This blog explores a term that most insurance experts will know, but many clients will not. Moral hazard can have negative consequences for clients, brokers and insurers. We plan to provide a simple explanation of moral hazard in insurance, and what it means for those at risk.

What is moral hazard in insurance?

Moral hazard is the idea that a party that is somehow protected from risk will behave differently compared to if they didn’t have that protection. For example, when people wear a bike helmet, they may take more risks than they would if they were not wearing one. 

In the context of insurance, increased coverage may mean policyholders prepare less or take risks that they would not otherwise take. It is a ‘don’t worry, I’m insured’ attitude. For example:

• Those with collision insurance driving more recklessly,
• Those with contents-insurance being more careless with locks and windows, 
• And those with flood insurance taking fewer measures to reduce flood damage.

What is the problem with moral hazard?

Insurance is a victim of its own success. While insurance aims to give peace of mind, it often results in an absence of mind. That’s where moral hazard creeps in. Ideally, clients should still want to prevent the worst from happening, with insurance acting as a support if it does.

Nyasha Kuwana, Head of Product at FloodFlash

First, let’s look at a situation where a person does not have flood insurance – person A. They may not be able to get insurance, or they may be facing a high excess. To account for this, they may raise their stock or possessions, install flood defences, and put money away in case the worst happens.

Now let’s look at a situation where a person has traditional flood insurance – person B. Feeling protected by their insurance, they may be less inclined to raise their stock and possessions, install flood defences, or put away money in case of the worst happens. After all, the insurance company has promised to pay their damages in the event of a flood. Of course, these decisions also depend on the behavioural characteristics of the policyholders, and how much they can spend on such risk avoidance measures.

However, having insurance for a flood does not make a property less likely to flood. Person B, with insurance but no physical resilience, will face more damage than the person A, who may avoid damage all together through physical measures. Further, traditional insurance can take months to pay out, which means the property-owner has to pay any immediate costs. This contributes to the following statistic:

40% of businesses who suffer a catastrophic flood do not reopen

Business in the Community, 2020

Moral hazard is also costly as it means insurers pay out more, or larger, claims. For example, if person B had physical resilience in place, they would not suffer as much damage, resulting in their insurer paying out less in their claim. Increased payouts feed through to clients, meaning higher premiums to account for moral hazard.

How traditional insurance deals with moral hazard

Add an excess:

An excess, or deductible, is the amount the policyholder pays before the insurer pays out any damage claims. If the insurer deems the risk to be high, this can amount to a significant proportion of the overall cost. The aim of an excess is to encourage policyholders to carry out additional risk measures to reduce their potential costs in the event of a flood. If a flood policy has an excess, the policyholder may choose to raise expensive stock, or install flood gates so that their damage is reduced. 

Add conditions:

Conditions are requirements that must be met to ensure a policyholder’s coverage is valid. Bicycle insurance may come with the condition that the bike must have a high-quality lock, or that the bike must be stored within the individual’s property, rather than in a communal space. These measures aim to reduce moral hazard, increase the protection of policyholders, and minimise the potential payout of insurers. However, conditions can result in added complexities. Many customers are unaware of them – leading to confusion, and often disappointment, in the event of a claim. 

Offer lower premiums:

Insurers may offer cheaper premiums if other measures are in place. This aims to reduce moral hazard, as well as the potential payout. For example, if a property has flood defences are in place at a property, an insurer may choose to reduce the premium. This is because it reduces the risk of flood damage for property owners and reduces the size of the payout for insurers. 

However, this is rarely the case. This is due to uncertainty around the potential damages and how well physical resilience measures are installed. Read more about how these measures interact with insurance here.

Moral hazard and parametric flood insurance

Parametric insurance reduces moral hazard. With FloodFlash, the depth of flood water selected by the client triggers their payout. The higher the trigger depth, the lower the premium. This incentivises policyholders to install flood defences up to the height of their first trigger depth, or move electricals and stock to above that height. As well as reducing moral hazard, this also means that a financial excess is not necessary with a FloodFlash policy. 

A good example of how FloodFlash and physical resilience measures can combine is Tonbridge Juddians Rugby Club in Kent. Repeated flooding meant they could no longer get flood insurance, forcing them to self-insure. To protect themselves from damage, they raised their clubhouse to 1.2m above ground level. Although this put them in a good position to deal with a flood, it required them to save significant amounts of money in case of a catastrophic event.

Using parametric insurance, we could provide affordable cover for a flood that reaches 1.2m. This is the point where water would enter the clubhouse. Our cover meant the club could reinvest the money they had saved up in the event of a flood. Watch the case study video below to find out more about how the club combined physical resilience and FloodFlash.

Parametric insurance encourages clients to actively engage with their risk. Physical resilience measures lower the risk of damages from flood. With FloodFlash, this means that trigger depths can be raised and payouts can be lowered, resulting in lower premiums and reducing moral hazard.

Moral hazard and government flood schemes

After Hurricane Harvey wreaked havoc in the US, the National Flood Insurance Program (NFIP) was responsible for a 15% increase in damages in Harris County, Houston

Peralta and Scott, 2015

When insurance is financially subsidised, it can result in customers valuing it less. Government flood schemes like Flood Re in the UK and the NFIP in the US subsidise flood insurance. Property-owners with access to subsidised premiums are less likely to fully appreciate the risks they face. This creates moral hazard at a community level. For example:

• Developers build on known floodplains with high flood risks, without fear that the properties will be hard to sell. In 2021, over 5000 homes in England were approved to be built on flood plains. 
• People move to high-risk flooding areas and be confident they can get flood insurance.
• Home- and business-owners may not feel the need to invest in resilience physical measures. 

This community level moral hazard means that government flood schemes can result in increased damages during a flood. A study found that the availability of flood insurance led to a 4-5% increase in population in high flood-risk areas compared to if there was no flood insurance available. Couple that with property-owners feeling less of a need to invest in physical measures due to insurance, and the damage caused by flooding can easily rise. 

Although the subsidised schemes contribute to moral hazard, it is a tricky policy decision. As climate change and urbanisation continue, the number of properties in high-risk flood areas will increase. The schemes existence provides affordable cover for those who would otherwise be unable to, or else would face high premiums or excesses – often maintaining vulnerable economies. 

How to reduce your own moral hazard

It is very hard to avoid moral hazard completely. Individuals are generally not able to delve into the exact risks they may face, and most events have an element of randomness that complicates things even further. Flood risk is particularly hard to quantify, resulting in underestimation of the risk. However, it is important to be aware of moral hazard and do what you can to reduce it.

If you are a business owner taking out flood insurance, remember insurance is not enough to fully protect you. Consider how you can limit your damages and costs in the event of a flood. A simple way to mitigate damage is having a detailed flood plan in place – the Environment Agency have a handy template that you can use. 

The more you know about how flooding might affect your property, the less likely moral hazard can creep in. FloodFlash smart quote helps you engage more with your flood risk. Smart quote asks some basic information about your property. It then produces a starting quote, and provides insights as to how we generated the quote. These insights aim to help you consider the right cover for your business. They can also help you think how you can physically protect your property and increase your trigger depths – reducing your premiums and moral hazard.