Outsourcing Regulation: How Insurance Reduces Moral Hazard

This Article explores the potential value of insurance as a substitute for government regulation of safety. Successful regulation of behavior requires information in setting standards, licensing conduct, verifying outcomes, and assessing remedies. In various areas, the private insurance sector has technological advantages in collecting and administering the information relevant to setting standards and could outperform the government in creating incentives for optimal behavior. We explore several areas that are regulated more by private insurance than by government. In those areas, the role of the law diminishes to the administration of simple rules of absolute liability or no liability, and affected parties turn to insurers for both risk coverage and safety instructions. This Article examines the methods used in regulation-through-insurance, and then explores the potential regulatory role of insurance in additional, yet unutilized, areas: (1) consumer protection, (2) food safety, and (3) financial statements.INTRODUCTIONLegal regulation of behavior requires information. Someone-a regulator or a judge-has to inspect the conduct of the regulated party and determine the legal consequences that will attach. Acquiring information about the conduct, setting benchmarks by which the conduct is measured, and establishing the correct scale of payoffs are costly and require expertise and motivation. Thus, economic theories of rulemaking are often based on the relative informational advantages that different regulatory bodies have and how this information can be harnessed to enhance incentives and thereby improve welfare.1There are plenty of reasons to worry that government regulators will make mistakes. First, they are not paid for performance and thus may lack adequate incentives. They are not disciplined by market forces and only imperfectly disciplined by career concerns and the political process. Moreover, they commonly lack the most advanced tools for information acquisition, aggregation, and prediction. Courts, for example, do not search for information independently but rather receive only what parties present to them through the litigation process, which is costly, ad hoc, and as a result often bypassed by crude settlements. Courts are also ill equipped to recognize the distribution of characteristics from which any given case is sampled. Government agencies too have limited resources to monitor and anticipate patterns in the behavior of sophisticated industries, often inspecting only a small sample of the regulated conduct. They may be plagued by internal principal-agent problems, and they are often outpaced and outsmarted by the regulated parties. This raises the following question: can anyone regulate risky behavior better than the government?This Article develops the claim that in a variety of areas private insurance companies can, and already do, replace or augment the standard setting and safety monitoring currently performed by government. And they do so in ways that may increase overall social welfare. Insurance is often thought of as an institution intended only for ex post indemnification, working to reduce the costs of risky activities through risk pooling and risk shifting. But insurance also performs other important functions: risk reduction and risk management.2 Insurance arrangements-by using such tools as deductibles, exclusions, and experience rating-give private parties the incentive to reduce risks. Insurance is a business that specializes in risk management. Insurers assemble large actuarial databases and use them both ex ante in underwriting (that is, in classifying and pricing) the risks they insure and ex post in verifying claims by separating valid from frivolous ones.To most readers, this claim-that insurance regulates safety-seems remarkably counterintuitive. In much of the economic literature, insurance is seen as antithetical to risk reduction. Indeed, one of the cornerstones of the economics of information, regarded by many as axiomatic, is the moral hazard problem-the idea that a party who is insured against risk has a suboptimal incentive to reduce it. …