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.

Number of Pages in PDF File: 50

Keywords: Liability insurance contracts, ex ante and ex post moral hazard, risk, social welfare, canonical model of the interaction between insurance and tort liability

JEL Classification: D10, D81, G22, K13

working papers series