In finance, the moral hazard problem is commonly referred to as the “agency” problem. Many, if not most real-world contracts involve two parties – a “principal” and an “agent”. Contracts formed by principals and agents also usually have two key features: 1) the principal delegates some decision-making authority to the agent and 2) the principal and agent decide upon the extent to which they share risk.
The principal has good reason to be concerned whether the agent is likely to take actions that may not be in her best interests. Consequently, the principal has strong incentives to monitor the agent’s actions. However, since it is costly to closely monitor and enforce contracts, some actions can be “hidden” from the principal in the sense that she is not willing to expend the resources necessary to discover them since the costs of discovery may exceed the benefits of obtaining this information. Thus, moral hazard is often described as a problem of “hidden action”.
Since it is not economically feasible to perfectly monitor all of the agent’s actions, the principal needs to be concerned about whether the agent’s incentives line up, or are compatible with the principal’s objectives. This concern quickly becomes reflected in the contract terms defining the formal relationship between the principal and the agent. A contract is said to be incentive-compatible if it causes principal and agent incentives to coincide. In other words, actions taken by the agent usually also benefit the principal. In practice, contracts typically scale agent compensation to the benefit received by the principal. Thus, in insurance markets, insurers are not willing to offer full coverage contracts; instead, they offer partial insurance coverage which exposes policyholders to some of the risks that they wish to transfer. In turn, partial coverage reinforces incentives for policyholders to prevent/mitigate loss.
Similarly, in a completely different setting, consider the principal/agent relationship which exists between the owner and manager of a business. If the manager’s effort level is high, then the owner may earn higher profits compared with when the manager’s effort level is low. However, if managerial pay consists of a fixed salary and lacks any form of incentive compensation (e.g., bonuses based upon meeting or beating specific earnings targets), then the manager may be inclined to not exert extra effort, which results in less corporate profit. Thus, compensation contracts can be made more incentive-compatible by including performance-based pay in addition to a fixed salary. This way, the owner and manager are both better off because incentives are better aligned.