Research Handbooks in Law and Economics series
Edited by Daniel Schwarcz and Peter Siegelman
Chapter 15: The law and economics of liability insurance: A theoretical and empirical review
Tort cases are typically denominated in terms of a victim suing an injurer. But injurers do not typically pay the damages (if any) for which they are held liable, insurers do. The presence of insurance shapes who is sued, and for what; it shapes litigation strategy and settlement negotiations; and, in some cases, it even affects the underlying liability itself (Baker 2006). Indeed, echoing the great biologist Theodosius Dobzhansky, we suggest that little or nothing in tort law makes sense except in the light of liability insurance. In similar fashion, Kenneth Abraham (2008) describes the relationship between tort law and liability insurance using the metaphor of a binary star: separate bodies that form a common gravitational field. Tort’s deterrence function requires that injurers internalize the social costs of the injuries they cause when they fail to take due care. Liability insurance would seem to sever the link between injurers’ behavior and its financial consequences, since the insured risk takers would seem to have little reason to pay for a loss for which others are liable. This is the well-known problem of moral hazard. Economic theory reveals, however, that insurance nevertheless can be compatible with robust deterrence, because insurers have various ways of reducing risk taking by insureds – thereby remedying the moral hazard problem. As we explain in detail below, insurance contracts contain numerous structural features designed to limit moral hazard. These features seem to work reasonably well.