How is 'moral hazard' defined?

Moral hazard refers to the phenomenon where the behavior of the insured changes for the worse after obtaining insurance coverage. This change in behavior can lead to riskier activities or less care being taken toward preventing losses, under the assumption that the insurance will cover any resulting damages or claims.

For instance, a person who has comprehensive health insurance may be less vigilant about making healthy lifestyle choices, as they feel protected against the financial consequences of potential health issues. Additionally, a homeowner with insurance may not take the same precautions to prevent home damage, knowing that they can claim for repairs later.

Understanding moral hazard is crucial for insurers, as it underscores the importance of risk management practices and can affect premium pricing and coverage conditions. By being aware of moral hazard, insurers can implement measures to mitigate its impact, such as introducing deductibles or requiring policyholders to engage in behaviors that minimize risks.