A moral hazard is when an insured party behaves recklessly because they know another party, often an insurer, will bear responsibility for any resulting costs.^[1] Some common moral hazards include neglecting maintenance, leaving doors unlocked, and driving recklessly.

Here’s what you should know about moral hazards in home insurance.

What does moral hazard mean?

A moral hazard can happen when two parties enter a contract. It occurs when one party acts in bad faith or knowingly takes on more risk because the other party is contractually bound to assume the risk. This hurts the risk-bearing party, often an insurance company, as it’s usually obligated to cover the risk.^[2]

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Moral hazard examples

To further understand the concept of moral hazard in homeowners insurance, consider the following examples.

A homeowner stops locking their doors

A homeowner buys insurance to protect their dwelling and personal belongings. Once insured, they may no longer take as many steps to protect their property, such as locking their doors to reduce the chance of theft.^[3]

A homeowner neglects home repairs

Another example of moral hazard is when a homeowner puts off performing maintenance, such as replacing a rotting beam beneath their deck. They may think they don’t need to replace it yet or don’t want to foot the bill. Being insured, they may assume that if their porch collapses, it’ll be covered by insurance.

Learn More: Do You Need Home Repair Insurance?

A renter leaves their bicycle unattended

Renters insurance, like homeowners insurance, protects your personal belongings up to the coverage limit. A renter without this type of coverage may be more inclined to protect their bicycle by locking it in a safe place. But if they know insurance will reimburse them for a stolen bicycle, the renter may not be as concerned with locking their bike up.

How does moral hazard affect insurance companies?

Moral hazard negatively affects insurance companies because they must shoulder the burden of paying claims when policyholders engage in risky behavior.^[3] Insurers often incentivize policyholders to behave responsibly to avoid this increased financial responsibility.

One way insurers incentivize policyholders to act with reasonable care is through deductibles. A deductible is the amount an insured person must pay before their insurance coverage kicks in. Standard deductibles typically range anywhere from $500 to $2,000. Most people want to avoid paying them, and so in this way, insurers reduce the likelihood of moral hazards.

Insurance companies also reduce risk through exclusions — provisions in an insurance policy that eliminate certain coverages. Most homeowners insurance policies exclude damage resulting from:

• Poor home maintenance

• Intentional neglect or damage

• Water seepage

• Regular wear and tear

• Pest infestations^[4]

By denying claims like these, homeowners insurance companies reduce the risk of moral hazard. These exclusions ensure policyholders take steps to care for their homes, preventing many avoidable, expensive claims.

Read More: What Does Home Insurance Cover and What Does It Exclude?

Moral hazard vs. morale hazard

The important distinction between moral hazard and morale hazard is intent. Moral hazard refers to intentional behavioral changes a policyholder may develop over time. They may take on greater risk than normal because they know they won’t have to bear the consequences.

Morale hazard, on the other hand, is not intentional. It happens when a person is indifferent toward potential risk because they know their insurance company will provide coverage.^[5] One example of a morale hazard is when a person owns an old car with little value and doesn’t bother locking their doors when parked in public.

Moral hazard vs. adverse selection: What’s the difference?

The concept of moral hazard is similar to adverse selection, a scenario in which two parties enter into a contract, but one party has more information than the other. The party with more information may take on more risk, leaving the other party at a disadvantage.^[6]

The key difference between the two is when the risk occurs. Moral hazard occurs after the parties agree to the terms of the transaction, while adverse selection happens before the parties enter into the agreement.

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How to avoid moral hazard

Policyholders may engage in moral hazard without realizing they’re causing harm to the insurer. But moral hazard generally increases costs for insurance companies, and those companies often make up for those costs by raising rates for policyholders. It’s in everyone’s best interests to avoid moral hazard when possible.^[3] 

Here are some ways ways to avoid moral hazard:

• Use a security system.

• Install smoke alarms.

• Lock your doors and windows when away from home.

• Extinguish candles when you’re not home.

• Buy a device that detects water leaks.

• Maintain your roof.

• Inspect your home regularly and make repairs as needed.

These factors are within your control, so it’s generally good practice to care for your property — a home, bicycle, car, or anything else — whether it’s insured or not. The purpose of insurance is to support you when something outside of your control happens and the peril is included in your coverage.^[7]

Check Out: 8 Simple Tips to Make Buying Bicycle Insurance Easy

Moral hazard FAQs