Research Handbooks in Law and Economics series
Edited by Daniel Schwarcz and Peter Siegelman
Chapter 14: The artificial collective-action problem in lawsuits against insured defendants
Liability insurance complicates efforts to settle lawsuits. It introduces a conflict of interests whenever the trial outcome is uncertain and the potential damages exceed the limit of the defendant’s liability policy. When such a case settles before trial, the insurer typically pays more, and the policyholder less, than each expected to pay had the case reached a verdict. This shift in liability from policyholder to insurer predisposes the policyholder toward settling, and the insurer toward trial. Therefore, if the insurer has the authority to settle on behalf of the policyholder, there is an undersettlement hazard. The insurer will sometimes choose trial even when settling would minimize the expected value of the total defense costs, which consist of payments to the plaintiff plus the defense’s litigation expenses. But giving settlement authority instead to the policyholder introduces an overpayment hazard: the policyholder will sometimes choose to settle even when the plaintiff’s settlement demand exceeds the expected costs to the defense of a trial. Liability insurers and policyholders would be better off if they could prevent this conflict of interests. When they enter into a liability policy, the insurer and the policyholder share an interest in minimizing total defense costs in lawsuits that the policy will cover. Minimizing such costs maximizes the joint surplus from the contract, which the insurer and policyholder divide between themselves when they set the price for coverage (the premium).
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