The Skin-in-the-Game Heuristic for Protection Against Tail Events

Abstract

Standard economic theory recognizes the agency problem but not the compounding of moral hazard in the presence of informational opacity, particularly concerning high-impact events in fat-tailed domains. Nor does it look at exposure as a filter that removes nefarious risk takers from the system so they stop harming others. But the ancients did, and so do many aspects of moral philosophy. The authors propose a global and morally mandatory heuristic that anyone involved in an action that can possibly generate harm for others, even probabilistically, should be required to be exposed to some damage, regardless of context. In the language of probability, “skin in the game” creates an absorbing state for the agent, not just the principal. Although insufficient, the heuristic is necessary to counter risk hiding—and risk transfer—in the tails. The authors link the rule to various philosophical approaches to ethics and moral luck.