Moral Hazard in Insurance: Definition and Examples

Moral hazard is when a person takes greater risks because they know they won’t bear the full consequences. In insurance terms, it means a policyholder might act less cautiously once they lock in coverage.^[1]

This behavior can increase an insurance company’s risk and, in turn, lead to higher deductibles and premiums. It may also result in stricter claims requirements, making it more difficult to collect reimbursements for covered losses.

As a policyholder, you should understand the concept of moral hazard and how it applies to insurance and risk management. Below, we’ll further explain what moral hazard is, share some real-world examples, and explain how you can avoid it to save on home insurance coverage. 

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What is Moral Hazard?

Once a homeowner secures a policy, they might change their behavior, knowing they’re financially protected and won’t bear the full consequences in the case of a loss. Insurance experts use the term “moral hazard” to refer to the risk that a policyholder may act carelessly after they lock in coverage.

A homeowner may do this for personal gain, hoping the insurance company will cover their losses. For example, if someone has a home insurance policy, they might neglect home repairs because they’d rather use the insurance payout to cover more serious damage.

How Moral Hazard Works in Insurance

As soon as an insurance policy takes effect, the financial risk transfers from the policyholder to the insurer. In some cases, this can encourage riskier behavior, making moral hazard a major concern for insurance companies.

To discourage moral hazard, insurers use deductibles, limits, and exclusions. Deductibles require policyholders to pay a set amount before their policy kicks in. Limits cap how much they’ll be reimbursed, and exclusions remove coverage for certain situations. 

Together, these components help hold policyholders accountable, reducing risk for insurance companies.

Examples of Moral Hazard

Several examples of moral hazards in home insurance include:

• Failing to fix leaks in your home because your policy may cover water damage

• Taking fewer precautions against theft or fire

• Not locking doors or windows, since you know your coverage will reimburse you for theft

• Choosing not to remove snow or ice from your walkways after you learn your policy covers slips and falls

If you’re a homeowner with an insurance policy, it’s a good idea to think about how moral hazard may apply to you. Look for small, everyday behaviors that might fall under this concept.

Why Moral Hazard Matters to Policyholders

When setting premiums, insurance companies assess the likelihood of risky behavior. If moral hazard is widespread, policyholders can expect to pay more for coverage. Conversely, lower perceived risk levels often lead to more competitive home insurance rates.

Beyond higher pricing, moral hazard may result in tighter underwriting and stricter coverage limits. To keep home insurance affordable and attainable for everyone, policyholders should practice safe, proactive behavior.^[3]

How Insurers Combat Moral Hazard

Home insurers use these strategies to mitigate moral hazard risk:

• Deductibles: Deductibles allow insurance companies to share financial responsibility with policyholders, ultimately reducing the number of frivolous claims.

• Policy exclusions: Exclusions limit coverage for preventable losses, such as maintenance-related neglect, flooding, earthquakes, and pest infestations.^[4]

• Premium surcharges: Home insurance companies may raise premiums for people who file frequent claims or engage in risky behaviors.

• Claims investigations: Thorough claim reviews help discourage frivolous or fraudulent claims.^[5] 

• Usage-based and telematics programs: In the auto insurance industry, these programs reward safe, lower-risk drivers with lower rates.

How to Avoid Moral Hazard and Save on Insurance 

Below are several strategies you can implement today to become a more responsible policyholder and, in turn, increase your likelihood of affordable insurance coverage. 

• Understand your coverage and limits. Take a close look at your insurance agreements to avoid unexpected surprises and prevent unnecessary claims.

• Keep up with regular maintenance on your home or car. Make an effort to care for your property and vehicle through routine tasks, such as roof inspections and oil changes.

• Avoid filing unnecessary claims. Only file claims with your insurance company when you believe they’re legitimate and worth pursuing. 

• Consider a higher deductible. A higher deductible reduces insurer risk and leads to lower premiums for you as a policyholder.

• Ask about telematics or safety discounts. Find out if your car insurance company offers a telematics program or discounts for safe or defensive driving. 

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Moral Hazard vs. Adverse Selection

Moral hazard occurs when a policyholder engages in risk-taking because they know an insurer will cover their losses. Adverse selection, on the other hand, occurs when a high-risk person is more likely to purchase coverage than someone with lower risk.

	Moral Hazard	Adverse Selection
What is it?	A policyholder engages in excessive risk once they know the insurer bears financial risk	A high-risk person buys insurance coverage, while someone with less risk opts out
When does it happen?	After securing insurance coverage	Before locking in an insurance policy

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