What does "moral hazard" refer to in insurance?

Moral hazard refers to a situation where the behavior of the insured party changes in a way that increases the likelihood of a loss occurring after the insurance policy is in place. This often involves the insured person potentially acting with less care or even intentionally causing or exacerbating a loss since they know they have insurance coverage to mitigate the financial consequences.

For instance, if someone has fire insurance on their property, they might be more careless with fire safety, or in some extreme cases, they might consider starting a fire themselves to collect the insurance payout. This kind of risky behavior arises because the individual does not bear the full financial responsibility for their actions due to the existence of the insurance policy.

The context of this term highlights the ethical considerations in insurance and risk management, emphasizing that insurers must be aware of the potential for increased risk stemming from the insured's behavior.