What does "moral hazard" refer to in insurance?

Moral hazard refers to a situation in insurance where the behavior of the insured changes as a result of having insurance coverage. Specifically, when individuals or businesses know they are covered, they may take on riskier behaviors or be less vigilant in mitigating risks because they believe that their insurance will compensate them in the event of a loss. This change in behavior can lead to an actual increase in the likelihood of a loss occurring, which is the essence of moral hazard.

Understanding moral hazard is crucial for insurers as it directly impacts risk assessment and management. Insurers typically implement measures, such as deductibles and copayments, to encourage policyholders to maintain responsible behaviors and to deter reckless actions that could lead to greater losses.

Other interpretations, such as linking moral hazard solely to fraudulent activities, the risks tied to natural disasters, or overestimating the value of insured items, do not capture the fundamental essence of how moral hazard affects behavior in the presence of insurance. These elements are different concepts that pertain to other facets of risk and insurance interactions.