Moral Hazard and Insurance Contracts

Abstract

This essay synthesizes and extends the theory of optimal insurance under moral hazard, with a focus on the form of insurance contracts. The simplest model illustrates the most fundamental result: that the market responds to moral hazard with partial insurance coverage. But this model is not general enough to predict the contractual form of this response. The most general model, the Principal-Agent model, yields mostly negative results. In extending the theory, I adopt an intermediate approach, distinguishing between moral hazard on the probability of an accident and moral hazard on the size of the loss. This approach generates predictions as to when deductibles, coinsurance and coverage limits will be observed. The essay reviews as well moral hazard with a partially informed insurer and dynamic models of moral hazard. It concludes with a discussion of open questions in the theory of moral hazard and insurance.