What is a moral hazard?

A moral hazard occurs when a policyholder's behavior increases the likelihood of a loss because they engage in riskier actions, knowing that they have insurance coverage to protect them. This concept is rooted in the idea that when individuals or organizations are insulated from risk, they may take actions that they would otherwise avoid if they bore the full consequences of their decisions.

In the context of insurance, moral hazards arise when the insured party alters their behavior, becoming less careful or taking excessive risks, as a result of feeling protected by their insurance policy. For instance, someone may drive more recklessly knowing they have comprehensive auto insurance, or a homeowner might neglect maintenance on their property because they trust that any damages will be covered. This deliberate decision or recklessness fundamentally shifts the risk dynamics, increasing potential claims and costs for insurers.

In contrast, the other options do not accurately capture the essence of moral hazard. A type of physical risk pertains more to tangible threats rather than behavior, concern related to legal liability is about legal implications rather than individual behavior, and a behavior unrelated to financial security does not connect to the insurance context where moral hazard exists.