Optimal Incentive Contracting with Ex Ante and Ex Post Moral Hazards: Theory and Evidence

Predictions concerning structure and performance for managerial incentive contracts designed to prevent accidents are developed and tested. The model predicts a step-function penalty with more costly, more reliable audits used for higher loss reports to control ex post exaggeration of the loss. In addition, the penalty induces nonreporting that is imperfectly controlled through random audits. An empirical contract implemented to control workers' compensation medical losses provides evidence consistent with these predictions. The contract reduces both accident frequency and total losses, but increases reported loss severity as managers evade approximately 40% of the accident penalty by underreporting small losses.