This paper provides novel evidence of the moral hazard problem in environmental insurance by investigating the effect of environmental liability insurance (ELI) on firms' environmental performance. Using the staggered adoption of ELI policies in China as a quasi‐natural experiment, we employ a difference‐in‐differences setup based on a comprehensive firm‐level data set. We find that the adoption of ELI policies significantly reduces firms' efforts in treating water pollution. The negative estimate indicates a moral hazard problem and is the opposite of the positive estimates found mainly in studies that focus on US firms. We further find that the negative effect is lessened for firms in strictly supervised regions and for firms with strong environmental awareness. This paper is one of the first to evaluate environmental insurance in developing economies and provides novel evidence on moral hazard in environmental liability insurance markets.