What does the term 'moral hazard' describe?

The term 'moral hazard' refers to a situation where the behavior of an insured party changes as a result of having insurance coverage. Specifically, it indicates that once an individual or entity is insured, they may engage in riskier behavior because they do not bear the full consequences of that risk. As a result, the likelihood of a loss occurring increases, since the insured may not exercise the same level of caution or responsibility they would if they were fully accountable for the potential losses.

This concept is crucial in the insurance industry as it highlights the importance of risk management and the need for insurers to implement measures such as deductibles or policy limits to mitigate this behavior. By doing so, insurers aim to encourage policyholders to maintain safe practices, thereby reducing the overall incidence of claims.