In the insurance world, a moral hazard exists when the insured engages in behavior that is much more risky because they know the insurance company will respond and pay for a loss.
As an example, imagine you own a building valued at $250,000 and you have two insurance policies covering that building. If you knew that you could collect $250,000 from both insurers in the event your building was a total loss, you might be inclined to neglect fire hazards… almost hoping for the building to burn to the ground because you’d receive $500,000 if it did.
Enter the “Other Insurance Clause” found in nearly all property insurance policies. This clause is designed to prevent an insured from receiving multiple payments for the same loss. A common other insurance clause looks like this:
"If a loss covered by this policy is also covered by other insurance, we will pay only the proportion of the loss that the Limit of Liability that applies under this policy bears to the total amount of insurance covering the loss."
So back to our example of your building valued at $250,000 and insured on two separate policies for that amount. If you suffered a total loss, each policy would pay its proportional share of the loss: 50% or $125,000 each, so you would collect $250,000.
How would it work if you had one policy with a limit of $150,000 and a second policy with a $250,000 limit? In this scenario, you have a total of $400,000 of coverage for a loss totaling $250,000. The policies would respond like this:
- Policy #1: $150,000/$400,000 = 37.5%. Since Policy #1 bears 37.5% of the total amount of insurance in place, it will pay this percentage of the loss, or $93,750 (37.5% x $250,000).
- Policy #2: $250,000/$400,000 = 62.5% so will pay $156,250.
Ultimately, you (the insured) still collect for the full value of your loss ($250,000), but you paid for insurance you didn’t need because of the Other Insurance Clause, you can’t collect more than the value of your loss.
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