Moral Hazard Model

A formal economic model showing how insurance, by cutting the marginal cost a policyholder faces, alters unobservable incentives around effort, precaution, or consumption.

Source: Holmstrom 1979

Under full cover the policyholder pays nothing at the point of use, so the price they face for care or for risky behaviour falls to zero, and they consume up to the point where they value an extra unit at nothing. Because the true cost of that unit is positive, the gap between what is used and what would be used if the person paid in full is at its widest. Partial cover narrows the gap by restoring some of the price. Zeckhauser (1970) modelled this effect of the coverage level.

Source: Zeckhauser 1970

The model represents hidden action by assuming the principal cannot observe the agent's effort or precaution, only an outcome that depends on that effort and on chance. Because effort is unobservable, the principal cannot contract on it directly and must instead tie the agent's reward to the observable outcome. The model then studies how the agent, bearing less than the full consequence once insured, chooses effort, and how the contract can be structured given that effort cannot be seen.

Source: Holmstrom 1979

The model reveals a trade-off between risk-sharing and incentives. Full insurance would protect the agent from risk but remove their incentive to take care or limit consumption, since they bear no consequence, worsening the hidden behaviour. Making the agent bear more of the outcome restores incentives but exposes them to risk they dislike. The optimal contract balances providing incentives against imposing risk, so some cost-sharing is retained, and full insurance is generally not efficient when actions are hidden.

Source: Holmstrom 1979

The model is important because it shows rigorously why insurance and other contracts cannot fully protect against risk without dulling incentives, and why partial coverage and cost-sharing are efficient responses to hidden action. It provides the theoretical basis for the design of insurance, provider payment, and employment contracts, and it underlies much of information economics. Holmström's formalisation clarified the incentive-risk trade-off that governs any relationship in which one party's actions cannot be observed by the other.

Source: Holmstrom 1979

The model informs health insurance design by explaining why some cost-sharing is efficient: if patients faced no price, they would use care with little regard to its cost, so deductibles, co-payments, and coinsurance restore an incentive to weigh benefit against cost. The design balances this against the protection insurance provides, since heavier cost-sharing exposes patients to risk and may deter needed care. The model thus guides how far to share costs, framing it as an incentive-risk trade-off.

Source: Holmstrom 1979