Moral Hazard, Adverse Selection, and Tort Liability* by Jim Garven Baylor Finance Workshop March 10, 2005

1. Moral Hazard, Adverse Selection, and Tort Liability* by Jim Garven Baylor Finance WorkshopMarch 10, 2005 *Forthcoming, Journal of Insurance Issues, Vol. 28, No. 1 (Spring 2005), pp. 1-13.

2. Executive Summary • Paper’s basic premises • Legal rules such as privity, contributory negligence, comparative negligence, and strict liability imply different types of risk sharing arrangements between potential victims and injurers. • Thus the tort liability system provides a laboratory setting for studying the economic consequences of moral hazard and adverse selection in real life.

3. Executive Summary • “Bonus DVD” features • Brief overview of the impact that the U.S. legal system has upon the growth and global competitiveness of the U.S. economy, and • Economic consequences of tort reform proposals such as the “Loser Pays” rule.

4. Tort Reform Roadmap (1/27/05 WSJ), p. A12 • “President Bush is making civil justice reform an early priority of his second term, and the business community is understandably pleased. Liability today has become what taxes and regulations were 20 or 30 years ago -- an enormous drag on our economy and a political tool for redistributing wealth unlinked to any genuine injustice…” • “The optimal fix would involve movement toward a British-style loser-pays system. That would curb incentives to bring the nuisance lawsuits that are bankrupting companies and individuals, driving up insurance premiums and increasing health-care costs.”

5. Plan for the Presentation • Overview of the insurability implications of moral hazard and adverse selection • The role and historical development of the U.S. tort system • How strict liability is plagued by moral hazard and adverse selection problems (thereby reducing consumer welfare). • Impact of the U.S. legal system upon the growth and global competitiveness of the U.S. economy • Economic consequences of tort reform proposals such as the “Loser Pays” rule.

6. Moral Hazard: The “Hidden Action” Problem • Moral hazard is the risk that a party to a contract will subsequently deviate from the terms of the contract. • Moral hazard is thus a problem created by information asymmetry after the transaction occurs. • In the context of principal/agent theory, moral hazard derives from the fact that principal and agent incentives may not be perfectly aligned; i.e., agency costs = moral hazard costs. • Note that moral hazard is a risk whenever it is difficult for the principal to monitor the agent.

7. Examples of Moral Hazard • Insurance markets: reflected in underinvestment in safety/loss prevention. • Corporate finance: reflected in perverse incentives faced by management and shareholders alike to not necessarily maximize firm value.

8. Innovations in contract design and pricing • Innovations in contract design involves finding ways to share risk between the principal and agent such that perverse incentives are mitigated. • Pricing innovation: Experience rating in insurance markets. • Contract design innovation: security design (e.g., rather than issue “straight” debt, the firm may issue convertible debt), insurance policy design (e.g., deductibles and coinsurance).

9. Moral Hazard Limits Insurability!

10. Adverse Selection: “Hidden Information” problem • Adverse selection is the risk that the party who wants to enter into a contract agreement with you is most likely to produce an undesirable outcome. • Adverse selection is the problem created by information asymmetry before the transaction occurs.

11. Adverse Selection • Examples of adverse selection • Insurers know less about the true risk characteristics of their policyholders than the policyholders themselves. • When a firm hires a worker, it knows less than the worker about his abilities. • The seller of a used car has more information about the car than the potential buyers. • Strategies for mitigating adverse selection • Risk Classification • Contract design innovations

12. Adverse Selection in Insurance

13. Adverse Selection Limits Insurability!

14. Practical Implications of Rothschild-Stiglitz • The Rothschild-Stiglitz "separating equilibrium" model shows that an insurer can mitigate adverse selection by limiting the set of contract choices offered to consumers.  • In the “real world”, insurers anticipate that bad risks will select lower deductibles than good risks; consequently, insurers adjust low deductible insurance policy premiums to reflect the anticipated cost of adverse selection. • Therefore, if you are a good risk, you ought to select high deductible insurance policies. 

15. Role of Tort Law • Tort law provides accident compensation • Two types of claims payments • Compensatory Damages • Special damages (direct costs) such as lost wages and medical expenses • General damages (indirect costs; based upon the principle of state dependent utility); also known as “pain and suffering” compensation. • Punitive Damages • Punishment for egregious conduct – for example, the famous case of the exploding Ford Pinto.

16. Historical Perspective on Products Liability • Pre-1916: Privity limitation - damages recoverable only from party with whom a contract exists • MacPherson v. Buick (1916): Adoption of negligence standard • Escola v. Coca-Cola Bottling Co. (1944): Adoption of strict liability • Initial defenses against strict liability: Assumption of Risk and Product Misuse

17. Tort Liability from an Insurance Perspective • The move from privity limitations to negligence rules to strict liability represents a significant shift in terms of how risks are shared ex ante between consumers and producers. • Initially, the financial consequences of product risks were primarily borne by consumers, and over time these risks have been shifted to producers. • Think of this shift in risk bearing as “tort insurance.”

18. Tort Liability from an Insurance Perspective • Tort insurance compensates for unexpected losses, and its premium is reflected in prices of goods and services. • What is the socially optimal level of tort insurance coverage? • We’ll view this question through the lens of insurance economics by assuming that a separate market exists for tort insurance. • In such a world, what would be the “optimal” level of coverage?

19. Economics of Strict Liability • Producers are compelled to bundle (full) insurance with their product. • In order to purchase the product, consumers must also purchase full insurance (i.e., there is no "opt out“ provision). • Tort insurance determines the scope of coverage ex post (private insurance contractually determines the scope of coverage ex ante).

20. Compensation for Non-Economic Losses and Moral Hazard • Is tort insurance “actuarially fair” (i.e., does the premium equal the expected value of loss?) • If it is actuarially fair, then strict liability results in an optimal level of insurance coverage (since consumers fully insure whenever insurance is actuarially fair (Bernoulli theorem)). • Tort insurance is probably actuarially unfair due to compensation for non-economic losses and moral hazard.

21. Compensation for Non-Economic Losses and Moral Hazard • Effect of non-economic losses • Pain and suffering is difficult for the insurer to monitor, thus creating a moral hazard problem. • One does not observe actively traded markets for pain and suffering insurance in the real world (probably because the premium would have to be too high to compensate for moral hazard). • Another important moral hazard issue: the weakening over time of the assumption of risk and product misuse defenses.

22. Biases in the Ex Post Determination of the Scope of Coverage • If the courts makes biased ex post assessments of the scope of coverage, then firms will • optimally underinvest in safety for products which have limited ex post coverage, and • optimally overinvest in safety for products which have excessive ex post coverage.

23. Economic analysis of liability rules • What is the ex post scope of coverage? Consider the following table on estimated costs of (federal) safety regulation __________________ Cost per life saved Regulation Passed Agency (in millions of 1984 $) Unvented space heaters 1980 CPSC $0.10 Passive restraints/belts 1984 NHTSA $0.30 Crane suspended personnel platform 1988 OSHA $1.20 Grain dust 1987 OSHA $5.30 Uranium mill tailings (inactive) 1983 EPA $27.60 Asbestos 1989 EPA $104.2 Arsenic/low-arsenic copper 1986 EPA $764.00 Formaldehyde 1987 OSHA $72,000.00 • Source: Kip Viscusi, Harvard Law School.

24. Economic consequences of adverse selection • Proposition: Tort insurance subsidizes risky people at the expense of safe people, and rich people at the expense of poor people. • How? Consider the following thought experiment. • Assume that consumers are heterogeneous in two dimensions: 1) wealth and 2) accident propensity.

25. Economic consequences of adverse selection • Suppose a firm sells motorcycle helmets. • All costs other than liability are $100 per helmet. • Since there is strict liability, the cost of which is reflected as a “pooled premium” in the product price, the firm must consider the potential economic losses associated with insuring product-related accidents.

26. Adverse selection – implications of wealth heterogeneity • Suppose 1) only compensatory damages are allowed, and 2) there are equal numbers of rich and poor consumers. • Compensatory damages for injured rich people are $150, and for injured poor people they are $50. Rich and poor people have the same (50%) probability of a product-related injury. • Expected liability cost per helmet for injured rich people is .5($150) = $75; for injured poor people it is .5($50) = $25. • Total helmet price = $100 + average expected liability cost = $100 + .5($75 + $25) = $150. • Therefore, rich people are subsidized $25 per helmet by poor people.

27. Adverse selection – implications of accident propensity heterogeneity • Now suppose all consumers have the same initial wealth, but different accident probabilities. • Compensatory damages for each injured consumer are $100. Half of all consumers have a 75% probability of a product-related injury, whereas the other half have a 25% probability of a product-related injury. • Expected liability cost per helmet for injured (high risk) consumers is .75($100) = $75; for injured (low risk) consumers it is .25($100) = $25. • Total helmet price = $100 + average expected liability cost = $100 + .5($75+$25) = $150. • Therefore, the more accident prone consumers receive a cross-subsidy of $25 per helmet from the less accident prone consumers.

28. Adverse selection in tort insurance • When consumers differ in terms of wealth, poor consumers cross-subsidize rich consumers. • When consumers differ in terms of accident propensity, low risk consumers cross-subsidize high risk consumers. • Since tort insurance is based upon a pooled premium, this may give rise to adverse selection in the product market.

29. Adverse selection in tort insurance • How can we limit consumer heterogeneity? • Product branding and differentiation strategies enable firms to encourage consumers with different accident propensity and socioeconomic characteristics to self select. • For example, an automobile marketer may attract high risk drivers by offering a sports car, and low risk drivers by offering a minivan. • Similarly, by offering different brands, an automobile marketer encourages drivers with different socioeconomic characteristics to self select.

30. Economics of Tort Reform Fig. 1. Tort expenditures as a percentage GDP. Source: Economic Report of the President, p. 216.

31. Tort Costs Have Grown Much Faster than GDP

32. Economics of Tort Reform • Lawyers do both positive and negative things for the economy. • Examples of positive economic contributions include activities such as making property rights clearer, protecting individuals from harm-doers and facilitating transactions. • Examples of negative economic contributions include predatory redistributive conflict, excessive litigation and the diversion of talent out of productive activity.

33. “Optimal” Numberof Lawyers for an Economy

34. “Loser” Pays “America differs from all other Western democracies (indeed, from virtually all nations of any sort) in its refusal to recognize the principle that the losing side in litigation should contribute toward “making whole” its prevailing opponent. It's long past time this country joined the world in adopting that principle; unfortunately, any steps toward doing so must contend with deeply entrenched resistance from the organized bar, which likes the system the way it is.” Source: “Loser Pays”, by Walter Olson, Manhattan Institute, May 2004

35. “Loser” Pays vs. “Loser Doesn’t Pay” • “Loser” Pays requires that the loser reimburse some portion of the winner’s legal expenses; this is the common practice in most modern legal systems (other than the United States). • Empirical evidence suggests that “Loser” Pays reduces the frequency of litigation and related expenses. • In the U.S., the “Loser Pays” proposal has been around since the early 1990s and was recently reintroduced as a legislative proposal in the U.S. Congress.

36. “Loser” Pays vs. “Loser Doesn’t Pay” • Under the “Loser Doesn’t Pay” system, the payoff from litigation resembles a call option. • From the plaintiff’s perspective, downside risk is limited to the option premium, (consisting of legal costs (if any) that are directly borne by the plaintiff.

37. “Loser” Pays vs. “Loser Doesn’t Pay” • Although the plaintiff will typically share upside risk (in the form of contingency fees), his or her payoff is not bounded from above, thus there is an apparent moral hazard. • “Loser Pays” transforms a nonlinear option payoff into a linear payoff that causes the plaintiff to bear downside as well as upside risk!