Abstract
This chapter examines key elements of the liability system in the USA: the basic theory on the role of liability rules in providing incentives for loss control; the effects of limited liability on the demand for liability insurance and on the ability of tort liability to provide optimal incentives; the problem of correlated risk in liability insurance markets; issues in liability insurance contract design; and the efficiency of the US tort liability and liability insurance system. The troublesome areas of medical malpractice, directors’ and officers’ liability and general liability insurance crises are highlighted.
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Notes
- 1.
We thank the previous authors for permission to use their work.
- 2.
Much of the exposure to liability losses in these areas is self-insured and thus is not reflected in premium volume. Commercial multi-peril coverage also includes coverage for many general liability hazards. General liability insurance often is called “other liability” insurance; this term is used in insurance company annual statements filed with regulators. We use the term general liability throughout.
- 3.
Other chapters in this volume consider auto liability and workers’ compensation. See Danzon and Harrington (1992) for an earlier introduction to the liability insurance literature.
- 4.
- 5.
As of year end 2011, punitive damages were not insurable in 16 states (McCullough, Campbell, and Lane 2011).
- 6.
- 7.
Since the product of st and l(x,y) is defined as expected losses, the model implicitly allows for losses to be of differing severity.
- 8.
- 9.
See Shavell (1984) for comparisons of tort liability and safety regulation as means to promote loss control.
- 10.
This notion of product defect reintroduces an issue of reasonable care, defined by some weighing of risks and benefits of additional care, analogous to a due care standard under a negligence rule. Thus strict liability for products is not absolute liability in the sense of the simple theoretical models.
- 11.
Cooter and Ulen (1987) argue that a comparative negligence rule is superior to a negligence rule when injurers and victims bear risk and there is evidentiary uncertainty. Rubinfeld (1987) reinforces this conclusion when injurers and victims are heterogeneous. Fluet (2010) shows that, under evidentiary uncertainty, comparative negligence may require more informative evidence than contributory negligence. Hence, there are situations where contributory negligence will do better.
- 12.
These conclusions follow from the standard assumption that the optimal damage award is chosen to maximize the utility of the victim, subject to a reservation level of utility for the defendant. Thus by assumption, the incidence of costs of liability is on victims. This is reasonable assuming a perfectly elastic long-run supply of the products or services that are subject to strict liability. But with imperfectly elastic supply in the short run, the incidence of unanticipated changes in liability costs is partly on defendants (Danzon 1990).
- 13.
Noncontingent periodic payment of awards, where the amount is determined at time of trial or settlement (also called “structured settlements”) are potentially more efficient than lump sum awards if the defendant is permitted to provide for the payment of these future damages by the purchase of an annuity or other financial instrument. This transfers from the jury to financial markets the issue of determining expected rates of inflation and interest (Danzon 1984b). Perhaps more important, structured settlements may reduce income tax costs.
- 14.
- 15.
Formally, the problem is to maximize expected utility of the victim, subject to constraints of (a) a reservation utility level for the defendant, (b) an overall resource constraint, (c) victims and injurers choose first party and liability insurance to maximize their respective utilities, and (d) insurers break even. If insurance is not available, then the choice between liability rules depends on which party is better able to bear risk. In particular, strict liability is preferable to negligence if injurers are risk neutral or better able to bear risk.
- 16.
Bajtelsmit and Thistle (2009) investigate efficiencies and incentives to insure when the information available to the potential injurer varies.
- 17.
A first best outcome is achieved only if victims can eliminate risk by buying actuarially fair first-party insurance.
- 18.
If the insured’s level of care is observable to the insurer, the optimal contract would exclude coverage if the defendant acted negligently. But if insurers had the information necessary to implement such a policy, the courts could use the information and eliminate the errors that generated the demand for insurance in the first place.
- 19.
Calfee and Craswell (1984) analyze effects of uncertain legal standards on compliance under a negligence regime in the absence of liability insurance.
- 20.
This assumes that government has no information advantage, damage awards are optimally set and defendants are not judgment proof.
- 21.
In the liability context, socially optimal coverage if the insurer could observe the insured’s care would provide full coverage of losses if care is efficient (x ≥ x∗) and zero coverage if care is suboptimal (x < x∗). But if there are Type 1 errors (failure to file or find liability for all injuries caused by x < x∗) then defendants may prefer a policy that provides coverage even if x < x∗ (Danzon 1985a).
- 22.
Paid claims do not convey perfect information about whether negligence occurred even if courts are unbiased because over 90 % of paid claims are settled out of court. The decision to settle and amount of settlement may be influenced by many factors other than the defendant’s level of care and plaintiff’s true damages, including the parties’ misperceptions of the expected verdict, costs of litigation, risk aversion, concerns over precedent, and other factors. This literature is reviewed in Cooter and Rubinfeld (1989).
- 23.
For product liability and medical malpractice, plaintiff and defense legal expenditures each average about one half of the net compensation received by plaintiffs (Danzon 1985b; Kakalik James and Pace (1986). For the effects of costly litigation on the efficiency of liability rules see, for example, Polinsky and Rubinfeld (1988), Cooter and Rubinfeld (1989). Also see Sarath (1991).
- 24.
For example, a deductible undermines the insurer’s incentives to fight claims that can be settled for less than the deductible. Incurring legal expense in excess of damages may be a privately optimal strategy if it deters other potential claims.
- 25.
- 26.
Professional liability policies explicitly exclude coverage of intentional acts. The existence of a demand for and a supply of coverage for punitive damages in states where this is permitted suggest a significant risk of Type 2 errors, despite the higher standard of proof (gross negligence or willful misconduct) for punitive awards.
- 27.
Buyers with preferences that are inconsistent with cost minimization may make arrangements with accommodating insurers. Also see McInnes (1997).
- 28.
The same general issue arises in the case of medical expense insurance, where the cost of the amount of care provided exceeds the assets of the patient or patient’s family. Easterbrook and Fischel (1985) provide comprehensive discussion of the rationale for the limited liability doctrine.
- 29.
Raviv (1979) provides an early treatment of upper limits of coverage that does not consider bounds on wealth net of indemnity for losses.
- 30.
See also Shavell (1986). To illustrate with a simple example consider a party with $10,000 of assets at risk who faces a 0.01 probability of causing $100,000 of harm to others. The expected loss to the party without insurance is $100; the actuarially fair premium for full liability insurance protection is $1,000. An unwillingness to insure fully in this case is hardly surprising.
- 31.
A large amount of anecdotal evidence on the demand for liability and workers’ compensation insurance is consistent with the prediction that parties with low wealth will demand little or no coverage.
- 32.
A related literature considers whether compulsory first-party insurance against catastrophic property losses can improve incentives for efficient investment and precautions (e.g., Kaplow 1986). Similar issues arise with respect to uninsured medical care.
- 33.
Other possible remedies are vicarious liability (see Sykes 1984, 1994) and imposing asset requirements for participating in the activity. Shavell (1986) shows that imposing asset requirements equal to the maximum possible loss may overdeter, because it is socially efficient for parties to participate in an activity if their assets equal the expected loss, which is less than the maximum possible loss.
- 34.
Keeton and Kwerel (1984) raise the theoretical possibility that subsidized liability insurance could be efficient. On the other hand, if compulsory coverage leads to a political demand for rate regulation that guarantees availability of coverage for high risks at subsidized rates, incentives for care will likely be undermined. The political economy of compulsory automobile insurance is analyzed in Harrington (1994b); for workers’ compensation, see Danzon and Harrington (1998).
- 35.
The effect of correlated risk on “crises” and cycles in the supply of liability insurance is discussed below. There are two aspects of correlated risk: (a) unfavorable realizations in underlying loss distributions that are correlated across policyholders and (b) errors in forecasting the mean of the underlying distributions. The actuarial literature refers to the former aspect as process risk and the latter as parameter uncertainty. The economics/behavioralist literature sometimes calls the latter type of risk “ambiguity” (see Kunreuther et al. 1993).
- 36.
Many of the thousands of asbestos claims arose out of exposure to asbestos in the 1940s and 1950s and are based on allegations of failure to warn of the hazards of asbestos exposure. Epstein (1982) argues that even if the medical risks were knowable at the time of exposure, the tort liability of asbestos manufacturers could not have been anticipated because at that time a worker’s sole recourse would have been through a workers’ compensation claim against his employer. Similarly, environmental liability under Superfund could not have been anticipated. Even if courts admit a state-of-the-art defense for product injuries in principle, some degree of retroactivity is implicit in basic common law rules of procedure and damages, and some courts have explicitly disallowed a state of the art defense. Retroactivity in tort is discussed in Henderson (1981), Schwartz (1983), Danzon (1984b) and Abraham (1988b).
- 37.
For example, the long-tail associated with liability claims may allow insurers time to respond gradually to unexpected increases in costs; this option is not available for catastrophe property losses. An analogous issue arises in assessing the risk of long-term versus short term debt instruments.
- 38.
Sommer (1996) and Phillips et al. (1998) provide evidence using insurer level data that insurance prices are positively related to measures of underwriting risk and capital. Also see Cummins and Lamm-Tennant (1994). Viscusi (1993) obtains inconclusive evidence of a relationship between premium rates and measures of ambiguity using ISO ratemaking files for 1980–1984.
- 39.
Use of capital market instruments or insurance derivative contracts is an alternate to holding more capital. However, the use of these types of instruments to manage long-tailed liability risk appears problematic given the long claims tail and lack of a suitable index that is highly correlated with changes in the value of claims liabilities (Harrington et al. 1995).
- 40.
- 41.
Much of this litigation has dealt with the interpretation of general liability insurance policies for environmental claims associated with the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) of 1980, which imposed strict, retroactive, and joint and several liability on firms involved in the creation, transport, and disposal of environmental toxins. See Abraham (1988b, 1991) for detailed discussion of the numerous aspects of environmental coverage litigation.
- 42.
- 43.
Court resolution of these issues often has been influenced by the doctrine of contra proferentem (ambiguous terms should be construed against the drafter) and the doctrine of reasonable expectations (see, e.g., Rappaport 1995). A large legal literature deals with these issues.
- 44.
- 45.
Thiel (1998) also argues that incorporating concern for post-accident utility into pre-accident preferences can motivate rational consumers to demand compensation for pain and suffering even if marginal utility does not increase following non-pecuniary loss. The argument may border on tautology; consumers demand compensation for pain and suffering because knowing that it will be paid ex post makes them happier ex ante.
- 46.
For example, Chin and Peterson (1985) find that jury verdicts are significantly higher for the same type of injury if the defendant is a corporation or physician, rather than an individual. Danzon (1980) provides evidence of a positive relation between award and limits of the defendant’s insurance coverage.
- 47.
Consistent with a possible disciplining effect on the level of risky activity, Core (1997) presents evidence that insurers charge higher premiums for directors’ and officers’ liability insurance to firms with weaker measures of corporate governance.
- 48.
Cummins and Outreville (1987) examine the question of whether cycles in reported underwriting results are simply caused by financial reporting procedures and lags in price changes due to regulation. They note that these phenomena are unlikely to explain large price fluctuations in the commercial liability insurance market in the mid-1980s. In a related vein, Doherty and Kang (1988) essentially argue that cycles reflect slow adjustment of premiums to the present value of future costs, but they do not identify causes of lags in adjustment.
- 49.
- 50.
Abraham (1988b) argues that expansive court decisions concerning contract language contributed to availability problems in the market for environmental impairment liability coverage in the mid 1980s.
- 51.
Increased variability in liability insurance claim costs need not be caused by an increase in idiosyncratic variation in individual awards and, of course, does not imply that court awards are largely unpredictable. Osborne (1999), for example, provides evidence of substantial predictability of awards given pretrial information.
- 52.
Berger and Cummins (1992) formally model adverse selection in liability insurance where buyer loss distributions are characterized by mean-preserving spreads.
- 53.
The anecdotal evidence about widespread availability problems strongly suggests that adverse selection played a role in these problems and price increases. Other observers and evidence, however, generally suggest that increased adverse selection was not the primary cause of the crisis (see, e.g., Abraham 1991, and Winter 1991a).
- 54.
Some authors suggest that regulatory constraints, such as restrictions on the allowable ratio of premiums to capital, exacerbate the shift in supply (see Winter 1991b, for detailed analysis of this case). In practice, however, constraints on premiums relative to capital are informal. As is true for risk-based capital requirements adopted in the 1990s, these constraints are unlikely to be binding for most insurers at once, even at the time of a hard market.
- 55.
Winter (1994) suggests that ex post unfavorable realizations of losses or omission of reinsurance capaCity from the capital variables may explain the 1980s results. Berger et al., (1992) analyze shocks to reinsurance supply during the 1980s crisis and provide evidence that shocks disrupted the price and availability of reinsurance.
- 56.
Gron (1994a) regresses both the difference between premiums and underwriting expenses and the difference in the ratio of all lines premiums to underwriting expenses on lagged capital and a variety of control variables. The results indicate that changes in the margin between premiums and underwriting expenses are negatively related to lagged values of capital, providing some support for the capital shock model.
- 57.
Yuengert (1991) also considers the issue of whether excess capaCity leads to soft markets.
- 58.
Of course, many decisions made by directors and officers may have adverse consequences. However, the “business judgment rule” protects D&O from liability in cases where a loss is incurred as a result of directors and officers making a business decision within the scope of their authority and acting in good faith and in accordance with the standard of reasonable care.
- 59.
Of course, motives for the corporate purchase of any type of insurance also apply here.
- 60.
A shareholder derivative suit is a suit brought by shareholders on behalf of a corporation against directors and/or officers of a firm. This type of suit is typically filed when the corporation has a cause of action against a director or officer but chooses not to exercise it. Proceeds from a shareholder derivative suit are distributed to the corporation rather than the shareholders themselves. In contrast, a direct shareholder suit is a brought by a single or group of shareholders on their own behalf with the proceeds going directly to the claimants.
- 61.
Note that the Towers Watson (2011) survey of publicly traded US firms reports that nearly all survey respondents purchase D&O insurance.
- 62.
This survey included only publicly traded firms, so the findings might not apply to private or not-for-profit insureds.
- 63.
The recent passage of health care reform has focused attention on ways to reduce health care costs and improve patient outcomes. Because malpractice costs are perceived to be a driver of health care cost increases, there is interest in experimenting with new systems for compensating patients with iatrogenic injuries. Consequently, consumer groups, physicians, and medical associations have created pressure for government intervention in, or reform of, the system.
- 64.
The recently enacted Patient Protection and Affordable Care Act may change the liability exposure for physicians and other medical care providers, but the potential impact of the Act is outside the scope of this chapter.
- 65.
For a comprehensive resource that reviews multiple dimensions of the medical malpractice system, see Sloan and Chepke (2008).
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Ambrose, J.M., Carroll, A.M., Regan, L. (2013). The Economics of Liability Insurance. In: Dionne, G. (eds) Handbook of Insurance. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-0155-1_12
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