1. The Reasonable Person Negligence Standard and Liability Insurance Vickie Bajtelsmit Colorado State University Paul Thistle University of Nevada Las Vegas

2. The Liability Insurance Puzzle  Law of negligence If you don’t meet the standard of care  you are liable for damages you cause If you do meet the standard of care  your victim bears the full cost of his/her injuries.  Implication: If you take appropriate care, you don’t need liability insurance

3. The Liability Insurance Puzzle  $100B+ premiums in 2005 Med mal, CMP liability, CGL non-product, Other liability  Why? Intuition: legal errors, mistakes, rogue agents Not much research on this question

4. Reasonable Person standard  Negligence is based on the Reasonable Person standard  What would a reasonable person do in similar circumstance?  Not the average person  Embodiment of community standard Rational Well informed Prudent Concerned for others

5. Reasonable Person standard  Same for all individuals “The standard of conduct which the community demands must be an external and objective one, rather than the individual judgment, good or bad, of the particular actor, and it must be, so far as possible, the same for all persons, since the law can have no favorites.” (Prosser & Keaton on Torts, 1984, pp 173-174)

6. Objective of the Paper  Reasonable person standard is uniform  People are not E.g., not all MDs are equally competent Question 1: Does heterogeneity lead to a demand for liability insurance?

7. Objective of the Paper  Negligence rules are deterrent They create incentives to take care  Insurance covers damages May weaken deterrent effect of liability law Question 2: Does availability of insurance increase social welfare?

8. The Basic Model  Standard model of accidents unilateral, between strangers  Risk averse potential injurer (PI) u – increasing, concave w – wealth, d – damage, x – expend on care  G (x),  B (x) – accident probabilities  decreasing, convex   G (x) ’ B (x)  G,  B – proportion of G, B

9. The Basic Model  Insurance policy p – premium, q – indemnity x is assumed to be observable Expected utility: U i (p i, q i, x) = (1 –  i (x))u(w–p i –x) +  i (x)u(w–d–p i –x+q i )

10. The Basic Model  Potential victims are risk neutral  Courts work perfectly Measure expenditure on care without error  Insurance market is competitive Fair premium p i =  i (x)q  Note: Fair premium implies Full coverage (q = d) is optimal Care min’s x +  i (x)d

11. Heterogeneous Risk  Proposition 1: Assume risk type verifiable by insurer  Then G’s fully insure (q = d) and spend x G * if and only if x* ≥ x G * +  G (x G *)d

12. Heterogeneous Risk  Interpretation What’s least cost way to avoid liability?  For informed B’s – meet negligence standard  For informed G’s – be negligent and insure  What is effect on social welfare? G’s better off B’s no change Victims better off  More accidents but insurance increases expected compensation

13. Heterogeneous Risk  What if risk type not observable? Potential adverse selection problems  Proposition 2: Assume risk type not verifiable by insurer and self-selection constraint is binding  Then (a) G’s less than fully insure (q x G *).

14. Heterogeneous Risk  Interpretation (same as Prop 1) What is least cost way to avoid liability?  For informed B’s – meet negligence standard  For informed G’s – be negligent and insure  What is effect on social welfare? G’s better off B’s no change Victims better off  Insurance increases expected compensation

15. Heterogeneous Cost of Care  Ins. lit. assumes different risk, same cost of care  Law & Econ lit. assumes common risk, different cost of care s = safety c H, c L = cost of care

16. Heterogeneous Cost of Care  Proposition 3: H’s fully insure (q = d) and choose care s G * if and only if c H s* ≥ c H s G * + (s G *)d

17. Heterogeneous Cost of Care  Same interpretation What is least cost way to avoid liability?  Same effect on social welfare  No adverse selection All have same loss prob, same E(loss)

18. Conclusions  Demand for insurance can result from Reasonable person standard and Heterogeneous population  For some, its cheaper to be negligent and insure than comply  Insurance increases social welfare Insurance increases E(accidents) But victims compensated for some

19. Want a copy of the paper?  Copies are available at http://ssrn.com/abstract=995816 http://faculty.unlv.edu/pthistle