What does the term "moral hazard" refer to in the context of insurance?

The term "moral hazard" in the context of insurance refers specifically to the behavioral risk that arises when the behavior of the insured party changes as a result of having insurance coverage. When individuals or entities are shielded from the consequences of their actions due to insurance, they may engage in riskier behavior than they otherwise would. For example, if a person knows that their insurance will cover the costs of damage or loss, they might take greater risks, such as driving recklessly or neglecting to protect their property.

This concept is crucial in understanding how insurance companies assess risk and determine premiums. A key aspect of managing moral hazard involves creating incentives for insured parties to act responsibly, such as through deductibles or coverage limits that encourage individuals to minimize potential losses. These mechanisms are designed to mitigate the negative impact of moral hazard on both the insurer and the insured, promoting a more responsible approach to risk management.