BUSE4024A Economic Analysis of Liability 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 2- 1 March 2023 ECONOMIC ANALYSIS OF LIABILITY RULES In this lecture, the purpose is to analy...

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 2- 1 March 2023 ECONOMIC ANALYSIS OF LIABILITY RULES In this lecture, the purpose is to analyse liability rules which were discussed in the previous section from an economic perspective. Descriptive and Normative Analysis When subjecting liability rules to economic analysis we seek to answer two questions: (1) What are the effects of liability rules in situations where they are applied? This is a descriptive question. (2) Are the existing liability rules socially desirable given the consequences they produce? This is a normative question. When answering the descriptive question we assume that people are forward looking and rational. Jeremy Bentham pioneered the economic analysis of liability rules. He developed the idea that legal sanctions discourage wrongful conduct. When analysing the efficacy of liability rules, the role of information is critical. Purpose of Liability Rules Liability rules serve two main purposes: (1) Compensation i.e. to ensure those injured by wrongful conduct of others get compensation (2) Deterrence i.e. to discourage wrongful conduct by creating incentives for care. Lawyers and economists have different perspectives on the role of liability rules. Lawyers see primary role of liability rules as providing compensation to the injured. Economists view the primary role of liability rules as deterrence. Economists argue that exposing people to liability ex post provides ex ante incentives to take optimal care. While it is less often that liability rules may result in over-compensation, it is possible that some liability rules may result in under or over deterrence. 1|Page Under deterrence = situation where a wrongdoer is sanctioned at a less optimal level in relation to their level of blameworthiness. Under deterrence is possible where joint and several liability applies. Over-deterrence = situation where a wrongdoer is sanctioned at an above optimal level in relation to their level of blameworthiness. By attributing full liability on one defendant regardless of level of blame, joint and several liability can result in over-deterrence. Vicarious Liability Vicarious liability is a key liability doctrine in many countries. It is liability imposed on a principal for harm caused by his agent e.g. employer (principal), employee (agent). The liable party need not be at fault. Vicarious liability in delict or tort arises from a relationship between the wrongdoer and the person who is vicariously liable. An agent’s conduct can create externalities for third parties hence it is necessary to sanction the principal. If principal can observe/monitor conduct of agent, then vicarious liability will induce him to force agent to exercise optimal care If principal cannot observe agent’s behaviour he must resort to indirect methods to force agent to exercise care e.g. by imposing penalties for adverse outcomes. Vicarious liability is always advantageous where principal has control over the agent. Vicarious liability is also desirable because principal usually has better knowledge of risks inherent in the agent’s mandate. Confronted with prospect of vicarious liability, the principal has incentive to do the following to prevent harm to third parties: (i) issue correct instructions (ii) organize conditions of service (iii) train the agent (iv) take other precautions to ensure accidents are prevented. A principal instead of external parties like courts and regulators has better information to judge appropriateness of agent’s behaviour while carrying out the mandate. A key assumption of vicarious liability is that principal has more assets than the agent. Vicarious liability assumes that economic circumstances of the principal are superior to those of the agent. In most cases that assumption holds but not always e.g. where a household hires a pest control company to carry out a mandate on its behalf. The primary requirements for vicarious liability are: • • • • There must be an employer – employee relationship The employee must be delictually liable The wrongful act must have been committed in the course and scope of employment The act must fall within the scope of employment. 2|Page Joint and Several Liability Joint and several liability is a liability rule applicable to situations where there are multiple wrongdoers. Where this rule is applicable, the victim can sue any of the wrongdoers for the full amount of the loss. The wrongdoer who is targeted has right to seek contribution from other wrongdoers afterwards. If the other parties cannot pay, the loss falls entirely on party ordered to pay. Joint and several liability is desirable because: (1) All parties covered by the rule will be wrongdoers hence risk of insolvency or failure to recover must fall on them not the victim. (2) Defendants often have liability insurance arranged on assumption that each will (3) Joint and several liability ensures equity and maximizes victim’s chances of recovery. Joint and several liability is commonly found in cases involving environmental damage. A firm that may have contributed little to the damage may end up being liable for the entire cost. Joint and several liability creates incentives for claimants to target defendants in a healthy financial position (i.e. deep pocket syndrome). By altering claiming behaviour of claimants, joint and several liability induces moral hazard in liability insurance. For liability insurers, joint and several liability also creates risk assessment difficulties if there is a possibility that their insured may be liable for loss they did not entirely cause. Risk Aversion and the Accident Problem Risk aversion is attitude of dislike of a risk situation. A risk averse person is prepared to pay more than the expected value of his loss to transfer the risk. Risk aversion creates demand for insurance. Under strict liability victims of accidents are insured by the legal system. Wrongdoers bear the risk of injuries they cause. Those wrongdoers who are risk averse will buy liability insurance. If insurer can observe level of care of each insured it can adjust the premium accordingly. Under such conditions it makes sense for insured to have full coverage. Where insurer cannot observe insured’s level of care it makes sense to for insurer to sell partial coverage. This is because insurer cannot observe level of care and cannot penalize insured for not taking care. Partial coverage under conditions of un-observability creates incentive for insured to exercise care because he bears portion of loss if he causes harm. Moral Hazard and Liability Insurance Moral hazard as a type of asymmetric information problem. Moral hazard in first party insurance focuses on behaviour of the insured. This is called policyholder moral hazard. 3|Page Policyholder moral hazard exists in all types of insurance including liability insurance. In addition to policyholder moral hazard, liability insurance is affected by moral hazard from other parties other than the insured. Jurisprudential moral hazard – change in behaviour of those responsible for applying liability rules in how they apply the rules e.g. judges, lawyers etc. Underwriting moral hazard – lack of incentives to exercise proper judgement by risk assessors Social Desirability of Liability Insurance Is liability insurance socially desirable (i.e. does it enhance social welfare) or it undermines deterrence? Do people act carelessly because they have liability insurance? If insurer can observe the level of care of the insured, it can charge the premium that reflects the care taken. The premium charged will increase where there is lack of optimal care and vice versa. By affording potential injurers the chance to seek protection against losses they may cause, liability insurance is socially desirable. In addition, by providing incentives for potential injurers to take care, liability insurance is also socially desirable. There is no reason to believe that existence of liability insurance causes people to act negligently. Acting negligently even in the presence of liability insurance is costly to the insured in the following ways: (i) Application of deductibles payable under insurance policies; (ii) Possible hiking of premiums by insurers for adverse loss experience; (iii) Potential reputational damage following string of claims that may attract bad publicity; (iv) Possible indirect losses not covered under existing insurance policy. Therefore, even under conditions of liability insurance there are strong incentives for the insured to take care. Liability Insurance and the Law of Large Numbers The law of large numbers is a principle of probability according to which the frequencies of events with the same likelihood of occurrence even out, given enough trials or instances. As the number of experiments increases, the actual ratio of outcomes will converge on the theoretical, or expected, ratio of outcomes. The law of large numbers is an enabler of the insurance mechanism. Liability risks may not be a perfect fit for the law of large numbers for the following reasons: (1) Cause of loss and circumstances of loss are unknown ex ante (2) Lack of homogeneity in liability risk pools e.g. PI portfolio would comprise doctors, engineers, valuators, brokers etc. 4|Page (3) Independence assumption of the law of large numbers may not hold e.g. change of a liability rule or standard may affect all liability insurance lines. Law of large numbers when fully operational reduces risk of an insurer failing to pay claims. However, given foregoing characteristics of liability risks, efficacy of law of large numbers is reduced compared to first party insurances. Part of the reason why liability risks are deemed riskier than other insurable risks is because they do not allow the law of large numbers to be fully operational. Historically, insurance companies writing predominantly liability classes have faced higher probability of failure compared to those writing non-liability classes. Most people are quick to attribute the above to the long tail nature of liability risks. We argue that inability of the law of large numbers rather long tail is a more plausible reason behind riskiness of liability risks. Desirability of Liability System Is a system of liability where there are rules to sanction wrongdoers necessary? Is it not possible to leave this function to the private market? To answer above questions, we need to understand conditions under which private market will create incentives for optimal care and compensation to victims. This brings the role of information into play. Suppose Co X manufactures a lawnmower with a 0.07 chance of causing an accident costing R10 000. Scenario 1 – if consumers are fully informed about product risk and that Co X faces no liability for injury caused. Here consumers will know that buying Co X’s lawnmower comes with an expected loss of R700 (i.e. R10 000 x 0.07). Consequently, consumers would insist on paying R700 less for the lawnmower in relation to a comparable product on the market. If Co X improves safety e.g. by reducing chance of accident from 0.07 to 0.5, fully informed consumers will be willing to reduce their discount for risk on the price. Thus where consumers have full information about product risk the liability system is not necessary since the market can handle this situation efficiently on its own through the pricing mechanism. Co X will have every incentive to improve safety of its product. Scenario 2- here consumers are not informed about product risk. We also assume Co X faces no liability since liability system does not exist. Co X knows it is dealing with uniformed consumers and that if they are injured by their lawnmower, no liability attaches. 5|Page Co X in this case has no incentive to invest in safety of its product. Furthermore, the private market is also unable to create the incentives for Co X to invest in safety. Even though the lawnmower imposes costs on consumers, Co X has zero incentive to improve its safety. Therefore, when dealing with uniformed consumers in the absence of a liability system results in no investment in safety by manufacturers. Scenario 3-here we have uniformed consumers but manufacturers of unsafe products face full liability for harm caused by their products. Here Co X has incentive to improve safety of its lawnmower because they know by doing so they reduce probability of facing a lawsuit. Therefore, one overriding conclusion for desirability of liability system is that consumers are uniformed. Liability creates incentives for manufacturers and others to improve safety. PS- 2023 6|Page