Moral Hazard: A Hidden-Information Agency Perspective

Abstract

In the literal sense, moral hazard relates to the adverse effects, from the perspective of an insurance company, which an insurer could have on the behavior of an insured. This situation arises from a common economic scenario in which an agent and a principle are in a situation of their choice in which the agent’s actions have an externality on the principle. It is notable that the principle will always want to influence the actions of the agent. Such an influence will always occur in the forms of a contract, which allows the principle to compensate their agent contingent on their direct activities or the effects of such actions. For example, one of the extreme examples is that of an individual who is insured under a fire cover who may wish to set their property ablaze for them to obtain the insurance money. In this case, the insurer needs to have an ability to cover such actions in the insurance contract, which is the idea of the moral hazard. The purpose of this work is to consider the hidden information problem, which turns out to be a game between two actors in the economic field, one whom holds information that is mutually important that the other lacks. The article describes that the concept of moral hazard is useful for companies that enter in trading negotiations with each other since it helps them to design contracts that would take advantage of the risk that they hold in trading with such partners.