BUSE4024A Lec 1, Liability Concepts & Rules 2023 PDF

UNIVERSITY OF THE WITWATERSRAND SCHOOL OF BUSINESS SCIENCES BCOM. HONOURS INSURANCE AND RISK MANAGEMENT BUSE4024A Advanced Liability Insurance and Risk Management 2023 Lecturer: Ms Penny Spentzouris Lecture 1- 22 Feb 2023 LIABILITY CONCEPTS AND LIABILITY RULES A liability risk arises from any action...

UNIVERSITY OF THE WITWATERSRAND SCHOOL OF BUSINESS SCIENCES BCOM. HONOURS INSURANCE AND RISK MANAGEMENT BUSE4024A Advanced Liability Insurance and Risk Management 2023 Lecturer: Ms Penny Spentzouris Lecture 1- 22 Feb 2023 LIABILITY CONCEPTS AND LIABILITY RULES A liability risk arises from any action obliging someone to compensate someone else for their loss. Generally, liability arises where one party breaches an obligation owed to another causing financial loss. This obligation arises from a breach of a legal obligation usually following an act of negligence. The concept of liability is rooted in the law in the sense that obligations and the rules that determine breach thereof are legal terms. In addition, liability only arises from the conduct or actions of people. From a legal perspective, the word person refers to natural persons and juristic persons e.g., companies, clubs, associations, and similar entities. Not all cases involving breach of an obligation have payment of financial compensation as a remedy. However, from an insurance perspective, only those breaches that attract payment of damages are of interest to insurers. Social Function of Liability Rules Liability rules seek to achieve two primary objectives.1 These are: § § To ensure that people who are injured through the culpable acts of others get compensation; and To achieve deterrence i.e., to ensure that there are correct incentives to minimize wrongful conduct that has potential to injure others. To achieve these two objectives, legal systems deploy a range of rules that courts, and other quasi-judicial bodies employ to adjudicate liability claims. These rules govern the ability of victims of harm to get compensation from those who injured them. Different liability rules have different effects on compensation and deterrence. For example, some liability rules such as strict liability prioritise compensation over deterrence while emphasis on proof of negligence prioritises deterrence. In practice, there are always trade-offs between the compensation and deterrence objectives of liability rules. 1 See: Shavell, S (2000) On the Social Function and Regulation of Liability Insurance, The Geneva Papers on Risk and Insurance, 25(2), pp.166-179 1|Page There is tension between economists and lawyers on the role of liability rules.2 Economists identify deterrence as the fundamental objective of liability rules whereas for lawyers, the fundamental objective is ensuring that compensation is payable to victims of accidents. Pre-Conditions of Liability To most people, the assumption is once someone commits an act that causes harm to another, the victim is entitled to compensation. This view is incorrect. In fact, it is possible to commit a wrongful act causing harm to another and not be liable at all. We shall return to this point towards the end of this section. For liability to exist, three elements must exist, namely: § § § Commission of a wrongful or negligent act by one party towards another (i.e., breach of an obligation); Occurrence of damage/harm to a third party because of the wrongful act; and Recognition at law that the harm in question is compensable. The first two requirements for liability are straightforward. Therefore, if X is driving without paying attention because he is talking on his mobile phone damages Y’s car, his conduct is wrongful and blameworthy. Likewise, the damage to Y’s car is a direct consequence of X’s wrongful conduct hence up to that point, there can be no doubt that X is liable to Y. Things get a bit complicated when it comes to the third requirement. In the same scenario, let us also assume that in addition to damage to his car, Y also is injured. Is X liable to Y for the injury? The answer depends on whether the law regards the harm in question as one that attracts compensation. In short, it is possible for a person to commit a wrongful act causing harm to another without incurring liability. Two scenarios drawn from the South African legal system illustrate this point. The first scenario draws from the example above of X injuring Y due to negligence. Even though X’s conduct is wrongful, the law does not recognize the right of Y suing X for bodily injuries sustained in this accident. This is because, in terms of Section 21 of the Road Accidents Fund Act 1996, Y has no claim against X but must approach the Road Accident Fund (RAF) for compensation. Therefore, even though X’s conduct is wrongful and is the direct cause of Y’s injury, the law does not recognize it as creating liability for X. S21 relieves drivers for injury or death to 3rd parties in connection with negligence or other wrongful acts associated with driving motor vehicles. In another country it might well be that X is liable. Hence, liability rules vary depending on country. A second scenario comes from workers’ compensation. Consider an employer who fails to service his plant and machinery rendering it unsafe. Consequently, an employee sustains injury while working with the machinery in question. The employer’s conduct is wrongful since he has a positive duty to ensure the safety of his plant and machinery. In addition, there is no question that the unsafe machinery is the direct cause of the employee’s injury. Is the employer liable to the employee for this injury? The answer is no because Section 35 (1) of the Compensation for Occupational Injuries and Diseases Act 1993 states that this type of liability does not exist in the 2 Faure, M (2016) Attribution of Liability: An Economic Analysis of Various Cases, Chicago-Kent Law Review, 91(2) pp. 603-635 2|Page South African legal system. The employee must approach the Compensation Fund for compensation. Therefore, from the two scenarios above commission of a wrongful act and causation of harm are not enough for liability to attach. The harm in question must be one that the law recognizes as creating a cause of action. A Conceptual Framework for Liability Risks A liability risk typically comprises four basic components each of which involves different considerations from a risk assessment perspective (Baker, 2004). The four components are: (i) (ii) (iii) (iv) Baseline Risk – this refers to the chance of causing loss based on experience assuming there is no change to the insured’s activities or the operating socio-economic and legal environment. This component of a liability risk conforms largely to the insured’s loss expectancy based on past behavior. Development Risk – this is the component of a liability risk arising from changes and developments that take place over the period of insurance causing material change to the insured’s loss expectancy and other variables affecting claim frequency and severity. Development risk could result from things like ex ante moral hazard, change in the law, changes to liability rules or a liability standard. Contract Risk - this component of a liability risk refers to the risk attaching to the drafting and interpretation of the insurance contract. It is like legal risk. The contractual nature of insurance comes with the risk that sometimes what the insurer thinks their contract says is not the same interpretation that courts will arrive at. Financing Risk – this is the component of a liability risk referring to changes in the investment performance and loss patterns under the policy. Due to the time lag between happening of the loss causing act and the settlement of the claim (long-tail), liability losses may not be expected in the short term after the policy comes into effect. The long tail feature of most liability risks could affect assumptions that insurers make when calculating the premium. When measuring baseline risk, insurers rely on historical data. Consequently, this task gets harder where a new insurance product is involved or where the risk in question is of a low frequency and high severity nature like a natural disaster. Low frequency risks do not generate sufficient historical data to enable past events to be good predictors of future events. Development risk is found in all types of insurance. For example, in life insurance the emergence of a pandemic like Covid-19 can push mortality rates beyond assumptions made by insurers based on mortality tables that are constructed from historical data. In health insurance, development risk can arise from changes in medical technology something that usually increases the cost of claims. Liability insurance is even more susceptible to development risk. This is mainly because, the longer the potential period between the loss causing act and the settlement of the claim, the higher the likelihood that something that may affect the claim be it in terms of size or likelihood of success may happen in the interim. This could take the form of changes in the conceptualization of the claim, changes in how damages are quantified, change in liability rules or standards or changes in how the claim is conceptualized. Development risk is like what liability 3|Page insurers refer to as the retroactivity problem where something that did not create liability in the past may do so today. Due to the strong relationship between legal developments and liability risks, legal institutions play a pervasive role in liability risks and insurance. Legal developments can influence how people behave through deterrence. They can also change incentives of claimants e.g., introduction of pro-plaintiff procedures like the contingency fee system tends to increase frequency of claims filed in courts. Additionally, legal developments can also affect conceptualization of claims for liability purposes. Nowhere has this been more evident than in the UK with pleural plaques and in the US with claims by unimpaired lives for asbestos injury compensation. In the UK, pleural plaques are not regarded as actionable injury in England and Wales, but they are regarded as actionable injury in Scotland and Northern Ireland through legislation. In the US, courts devised rules allowing people with no functional disability from exposure to asbestos to claim merely out of fear of incurring injury in future. Contract risk arises from the nature of insurance as a product. Insurance involves charging a price in return for a promise (Baker, 2004). Since the insurer’s promise cannot be fulfilled until the insured event (loss) takes place, there is no certainty about the exact meaning of that promise in a practical sense. Furthermore, terms commonly used in insurance contracts such as property damage, bodily injury and loss among others are clear from a commonsense standpoint, but their meaning can be highly problematic in the event of a claim. That is not all. Contract risk can also arise from conflict between broad operative clauses used in some insurance policies and exclusions. Finally, contract risk can also be due to the disconnection between the sales and claims functions within insurance companies. To generate more sales insurers often give liberal and broad promises about what their policies cover and seek to restrict this at the point of claim. This opens the door for courts to be involved. Financing risk affects assets (investments) that insurers hold to cover their liabilities. Premium especially in liability insurance is not based on baseline and development risk alone. It also depends on projections of the insurer regarding returns expected from investing those premiums. Changes in market dynamics and timing of claim payments can affect the value of assets and returns. Key Liability Concepts and Rules Although liability rules vary according to country or jurisdiction, some are common to most jurisdiction. Below is a summary of some of the main ones. § § Fault. In many countries, the primary basis of liability is fault or blameworthiness of conduct. There are two dimensions to fault, namely negligence (culpa) and intention (dolus). Therefore, wrongful conduct arises from negligence or willful conduct on the part of the wrongdoer. By far, most wrongful acts arise from negligence. Negligence exists when a person fails to exercise the socially optimum level of care resulting in harm to another. The essence of fault lies in sanctioning those who fail to take precautions in circumstances where the law experts all reasonable persons to take care. Strict liability. This is liability without fault. Under strict liability, the victim only needs to show that the conduct of the defendant is the cause of the harm sustained by him/her and 4|Page § § § § liability attaches. There is no need to prove that the conduct in question is blameworthy. Clearly, strict liability could result in over or under deterrence. Consequently, strict liability applies to a limited number of situations in most countries e.g., workers’ compensation, liability for defective products and environmental impairment liability. Under strict liability, most common law defenses are not available to protect the defendant as is the case under fault-based liability. Joint and several liability. This rule applies to situations where harm results from the conduct of multiple wrongdoers. Where joint and several liability applies, the victim of harm can choose to claim from any of the wrongdoers for full compensation. The wrongdoer sued for full compensation has a right to recover a proportion of the compensation from the other wrongdoers. Joint and several liability maximizes the victim’s chances of recovering compensation. Furthermore, the rule reduces the victim’s transaction costs. Without joint and several liability, the victim must sue each wrongdoer separately (severally) for the share of the harm each caused. A wrongdoer’s liability under the joint and several liability rules is not limited to the risk created by his/her conduct. It extends to harm caused by others. This raises an important insurance question, namely, does joint and several liability endanger insurability of liability risks? Long tail (or long latency). A significant proportion of liability claims have a long tail feature. This refers to the time lag between the commission of the wrongful act and the manifestation as well as the settlement of the claim. The tail or latency period can be if several decades in some cases e.g., those involving liability for occupational diseases. For liability insurers, the long tail feature of some liability risks provides enormous insurability challenges because a risk insured today could produce a claim twenty years later. Retroactive liability. Since most liability claims have a long-tail feature, they are susceptible to the problem of retroactivity. Retroactive liability refers to the possibility that between the wrongful act whose consequences remain hidden for years, liability rules and standards might change. It implies that courts and others similarly placed may apply a new standard of care or liability rule to an act that took place decades ago when that standard or rule did not exist. In its extreme form retroactive liability means an act that was legally permissible and not wrongful decades ago might be wrongful today when a claim arises. Sources of retroactive liability are judicial decisions and changes in legislation. Causation. Another important liability concept with huge implications depending on its conceptualisation is causation. Liability only attaches where the conduct of the defendant caused harm to the victim. Because of the long-tail nature of most liability claims, proving causation is often problematic. Things get even more complicated in cases where multiple factors combine to produce a particular outcome. For example, if exposure to asbestos causes lung cancer and smoking has a similar effect, what is the cause where an employee was exposed to asbestos, but he was also a smoker? There are various rules developed in different jurisdictions to resolve this and other similar problems in a variety of contexts. For example, under workmen’s compensation, this problem is usually resolved using the presumption of causation clause found in statutes of many countries. Under this presumption, if exposure to asbestos occurs at work, then the presumption is asbestos is the cause of the cancer regardless of what the employee did as a social habit. 5|Page § In the UK, courts developed the material contribution principle to navigate evidentiary hurdles such as this. In terms of this principle, liability attaches to the person who exposed the employee to asbestos if there is evidence showing that such exposure materially increased the risk of developing cancer. Legal liability. Understanding of the meaning of this term is critical to the study of liability insurance because virtually all liability insurance contracts employ it in the operative clause. Liability insurance regardless of type undertakes to indemnify the insured for claims it shall become legally liable to pay as damages to a 3rd party. This means, for an insurer to assume responsibility to pay the insured under the policy, there must be a basis at law for the insured to be responsible for the loss incurred by the victim. That basis could be a court judgment, ruling of a tribunal/arbitration, order of a regulatory agency or an admission of liability among others. An insurer never assumes responsibility to indemnify the insured in the absence of legal liability. Determinants of Liability Outcomes What factors influence the level of liability risk and their difference among countries? To understand what this question means consider the following simple example. X resides in the USA and his friend Y resides in South Africa. Both operate a crèche in their respective countries. Due to the negligence of their employees, a child at each crèche is injured while in the care and custody of the facility. What factors determine the liability of X and Y as well as how much each will pay as compensation? The following factors among others influence liability outcomes for each defendant: § § § § 6|Page Liability rules applicable in the country concerned e.g., it may be that in one country such injury to a child fall under strict liability. Structural features of the legal system of the country concerned – in the US, they use juries in trials whereas in South Africa we use bench trials with a single judge or magistrate hearing the matter. In addition, how lawyers conduct business also influences liability outcomes. In the US and to a limited extent South Africa, lawyers are allowed to file cases on a contingent fee basis. This system allows lawyers to take up a case on behalf of a client without receiving a retainer or deposit on the understanding that if they win, they will deduct a portion of the damages as legal fees. This system encourages proliferation of litigation and offers lawyers incentives to inflate claims. Another structural feature of a legal system that influences liability outcomes is forum shopping. Forum shopping is the process where a case is filed in a different jurisdiction to the one where the cause of action took place e.g., a wrongful act happens in South Africa against local victim, but the victim sues the wrongdoer in London. Types of damages that a court can award against a defendant. - in the US, some wrongful acts attract extra-compensatory or punitive damages over and above compensatory ones. Legal defences available to the defendant against the claim. Legal defences available to the defendant depend on liability rules applicable in a particular country. Therefore, suppose in the US injury to a child under the care of a § crèche falls under strict liability while in South Africa, it falls under the fault principle, the liability outcomes for X and Y will turn out differently. Availability of liability insurance for the wrongful conduct in question. Liability insurance enables potential injurers to transfer risk of injuring a third party to the insurance market. Therefore, in liability risk assessment and management it is critical to understand the factors that influence liability outcomes. Whether it is for purposes of providing insurance coverage or offering general risk management advice it is important to understand the factors that determine the level of risk in any given context. Liability Insurance Liability insurance protects the insured from having to pay legally mandated sanctions in the form of damages. Liability insurance only comes into play when the sanctions in question have a monetary value. Since the purpose of sanctions is to discourage wrongful conduct (deterrence), a question arises whether liability insurance undermines the deterrence objective of legal sanctions. This concern led to resistance to the sale of liability insurance at the beginning of the 19th century in some European countries e.g., there was a complete ban of liability insurance in the former Soviet Union.3 Typically, liability insurance seeks to do two things: § § Indemnify the insured for claims he becomes legally liable to pay as damages for harm caused to a third party (the duty to indemnify); and Defend the insured against lawsuits seeking those damages (the duty to defend). However, it is possible to get some liability policies that do not contain the duty to defend. Liability insurance is third party insurance. It differs from first party insurance in that in liability insurance, the insured is not the party who suffers loss. The insured buys coverage against the possibility that he might cause loss to a person unknown in future. By contrast, in first party insurance, the insured is the person expected to suffer loss e.g., property insurance. The duty to indemnify arises when two requirements exist. These are: § § The insured must be legally liable to the third party; and There must liability in terms of the existing policy i.e., policy liability. The mere fact that the insured is legally liable to a third party does not necessarily imply that the insurer is liable to pay the claim. A further requirement applies; that of policy liability. This requires the claim to fall within the available scope of coverage. Policy liability also depends on the insured having complied with his/her obligations under the policy. Therefore, if the insured is in breach of a policy condition, the insurer may still repudiate the claim despite existence of legal liability. Unlike the duty to indemnify, the duty to defend has attracted debate. What does this duty entail and when does it come into play? The efficacy of the duty to defend lies in the logic that there is 3 Shavell (2000) supra 7|Page community of interest between the insured and the insurer when it comes to attempts to sanction the insured for wrongful conduct. A successful defence of the insured means a claim avoided for the insurer. Whether the duty to defend arises in any given situation depends on the pleadings of the third party. The duty is different from the duty to indemnify in that it arises whether the claim succeeds or not whereas the duty to indemnify only arises if the claim is valid. If the pleadings (allegations) of the third party raise the prospect of a claim within the policy, no matter how remote or farfetched those allegations might be, the duty to defend arises i.e., the insurer must defend the insured against them. There are different types of liability insurance products each with its own unique features. However, all liability insurance policies share the requirement that for the insurer to be liable there must be legal liability of the insured towards the third party. In addition, there is scope for using the duty to defend in all liability policies. Conclusion Liability risks derive their shape and complexity from the law and legal systems that administer that law. Therefore, to understand these risks, one must be aware of legal developments and judicial trends in the country where liability may arise. It is also important to have an appreciation of the various liability rules available and contexts where they apply. Yet another important aspect of liability risks to remember is the possibility that the consequences of wrongful conduct may remain hidden only to become manifest decades later. This feature of liability risks does not only complicate risk assessment but presents other practical difficulties especially for insurers. Reflection Questions: 1. From an insurance perspective, what practical difficulties does the joint and several liability rule/principle entail for liability insurers? 2. Summarize reasons why the concept of retroactivity might complicate liability risk assessment. AZM-2022 Revised PS- 2023 8|Page