Optimal Insurance under Moral Hazard

Abstract

This chapter surveys the theory of optimal insurance contracts under moral hazard, revisiting the topic in light of developments in contract theory over the past twenty-five years. Moral hazard leads to less than full insurance, so that the insured retains some incentive to reduce accident costs. What form does the partial insurance contract take: a deductible, co-insurance or a ceiling on coverage? Posed in the most general form, the problem is identical to the hidden-action principal-agent problem. The insurance context provides some structure that allows more specific predictions. Optimal insurance contracts vary, for example, depending on whether effort affects the probability of an accident or its severity. The chapter characterizes the optimal insurance contract and integrates developments in contract renegotiation, contract dynamics and other extensions.