The Law and Economics of Liability Insurance: A Theoretical and Empirical Review

Abstract

We survey the theoretical and empirical literature on the law and economics of liability insurance. The canonical Shavell model predicts that, despite the presence of some ex ante moral hazard (care-reduction by insureds), liability insurance will generally raise welfare because its risk-spreading gains will likely be larger than its adverse effects on precautionary activities. We discuss the numerous features of liability insurance contracts that are designed to reduce ex ante moral hazard, and examine the evidence of their effects. Most studies conclude that these features work reasonably well, so that liability insurance probably does not generate substantial ex ante moral hazard. Its effects on ex post moral hazard (the increased tendency of victims to sue in the presence of insurance) are not as clear, however, and the welfare consequences of increased litigation are ambiguous, for reasons we explain. We discuss additional issues such as the effects of liability insurance when some defendants are judgment-proof, the problems posed by non-independence of liability risks owing to changes in legal doctrines, and the cyclical nature of liability insurance markets.3

Limited Liability and the Demand for Coinsurance by Individuals and Corporations

“…For further studies on the welfare impact of mandatory liability insurance for individuals and corporations, references include Keeton and Kwerel (1984), Han and MacMinn (1990), Jost (1996), andBoomhower (2019). For a general review of theoretical models and empirical applications related to personal and corporate liability insurance, see Baker and Siegelman (2013).…”

Correlated Accidents

“…Insurance against liability claims for bodily injury and property damage arising out of premises, products, and completed operations is usually available to business organizations, under so called CGL policy. Insurance often comes together with "loss control" provisions, aimed at reducing liability risk (Baker and Siegelman (2013)). In what follows, I extend the model to the case in which parties can purchase insurance on the market.…”

“…9 The focus of this scholarship is the positive correlation that arises out of legal changes ("socio-legal risk") affecting, for example, the notion of defectiveness or the eligibility of claims. Such changes can either spawn or wipe out thousands of similar claims at the same time (see Baker and Siegelman (2013) and Hylton (2013)). In this paper, I build on these early insights and develop a formal model in which (positively or negatively) correlated claims arise from the nature of the harmful activity itself, rather than from legal change.…”