Moral Hazard

A moral hazard is a situation in which a person with insurance takes greater risks than they normally would without insurance, because they know their insurer will foot the bill if something bad happens.

What is moral hazard?

A moral hazard is a type of risk. More specifically, it’s a risk that someone takes because they know someone else will pay the consequences of that risk.

Two conditions need to happen in order for a moral hazard to exist:

  1. Two parties enter into an agreement
  2. One party has more information than the other

Moral hazard, applied to insurance

The idea of a ‘moral hazard’ actually originated in insurance, because insurance companies were worried that people would behave in riskier ways if they had an insurance policy.

For example:

Those without HO4 insurance would probably be extra careful when it came to their home and stuff. They’d take the time to do things like get a burglar alarm, install video cameras, double-lock their apartment in case of theft, or even take extra precautions to avoid a burst pipe.

On the other hand, someone who has renters insurance may become more careless (e.g. leaving their apartment unlocked) because they know that if something happens, their renters insurance company will cover the loss.

In other words, they’ll no longer have to (literally) pay the consequences for their behavior.

Example of a moral hazard

Let’s say you just bought a shiny new bike. You love your bike, and take care of it to make sure nothing happens – you lock it every time, take your seat with, and make sure not to park it anywhere someone could damage it.

Then, you hear of something called renters insurance, which protects your bike – among other stuff – against things like theft, fire, windstorms, hail, etc. You get an insurance policy, and suddenly feel much more relaxed at the thought of your bike being snagged. ‘Who cares if my bike’s stolen,’ you think. ‘My insurance company will just get me a new one.’

Based on that, you decide to be lazy – you stop locking your bike and taking your seat with you, unbeknownst to your insurance company.

This, my friend, is a moral hazard.

Please Note: These definitions don’t alter the terms, conditions, exclusions, or limitations of policies issued by Lemonade. They are intended for educational purposes only - they’re not meant to be used in lieu of professional legal or financial advice. We’ll do our best to keep them updated, but they may not always reflect current industry developments. Feel free to use the terms with attribution (friends don’t let friends plagiarize!)

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