What is meant by the term 'moral hazard' in underwriting?

The term 'moral hazard' refers to the situation where the behavior of the insured party changes as a result of having insurance coverage. In essence, it describes a scenario where the insured has less incentive to take precautions against loss because they know that any potential losses will be covered by their insurance policy. This can lead to an increased likelihood of loss or damage occurring, simply because the insured feels safer or less responsible for preventing the loss, knowing that the financial burden will be alleviated by their insurance coverage.

Understanding moral hazard is crucial for underwriters, as it highlights the importance of assessing the risk associated with an individual or entity's behavior after obtaining insurance. Underwriters must consider this when evaluating applicants for insurance and determining premiums, as a higher moral hazard can lead to higher loss ratios and ultimately impact pricing and terms of coverage.