Moral Hazard, Insurance, and Options

Some years decades ago, I was lucky enough to visit the floor at Lloyds of London.  I had spent some time on the floors of the NYSE and AMEX, and there were many superficial similarities.  Each had a large open room with guys (almost all guys) moving busily and speaking in jargon that was difficult for outsiders to understand.  But there was a key fundamental distinction.  Stock and options traders are trading fungible securities with a clearinghouse acting as a third party, while the Lloyd’s members were syndicating idiosyncratic risks guaranteed by direct contracts.  We noted yesterday that while listed options can provide valuable insurance for investors, they operate quite differently from other forms of insurance.  Here is why.

Insurers go to great lengths to avoid “moral hazard”.  We noted that this is not a moral judgment in the religious or ethical sense, but a core concept underlying insurance.  No insurer wants to write a policy where the beneficiary could end up better off by collecting on that policy.  If one owns a car worth $20,000, an insurer would not write a theft or collision policy on that for $25,000.  There would be a potential incentive for the owner to leave the keys in the car, hoping it gets stolen in order to collect more money than the car is worth.  Even when the risk is syndicated, like they do at Lloyds, the policy writer is still exposed to moral hazard, just a bit less. 

The economics of writing an insurance policy is not unlike selling put options.  In both cases the writer accepts an upfront premium to assume a risk, with the understanding that they will need to pay out far more if the risk occurs.   But insurers require an “insurable interest” before allowing someone to purchase a policy.  In the automobile example above, I can’t buy a collision policy on someone else’s car.  Otherwise I would have an incentive to arrange an accident that totals the car and pays me the money. That would be a complete moral hazard.

This is the key difference between options markets and conventional insurance.  With options, we don’t need to demonstrate any insurable interest in order to buy them.  If an insurable interest was required, traders would only be able to buy puts on stocks they own and only in quantities that don’t exceed their holdings.  We know, of course, that anyone can buy listed puts on any company regardless of whether the put buyer owns shares or not.  In short, conventional insurance can only be used to hedge risks — and the insurers almost always require the buyer to retain some of that risk during the life of the policy – while options allow people to hedge risks or speculate. 

As we noted yesterday, the options market is the lone insurance venue that is thoroughly unconcerned with things like moral hazards or insurable interests.  That is a feature and benefit of centralized clearing.  Listed options writers have no way of knowing who is on the other side of their trade – the counterparty is always the clearinghouse.  We would all like to know whether we have sold options to hedgers (those with an insurable interest) or speculators (those without), but ultimately it is something we can only intuit.

As a result, moral hazards abound for options writers.  We all can imagine situations where someone buys a large amount of puts or calls before spreading a negative or positive rumor that gets a stock moving in the direction that would benefit their options position.  We also see options buying by those who possess material information that is undisclosed publicly.  These activities are illegal, of course, but economic crimes of all sorts occur if the perceived economic incentive is large enough for the perpetrator to take the risk.  (Prisons are full of those who miscalculated).

During the height of the meme stock craze, we saw another way how options speculators without insurable interests were able to move stocks higher.  Enough buyers, acting independently though in concert, bought sufficient numbers of calls to create a “gamma squeeze” – a feedback loop that pushed individual stock prices higher.  The vast majority of those call buyers were not hedging short stock positions.  Most were already long stock or simply speculating in calls. 

To be clear, this piece is not meant to dissuade readers from writing options altogether.  Covered call writing, cash-secured put writing, and a range of other strategies can and do benefit traders and investors.  The ability to speculate is what makes option trading far more dynamic than the insurance business, and ultimately offers greater liquidity in the options marketplace.  My goal was to explain the differences and similarities between options and conventional insurance in the hope that readers will make more informed decisions when they choose to trade.