Final answer:
Professional liability insurance protects against financial losses from legal liabilities, including those assumed under contracts. It helps mitigate the financial impact of lawsuits due to professional errors or omissions, though it may also contribute to moral hazards by diminishing incentives to prevent loss.
Step-by-step explanation:
Professional liability coverage is an insurance method of protecting a person or entity from financial loss due to legal liability resulting from various professional actions or inactions. This type of insurance is particularly crucial for service-providing professionals like doctors, lawyers, and architects, where a mistake can lead to a lawsuit. Among its coverage aspects, professional liability insurance can extend to liability assumed under a contract, which means that if the insured has agreed to take on liability as part of a contract and then is sued for not meeting those contractual obligations, the insurance may cover the resulting claims, provided they fall within the policy's terms.
Interestingly, professional liability insurance also addresses moral hazard, a situation where the insured might engage in riskier behavior because they have coverage. For instance, a business with insurance might install minimum security systems as opposed to a more robust one they might have installed without the insurance, thinking the policy will cover any potential loss. This implicitly suggests that while insurance provides safety, it can also lead to decreased incentives for the insured to prevent loss.