An insurance policy is a contract comprising a promise by the insurer to indemnify the policyholder for loss as defined under the policy, in return for consideration of the payment of premium to the insurer. The purpose of the insurance policy document is to assemble, set out and record the intentions of the parties for the regulation of their relationship in relation to the subject matter of the insurance. There is no further magic in the word “policy” – it embodies the terms of the cover. The insurer’s obligations under the policy are to cover the insured for the specified losses as outlined within the policy document.
The underlying transaction in insurance is therefore the purchase of “risk” by the insurer from the insured. The insurer accepts to purchase risk from the insured for a specified premium. At the time that the risk is bought or written, the insurer does not know the individual risk. The price of risk is therefore calculated by considering the data about those types of risks and through the disclosure made by the insured.
Another screened factor that influences the price of the risk is the principle of “moral hazard”. Moral hazard in short is the fear of insurers. Firstly, the fear that the accessibility of insurance relaxes the usual human and institutional energies directed towards reducing the likelihood of risk. Moral hazard in this sense, means that people who are insured will likely take more risks knowing that they are insured than they would without insurance cover. This is a natural psychological reaction as the insurance cover leads the insured to feel more comfortable that whatever happens, the insurance cover will take care of any losses. Secondly, the fear of the personality of the insured, and whether the insured is naturally careless, righteous or a criminal. With the extreme form of moral hazard being, that the insured may take intentional risks in order to maximise financial gain through insurance payouts.
The economists tend to see moral hazard as an incentive problem involving actions of the insured and external uncertainty. Insurance practitioners tend to distinguish between moral and physical hazard, with the former relating to the diversity of human behaviour and the latter not.
