Moral hazard
Being protected from a risk changes how carefully you behave around it.
The claim
Insure a car fully against theft and, on average, it gets locked slightly less carefully. Not because the owner is dishonest — because the cost of carelessness has been moved onto somebody else.
The name is misleading and has caused a century of confusion. It is not about morals. It is about incentives changing when consequences are transferred. The term comes from the fire insurance trade in the 1800s, and it has been annoying economists ever since.
The assumption underneath
Moral hazard needs one specific thing to be true: the insurer cannot observe the behaviour. If the insurance company could watch you lock the car, it would simply write “lock the car” into the contract and refuse to pay when you did not.
So this is not really a problem about insurance. It is a problem about hidden action — one party takes a decision the other cannot see, and the contract has to be written around that blindness. That is why deductibles exist. Making you bear the first ₹10,000 of any loss is a crude way of keeping some of the consequence attached to you.
Note what separates this from its cousin, adverse selection. Adverse selection is hidden information before the deal is struck — the insurer cannot tell a careful driver from a reckless one. Moral hazard is hidden action after. Different problem, different fixes.
Where it stops working
The idea gets overused, badly, in two directions.
It is used to argue against almost any protection — unemployment benefit, health cover, bank rescues — on the grounds that people will slack off. Sometimes true, often much smaller than claimed, and the size is an empirical question, not something you can settle from the armchair. The evidence on unemployment insurance, for instance, finds real but modest effects, and they vary enormously with how the scheme is designed.
It also assumes people respond to incentives sharply at the margin. Someone with full health cover does not usually seek out illness. Most people are not running the calculation at all.
The one thing to keep
Whenever somebody is shielded from the cost of their own choices, ask who is now carrying that cost, and whether they can see what is being done with their money.