Explain moral hazard.

• A. Moral hazard is the tendency to take more risks because losses are insured, increasing the likelihood or severity.
• B. Moral hazard is the policyholder refusing to file claims.
• C. Moral hazard is the insurer's right to cancel coverage.
• D. Moral hazard is a calculation of actuarial risk independent of behavior.

Answer: (A)

Moral hazard occurs when having insurance changes the insured’s behavior, making them more likely to take risks or incur larger losses because the financial burden is shifted to the insurer. When losses are covered, there’s less incentive to avoid risky activities or to take precautions, which can raise both the probability of a loss and the potential severity. For example, someone with insured valuables might take fewer precautions to protect them, knowing a claim could cover any loss. Insurers counteract this with design features like deductibles, co-pays, claim audits, and incentives that keep the insured bearing some cost.

The other choices miss the behavioral shift aspect: refusing to file claims isn’t about changing behavior to take more risks; it’s a behavior related to claiming itself and isn’t the defining feature of moral hazard. The insurer’s right to cancel coverage is a contractual right, not a change in how the insured behaves after coverage is in place. A calculation of actuarial risk independent of behavior describes pure risk or baseline risk assessment, not the change in behavior that moral hazard describes.