Moral Hazard in Insurance – What it is, How it works, Examples

What is Moral Hazard? - Definition

“Moral Hazard” in Insurance refers to a situation where the Policyholder takes bigger risks than he normally would, simply because the Policyholder is insured and knows that the Insurance Company would reimburse the losses in case of a Claim. Moral Hazard is a situation where an Individual takes advantage of a situation, knowing well that the risks and losses are covered by the Insurance Company, and he won’t have to bear the losses.

How Moral Hazard works? – Examples of Moral Hazard

Moral Hazard happens when the Insured take higher risks than warranted because the risks are limited because of being covered by an Insurance Policy. For Example, A Company may have purchased a Fire Insurance Policy for its factory. The Insurance Company is responsible for any damage to the factory assets by fire or allied perils and the Insured Company pays an Insurance Premium for this protection. The Policyholder knows that there is less risk in taking precautionary measures to protect the factory assets against fire since all the losses will be borne by the Insurance Company in case of a Claim. Thus, the customer won’t invest money in Fire Extinguishers or Fire Alarm Systems which reduces the risk of Fire Damage. An employer might insure his employees on a selection basis under a Group Mediclaim Policy in order to reduce his premium outgo. This is also an example of Moral Hazard.

How does Moral Hazard impact Insurance Companies?

Being Insured impacts the behaviour of the Policyholder and might encourage him to take greater risks. As explained in the above example, the Policyholder would not want to invest in fire protection measures in his factory to save money because he knows that the Insurance Company will bear the loss of any damage to assets. In case of Life Insurance, if an Individual believes that he is likely to die soon because of some illness, he might purchase a Life Insurance Policy by withholding the information about the Illness from the Insurance Company.

How do Insurance Companies prevent Moral Hazard?

Insurance Companies prevent Moral Hazard in several ways: All Insurance Policies have a Deductible, which is the amount of loss that the Insured has to bear from his own pocket before the Insurance Company starts paying out the claim. The Insurance Policy will pay the Claim only after the loss exceeds the Deductible Amount. So, the Insured has to bear a certain amount of loss from his own pocket in any loss situation. In case of Health Insurance, the Insurance Company asks for a Medical Test which is likely to reveal any ailment that the prospective Policyholder is suffering from. Another way Insurance Companies prevent Moral Hazard is by adding exclusions to the Insurance Policy. For example, a Life Insurance Policy will not pay the Claim if the death happens by suicide.

Moral Hazard and Adverse Selection

Adverse Selection refers to the tendency of a person who is more likely to suffer a loss to purchase Insurance Coverage, so that the person does not have to bear the loss. So, a healthy person will not purchase a Health Insurance Policy while a person with ailments will purchase robust Health Insurance Coverage. Over time, the Insurance Company will insure a greater proportion of high risks or bad risks which increases the overall risk for the Insurance Company. So, the Insurance Company will be left with a greater proportion of high risks resulting in ‘Adverse Selection’.

Conclusion

Moral Hazard is an important factor in Insurance and Insurance Companies take steps to prevent Moral Hazard. If you require any further information about Insurance, please reach out to us via email at insurance@qian.co.in or call us on 022-35134695. We would be glad to assist you.