Risk-incentive trade-off in moral hazard with risk management: Theoretical analysis and empirical verification

Abstract

This study incorporates risk management into a continuous-time principal–agent model based on moral hazard, analyzing how risk and incentives interact when preferences are risk-sensitive. We focus on how principal adjust compensation, comprising performance pay, risk penalties, and basic salaries, to incentivize agents under hidden information. Our findings confirm the classic negative trade-off between risk and incentives, alongside a novel positive relationship between risk and risk–penalty sensitivity. In high-risk environments, the principal frequently seeks out more skilled agents and offer them greater incentives, thus disrupting the relationship between risk and compensation sensitivities. Our empirical analysis underscores the significance of adaptive compensation strategies in improving agent behavior in the face of escalating risks, supporting these theoretical predictions. These insights underline the potential for refining incentive structures to better align with varying levels of firm risk.