The Reasonable Person Negligence Standard and Liability Insurance

ABSTRACT We show that, under the reasonable person negligence rule, heterogeneity of potential injurers can be sufficient to create a demand for liability insurance. Potential injurers with a low probability of accidents or a high cost of exercising care have optimal levels of care that are below the negligence standard. For these groups, it may be less costly to be negligent and purchase insurance than to comply with the negligence standard. We show that the availability of insurance is socially desirable. INTRODUCTION The purpose of this article is to provide a possible explanation for why individuals purchase liability insurance under a negligence rule. Under a negligence rule, injurers are responsible for the damages they cause to their victims only if they have not met the applicable standard of care. If injurers meet that standard of care, then they are not liable and victims bear the full cost of their injuries. Brown (1973) shows that risk-neutral agents will meet the negligence standard if it is set optimally. Shavell (1982) proves that this implies that risk-averse agents will meet the negligence standard and therefore will choose not to purchase liability insurance. In the United States, negligence is usually determined by the "reasonable person" standard, that is, the level of care that would be taken by an average reasonable person. Thus, if a person takes appropriate care, there is no reason to purchase liability insurance. Substantial amounts of money are spent on liability insurance each year by individuals and businesses. For some types of negligence, the demand for insurance is the result of legal (e.g., automobile liability, workers compensation) or contractual (e.g., homeowners) requirements. The markets for other types of negligence liability insurance, such as medical malpractice, professional liability, and commercial general liability insurance, are more difficult to explain. The Insurance Information Institute reports that in the United States during 2005, premiums for medical malpractice insurance were $12.1 billion, premiums for the liability portion of commercial multiple peril insurance were $13.9 billion, premiums for commercial general liability (excluding products liability) were $39.5 billion, and premiums for "other liability" were $54.1 billion. (1) But for the types of liability covered by these policies, knowledge of the standard of care would imply that every potential injurer could simply meet the standard of care and would never be liable. Shavell (2000, pp. 171-172), reflecting widely held views, argues that liability insurance is purchased to protect against possible risks arising out of the following: (1) the uncertain operation of the legal system, (2) risks due to momentary lapses in care, and (3) risks due to the negligent behavior of agents. In this article we show that even in the absence of these three risks, heterogeneity of potential injurers can be sufficient to create a demand for insurance. (2) The reasonable person standard applies the same standard of care to all individuals. (3) However, potential injurers may have different probabilities of accidents or different costs of care (e.g., not all doctors are equally competent). We show that if the reasonable person negligence standard is applied to a heterogeneous population, then some individuals may find that it is less costly to be negligent and purchase insurance than to meet the negligence standard. (4) Liability insurance protects individuals against the risk of having to pay legal sanctions. The purpose of these legal sanctions is to discourage unwanted behavior. This raises the question of whether the availability of insurance weakens the deterrence of unwanted behavior and undermines the effect of the law. Indeed, we show that potential injurers who purchase insurance will optimally choose levels of care that do not meet the negligence standard. Since these individuals choose to be negligent, the insurance increases the expected number of accidents. …