Final answer:
Moral hazard occurs when a person or entity takes on increased risks because they do not bear the full consequences of their actions, often due to protective measures like insurance. Banks might make riskier investments knowing that deposits are insured, thus shielding them from repercussions. To reduce moral hazard, insurance companies implement preventive measures and incentivize clients to engage in safer practices.
Step-by-step explanation:
The term moral hazard refers to situations in which there's an increase in risky behaviors because individuals are protected from the consequences, often by insurance. When a firm is insured, it may engage in behavior that is riskier than if it were fully exposed to the financial consequences of its actions. For instance, in the context of bank regulations like deposit insurance, banks might take on riskier investments or loans because they know that the customers' deposits are insured, thus the potential negative impacts of such risky actions are mitigated.
Insurance companies work to reduce moral hazard through measures like conducting investigations to prevent insurance fraud and monitoring behaviors. They might offer lower premiums to businesses that install top-level security and regular inspections for their fire sprinkler systems. These preventative measures encourage safer practices and reduce the likelihood and impact of moral hazard.