On the Social Function and the Regulation of Liability Insurance

Abstract

The sale of liability insurance presents us with a basic question. On one hand, individuals want to purchase liability insurance coverage, suggesting that its ownership is socially good. On the other, the risk against which liability coverage protects its holders is having to pay legallymandated sanctions. And because the purpose of legal sanctions is in significant part to discourage and to punish unwanted behavior, the fundamental issue arises whether liability insurance might undermine the effect of the law and thus be socially undesirable. This concern led to early resistance against the sale of liability insurance, and reservations about the wisdom of liability insurance are reflected today by certain limitations on the sale of coverage. However, liability insurance is widely held, and without apparently untoward consequences for the functioning of the legal system. My purpose in this paper is to discuss what the economic theory of insurance and of liability law imply about the social desirability, or lack thereof, of liability insurance. I first consider the standard model of accidents and determine there that liability insurance is socially desirable. I then turn to the chief circumstance under which regulation of liability insurance coverage may be justified -when incentives to reduce risk are inadequate. Inadequate incentives may arise because of judgment-proof problems or the possibility of escape from liability. Regulation of liability coverage may then help to augment diluted incentives to reduce risk. Notably, requirements to purchase coverage may improve incentives when insurers can monitor insured behavior; and the opposite form of regulation, forbidding coverage, may increase incentives when insurers are not able to monitor insured behavior. *Harvard Law School and the National Bureau of Economic Research. This paper was presented as the Annual Lecture of the Geneva Insurance Association in Amsterdam, March 31, 1999. Professor of Law and Econ omics, Harvard University, an d Research Associate, Nation al Bureau of Economic Research. I thank Lucian Bebchuk and Louis Kaplow for comments. This paper was presented as the Annual Lecture of the Geneva Insurance Association in Amsterdam, March 31, 1999. Tunc (1974, p. 50). Tunc (1974, pp. 50 -51). On the Soviet ban on coverage, see generally Rud den (1966); and see also T unc (1974, pp. 51 -52). 1 forthcoming in Geneva Papers on Risk and Insurance ON THE SOCIAL FUNCTION AND THE REGULATION OF LIABILITY INSURANCE Steven Shavell © 2000 Steven Shavell. All rights reserved.