Security

Moral Hazard And Risk-Sharing: Risk-Taking As An Incentive Tool

Date Added: Aug 2010
Format: PDF

The authors examine how moral hazard impacts risk-sharing when risk-taking can be part of the mechanism design. In a two-agent model with binary e ort, they show that moral hazard always increases risk-taking (that is the amount of wealth invested in a risky project) whereas the effect on risk-sharing (the amount of wealth transferred between agents) is ambiguous. Risk-taking therefore appears as a useful incentive tool. In particular, in the case of preferences exhibiting Constant Absolute Risk Aversion (CARA), moral hazard has no impact on risk sharing and risk-taking is the unique mechanism used to solve moral hazard. Thus, risk-taking appears to be the prevailing incentive tool.