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

The term "moral hazard" in insurance refers to a situation where individuals or entities that are insured may engage in riskier behavior because they know they have coverage. This concept arises from the perception that when people are protected from the consequences of their actions, they may be less motivated to exercise caution. For instance, if a homeowner knows their property is insured, they might be less careful about maintaining the property or might even take risks that could lead to loss or damage, knowing that the insurance will cover the financial repercussions. This behavior is particularly concerning for insurers, as it can lead to increased losses, thereby impacting the overall cost of insurance. Understanding moral hazard is crucial for insurance providers, as it shapes underwriting practices and policy design to mitigate these risks.