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 legally-mandated 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.

JEL Classification: D8, K13, L5