Moral hazard

A situation that exists in contracts when one party has either entered the contract in bad faith or has an incentive to take abnormal risks

A woman smiles while locking up her bike

What is a moral hazard in insurance?

In insurance, a moral hazard is when the person covered by a policy has an incentive to take risks they wouldn’t if they were uninsured. The idea is that getting coverage might discourage a homeowner from taking reasonable and prudent actions to protect their home and belongings because they know the insurance company will pay for damages.

For example, a homeowner who has insurance may be less likely to lock their doors because they know that the insurance company covers their stolen property. Not locking doors increases their chances of a loss, but the homeowner is less concerned because they aren’t the ones that have to pay.

Looking at it that way, it’s probably not a surprise that the term “moral hazard” originated in the insurance industry, or that it continues to be an issue for insurance companies to this day. It’s one reason some insurers hesitate to offer coverage to certain types of risks, like vacant buildings. The owner of a vacant building may not have an incentive to protect it – or may even see an economic advantage to burning it down.

Moral hazard: Insurance example

Bikes are often used as examples of moral hazards for insurance because they are usually included in your personal property coverage, are used outside the home, and are often the target of theft. If you buy a bike and don’t have coverage (or don’t realize that your homeowners insurance covers it) you’re more likely to be vigilant about locking it up in safe locations. But someone who knows that insurance will replace the bike might decide that locking it is unnecessary and a waste of time.

How insurance companies handle moral hazards

Your insurance company can’t control whether or not you lock your bike, but it can create incentives for you to behave in a way that’s more responsible. In homeowners insurance, one of those incentives is the deductible. This is the amount the policyholder is responsible for in a claim. By requiring homeowners to choose a deductible of anywhere from $500 to $2,000 or more, insurance companies increase the likelihood of homeowners taking better care of their property, and this mitigates the insurance company’s risk.

Another way your insurance company encourages responsible behavior and limits its losses is through exclusions. For example, most home insurance policies exclude damage resulting from:

  • Poor home maintenance.
  • Regular wear and tear.
  • Pest infestations.
  • Gradual leaks.

For example, say you discover a beam under your deck has started to rot, but you put off fixing it. Over time, the situation gets worse, the beam fails, and your deck collapses. Your insurance company may deny your claim because your damages are the result of a maintenance issue.

By denying claims like these, your insurance company encourages homeowners to perform routine maintenance to ensure there are no problems with their homes’ plumbing, electrical, or other systems.

Many insurance companies go a step further to reduce the impact of a moral hazard in insurance policies by offering discounts for customers who exhibit safer behaviors. These might include discounts for:

  • Getting a security system.
  • Installing a fire alarm.
  • Buying a water leak detection device.
  • Upgrading your roof.
  • Living in a gated community.

You might also be offered a discount if your insurance history is free of claims. The hope here is that you’ll only file a claim when absolutely necessary because you want to keep the discount.

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