Liability Insurance

In recent columns I have concentrated on the economics of law practice. We have discussed the economic motives of plaintiff lawyers, the economic motives of defense lawyers, and the fact that the combination may impact adversely on the ability of the legal system to efficiently resolve disputes. This column will focus on liability insurance and will complete the current discussion of the economics of law practice. Liability insurance companies exist because of litigation, and have a major impact on the legal system. It is time that the functions of insurance be carefully reconsidered.

Liability insurance has been around for a long time. While the concept existed prior to automobiles being produced on assembly lines, the concept of liability insurance took a major step forward with the advent of the automobile. Liability insurance also extends generally to almost any business activity. In the modern world it is not considered prudent to operate any type of business without liability insurance. State law generally requires that there be liability insurance in place before an automobile is operated on a public highway. State law also provides that in the event that a tort-feasor in an accident on a public highway does not have liability insurance or if the insurance is inadequate, that the insurance company for the injured party provides uninsured or underinsured motorist coverage.

With the inception of liability insurance there were significant policy arguments as to whether liability insurance is a good idea. It was argued that for an insurance company to assume financial responsibility of tort-feasors could have several undesirable effects. One concern was that the person with insurance might be less inclined to be careful. That concern probably is unfounded. A more worthy concern in the realm of economics is whether the existence of insurance would encourage litigation. It certainly has. The defendant’s insurance makes litigation by the plaintiff and his attorney economically feasible in many cases in which it would not be economically feasible otherwise. Ironically, insurance probably prevents disastrous results for plaintiffs more often than for defendants.

The actual function of insurance in the modern legal economy is quite beneficial, even though it encourages litigation that would not otherwise be possible. People are really injured in automobile accidents and business transactions. The existence of insurance provides partial or total compensation for the loses that are suffered by the injured parties. Insurance spreads the risk of loss. In an ideal world insurance would compensate the injured party and would also produce normative force that would require the exercise of care by the potential defendants. The fact is that spreading the risk of loss and providing adequate compensation to the injured party is the greatest benefit provided by insurance. That economic justification, however, is not well recognized in the operation of the judicial system. Despite the fact that everybody and his brother knows that it is illegal to operate a vehicle on a public highway without insurance, the mere mention of insurance in the course of a trial justifies an immediate order of mistrial by the judge. The system still assumes that the case deals only with the injuries of the plaintiff and the negligence of the defendant. It assumes that the defendant will stand for the loss. Obviously, that is just false. The maintenance of the philosophy that only the plaintiff and defendant are involved in the litigation, and the continued practice of the judicial and legal system of ignoring the mandatory existence of insurance feeds the undesirable effects of the economic motivations of plaintiff lawyers and defense lawyers and the insurance companies themselves. It ignores the pervasive systemic effect of liability insurance. We have described the inordinate transaction cost that renders the legal system ineffective. If our legislature, courts, and attorneys would take a closer look at the underlying role of insurance and would come up with different economic practices for dealing with claims, the system could be improved immeasurably.

The ironic truth is that businesses and car owners must pay for insurance that ultimately is obviously for the benefit of the injured plaintiff who brings a law suit against the person who paid the premium. The focus of insurance remains on defense for its tort-feasor rather than compensation for the injured party.

A slightly different conceptualization that recognizes the obligation of the insurance company to the injured plaintiff could dramatically improve the ability of the legal system to adequately resolve disputes more efficiently.