the major issues in corporate governance (“CG”)”. Moral hazard is based on asymmetric information, and it happens when one party gets more information about the intentions or actions and has an inappropriate tendency to behave from the deviation of another party with less information. More precisely, moral hazard occurs due to one party is not willing to bear the full reactions of its actions, and has a proclivity to act less carefully than it otherwise would, know that any responsibility for the reactions of any loss from its actions would be bearable by another party (insurers). For example, executives…show more content…
Adverse selection is an economics term means an undesired result happens which the quantity and the price of goods or services altered because of sellers and buyers have different or imperfect market information. For example, executives may more willingly issue shares when the share price is overvalued compared to the real value, buyers will finally buy the overvalued shares and lose money. If the company charges an average price but only the consumer who can pay more buy, the company takes a financial loss by paying out more benefits. Due to adverse selection may lose some of the customers, and we assume that every company should be profit maximization, moral hazard is more widespread than adverse selection in a company. We will discuss few major issues regarding tackling moral hazard under the CG requirements: Issue 1 – executives should act in the best interests of the company and…show more content…
By cause of the presence of D&O insurance, there are fewer financial incentives vis-à-vis directors and officers to present the duty of care and skill (i.e. the moral hazard). As a result, the precautionary function of directors or officers liability law is undermined or negatively affected by the D&O insurance. D&O insurers should take various measures to mitigate the moral hazard. Issue 3 – the method / policy to set up the bonus and allowances for executives Shareholders concern about executives may overpay themselves, get extravagant allowances, carry out unprofitable but power enhancing investments. For example, the bonus should be paid according to the executives’ performance which should be related to the company’s profit, however, many executives bonus pools are paid as a percentage of revenue. This shows that as long as the revenues can be churned up and whatever any losses and costs result in negative profits, the executives still get paid. Therefore, Executives may only make decisions according to their own interests and the moral hazard problem is executives may deceive investors to pursue their own
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