How is "moral hazard" defined in the context of insurance?

Moral hazard refers to the behavior of individuals who, when protected by insurance, may take on greater risks or behave less cautiously than they would if they were not insured. This change in behavior occurs because the individual knows that the financial consequences of any potential loss will be covered by their insurance policy. Therefore, the essence of moral hazard lies in the alteration of a person's actions due to the safety net provided by insurance.

In this context, the correct answer highlights the fundamental issue that insurance seeks to mitigate: people might take unnecessary risks because they do not bear the full consequences of their actions. This understanding is crucial for insurance providers as they develop policies and set premiums, as they need to account for the potential increase in risk that moral hazard generates.