Principal-Agents Contracts Under the Threat of Insurance

The traditional principal-agent model assumes that the principal offers an exclusive contract to the agent. This paper shows that the standard results are not robust to the introduction of additional contracting opportunities for the agent. We analyze equilibria of an extended game with the presence of additional players who might trade risk away from the agent. The contract offered by the principal in order to elicit high effort is steeper than in the standard model. In some settings, the agent accepts this contract and then unwinds part of those incentives through additional trades. (This seems consistent with some findings in the literature on managerial compensation). For some settings and parameter values, suboptimal effort is implemented in equilibrium, the principal is worse off, and total welfare is lower. These findings may call for a revision of some previous theoretical and applied conclusions. In designing compensation schemes, attention should be paid to outside opportunities, even when they are productively unrelated. Some results such as “the Informativeness Principle” might need to be reformulated to consider the observability of signals by the principal relative to their observability by other potential traders.