What is Moral Hazard?Moral Hazards

When you have assets to protect, like your car or your house, it makes sense to insure them. However, while insurance provides peace of mind, it may not have the intended effect. In some cases, individuals may be more likely to engage in risky behaviors because they know they are insured.

For example, let's say you have excellent insurance on your car and want to buy a new one. Rather than paying for another vehicle, you intentionally total your current one for the payout.

The incentive is known as a moral hazard, and it can be tricky for insurance companies to measure. On the one hand, the goal of insurance is to provide financial compensation for the loss or damage of an asset - on the other hand, if coverage encourages risky behavior, it can create a substantial burden for the insurer. Additionally, insurance companies specifically exclude coverage for intentional damage by the insured. Let's take a closer look at moral hazard and what it means for the insurance industry.

What is Moral Hazard?
The simple definition of moral hazard is a situation when the probability of loss or damage goes up when the insured has more incentive to invite damage claims or will not face any consequences of their actions.

Part of the problem of moral hazard is that it can be hard to pin down because it measures the insured's attitude. Since no one will come out and say that they plan to commit insurance fraud, the insurance company must determine whether a person is acting in bad faith.

One way to get around this conundrum is to avoid specific situations that could lead to a significant moral hazard. For example, discourage an insurance payout worth more than the insured asset.

Moral Hazard vs. Morale Hazard
At first glance, these two terms look almost identical. However, that little e makes a big difference. While a moral hazard assesses a person's willingness to take more significant risks, a morale hazard refers to one's indifference to loss.

So, a moral hazard could be wanting to torch your car to get a settlement to buy a new one. However, a morale hazard could be leaving your car in a bad neighborhood because you do not care if someone steals it. In both cases, your attitude stems from the fact that you have excellent insurance, but the difference is if you choose to act on it.

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What is Moral Hazard in Insurance Terms?
For individuals, moral hazards can come up in various types of insurance, such as:

  • Homeowners Insurance. If your coverage is worth more than your house, you may be tempted to damage or destroy it to get a settlement.
  • Automotive Insurance. If you cover your car against theft, you may leave it in an area likely to get stolen.
  • Renters Insurance. You may not care if your apartment gets damaged because you are covered if that happens.

What is Moral Hazard Risk?
Nobody is going to admit that they plan to commit insurance fraud. However, in some cases, the insured may know more than the insurance company, which creates a moral hazard risk for the insurance company. In this case, there is information asymmetry -- the insured knows something the insurer does not, which can give them a financial advantage.

For example, let's say that you own an asset that is worth a lot of money right now, but you know that it will be worthless in the future.

Asymmetric information can also lead to adverse selection. In the insurance industry, adverse selection refers to a situation where one-party gains while the other loses. It could mean that a high-risk individual gets life insurance without disclosing any physical hazard that stems from their job.

3 Examples of Moral Hazard
Here are three primary examples of moral hazard risks that may affect insurance markets and companies, which may help provide further insight into this phenomenon.

  • Moral Hazard in Fire Insurance. Insurers typically do not cover abandoned or vacant real estate properties. The reason is that the insured owner can burn the home down to claim a settlement, all without risk to themselves or potential tenants.
  • Flood Insurance. Many homeowners have no issues living in a flood zone because flood insurance from the National Flood Insurance Program (NFIP) will pay for damages whenever water gets into the home.
  • Theft Insurance. Whether it is a car or some other asset, the owner could stage a heist to get a settlement while keeping the original item.

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Hope that helps!

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At your service,
Young Alfred