Moral Hazard:

Moral hazard is used to describe the fact that people tend  to engage in riskier behaviour when they are insured against losses resulting from their behaviour. For example,  drivers may  take more risks  on  the  road when  they  know  the insurance company will pay  for damages. Moral hazard is a problem if such a fact causes someone not  to be  able to  insure against  risk  that would  be insurable if it didn't  exist.  

Example

Suppose  you  have a driver with a  car  worth  Rs.20,000.  It will  meet  an accident with probability p = 0.05. But  if  the driver  is fully insured, he will drive more recklessly with p = 0.1. Uninsured, the driver faces a gamble with a 95% chance of Rs.20,000 and 5% chance of no  loss. The expected value of this gamble  is  Rs.19,000.  Because the driver is  risk  averse,  his  certainty equivalent  for this  gamble  is Rs. 1 8,500. Therefore, the maximum premium he'll  pay  is  Rs.1500.  But  fiom  the insurance company's perspective,  the chance of  an  accident  is 15%  indicating  the  expected loss (minimum insurance premium)  is  [0.1 (Rs.20,000)] = Rs.2000. Notice that this premium is more than the driver is willing to pay. As a result, no full  insurance policy gets sold.

The  best  possible outcome would  be  if  the  driver were  fully  insured  but continued to drive carefully, just  as  he  were not insured. But once  he  is insured, he'll  drive recklessly just  because  he's  already got the policy.  If  he could care for the consequences of his behaviour, he would (prior to buying insurance) agree to a self-imposed commitment to driving carefully in future.

One solution to  deal with such a problem is to charge higher premiums for people with records of claims before  for  accidents. Such a provision  will compel the parties to act carefully even when insured. To have  less-than-full insurance, in the form of deductibles or co-payments is another solution. Suppose that a potential loss of Rs. 10,000  is  enough  to induce the driver above to drive carefully. Then the insurance company could offer a policy to  insure a loss upto Rs.10,000, with a minimum premium of [0.05(Rs.10,000)]= Rs.  500. Becaiise  it's  better than no insurance at all, the driver will buy  the policy. However, this is a second best  solution, given that full insurance with careful behaviour is the best.