Compensation of Uncertain Lost Earnings

Abstract

The present value of expected lost earnings is normally regarded as the amount that fully compensates the victim of an accident. Courts tend, however, to pay less compensation for uncertain losses. We show that such under-compensation may be efficient if the victim is risk averse. In the framework of the von-Neumann-Morgenstern utility theory, a rule for determining an immediate certainty equivalent for lost potential earnings is suggested. The equivalent depends not only on the degree of risk aversion but also on the interrelation between the future losses. The importance of the correlation is normally neglected, although it is quite intuitive that a risk averse victim judges a stream of negatively correlated random amounts to be less risky than the analogous stream of positively correlated losses.