Even when the technical conditions of insurability are satisfied, behavior can distort the picture. Moral hazard refers to the tendency of insured parties to take on greater risks or behave less carefully once protected by insurance, because they no longer bear the full consequences of potential losses. Morale hazard is a related but distinct concept: it is a careless or indifferent attitude toward loss caused by having insurance, but without any intent to cause the loss. A related distinction is between perils, the direct causes of loss such as fire or windstorm, and hazards, which are conditions that increase the likelihood or severity of a peril. Hazards may be physical (defective wiring, slippery floors), moral (intentional misconduct), or morale (indifference arising from coverage).
Adverse selection describes a market failure in which higher-risk individuals purchase insurance more often or for greater amounts than lower-risk individuals, driven by information asymmetry between buyers and sellers. Anti-selection describes the related tendency of those with higher probability of loss to seek or maintain coverage more aggressively. Cream skimming is the opposite, in which insurers select only the lowest-risk applicants to maximize profit, leaving competitors with disproportionately poor risks. Insurers counter these dynamics through underwriting, eligibility rules, and renewal controls.
Insurers and policyholders also employ four fundamental risk management strategies. Avoidance eliminates the exposure entirely, for example by choosing not to undertake a hazardous activity. Reduction lowers the frequency or severity of potential losses through measures such as installing sprinklers or improving safety protocols. Transfer shifts the financial consequences of loss to another party, with insurance being the classic example. Retention accepts the risk, either knowingly or through the use of deductibles and self-insured retentions. Geographic and line-of-business diversification is a complementary technique: spreading exposures across regions and risk types prevents any single event or correlated set of losses from overwhelming the pool.