«Abstract Insurance companies are financially responsible for a substantial portion of the losses associated with many risky activities, and those ...»
Encouraging Insurers to Regulate: The Role (If Any) for Tort Law
Kyle D. Logue
University of Michigan Law School
Insurance companies are financially responsible for a substantial portion of the losses associated with
many risky activities, and those losses get mostly distributed among participating insureds through the
premiums that are charged. The more they can lower the risks posed by their insureds, the more
competitively they can price their policies, and the more customers they can attract. Thus, competition forces insurers to be private regulators of risk. To that end, insurers deploy a range of techniques to encourage their insureds to reduce the risks of their insured activities, from charging experience-rated premiums to giving special premium discounts to insureds who make specific behavioral changes designed to reduce risk. Somewhat paradoxically, however, tort law discourages insurers from engaging in the direct regulation of their insureds’ behavior. Under longstanding tort principles, if an insurer “undertakes” to provide serious risk-reduction services to an insured, the insurer can be found to have a duty of reasonable care and, they breach that duty, held liable for any harms caused to third parties. This application of tort principles to insurance companies could be contributing to the moral hazard problem often associated with insurance—the tendency of insurance to cause risk to increase rather than decrease. This Article explores this problem and analyzes a number of ways to encourage insurers to regulate—from insurer-specific Good Samaritan statutes (which we might call a “carrot”) to the expansion of tort principles to create an affirmative duty on the part of insurers to regulate (which would definitely be a “stick”). What combination of carrots and sticks produces the optimal insurer incentives to regulate their insureds’ behavior? That is the question the Article addresses.
Encouraging Insurers to Regulate: The Role (If Any) for Tort Law Kyle D. Logue * I. Introduction It is well known that insurance companies are financial intermediaries that transfer and spread risk. Specifically, insurers enter into contractual arrangements with risk-averse individuals and corporations in which a broad range of hazards, or sometimes a specific set of hazards, is shifted from the latter to the former. The insurers, who themselves are corporations owned by private shareholders, spread this risk across their policyholders through premiums that reflect average policyholder risk.
Thus, each policyholder pays a relatively small and certain premium to the pool in exchange for shifting the risk of a large loss to the pool. The risk-transferring and risk-spreading functions compose the standard picture of insurance markets.
But insurers do more than this. Insurance companies also serve as active risk regulators. 1 In many of the same ways that government agencies monitor and place limits on the risky behavior of individuals and businesses within their jurisdictions, insurance companies also monitor and place limits on the risky behavior of the people and firms whom they insure. In fact, because insurance is a practical if not a legal requirement with respect to some activities, insurers for those activities function as gatekeepers, determining who gets to engage in the risky activity and who does not. Homeownership, for example, is not possible for most people without home-mortgage financing, which in turn is not available to anyone who does not first purchase homeowners’ insurance. Similarly, one cannot legally drive a car in most states without first purchasing the statutory minimum amount of liability insurance.
It is also difficult if not impossible to be actively engaged in a profession—law, medicine, engineering, whatever—if one does not have professional liability insurance coverage, purchased either individually or through one’s employer.
* Wade H. and Dores M. McCree Collegiate Professor of Law, University of Michigan Law School.
See generally Omri Ben-Shahar & Kyle D. Logue, Outsourcing Regulation: How Insurance Reduces Moral Hazard, 111 MICH. L. REV. 197 (2012) In addition to keeping the gate to much commercial activity, insurers, like government regulators, also have more subtle regulatory tools. For example, auto insurers charge higher premiums for vehicles that pose a statistically greater chance of being involved in an accident or that are more expensive to repair or more likely to cause harm to others if an accident occurs. Such risk-differentiated premiums create incentives at the margin for auto purchasers to take into account the risks associated with their vehicle choices. Likewise, when auto insurance companies adjust premiums based on the accident experience of individual drivers or alter rates based on the way in which drivers operate their vehicles or based on the numbers of miles the insured drives, the insurer is in effect regulating driver behavior--forcing drivers to internalize the expected value of the accident-costs associated with her driving choices. In this way, auto insurance premiums—all insurance premiums—can be viewed as costinternalizing Pigouvian taxes, similar to taxes on carbon emissions, only here administered by private insurance companies rather than by a government agency.
An argument can be made that this is all to the good. We should want insurers to act as risk regulators. Sometimes regulation is needed, whether because of externalities or cognitive biases or some other market failure. Moreover, there are times when private regulation through insurance can be superior to government regulation. This happens when insurers are able to take advantage of their two primary institutional advantages over government regulators: First, private insurers have relatively cheap access to highly relevant risk-related information; second, private insurers are motivated by profit to find clever and practical ways to reduce risks. These two factors explain not only why regulation by insurance is often desirable, but also why it is common.
There is one type of regulation by insurers, however, that is surprisingly uncommon. It is analogous to what the literature on government regulation might call “direct regulation” or “input regulation” or “command-and-control regulation.” For example, when the EPA inspects a coal-fired power plant and issues an order specifying steps that the operator of the plant must take to minimize harmful emissions into the atmosphere, such an intervention is a quintessential example of direct regulation. Direct regulation is generally considered the policy instrument of choice only if the regulator has vast quantities of information regarding the regulated risk. Insurers, because of their access to information regarding insured risks, are uniquely suited to engage in direct regulation. Insurers, for example, could inspect their insureds’ activities and recommend specific steps that the insureds should take to reduce the risks that they pose to themselves and to others. Moreover, insurers could give those recommendations teeth by linking them to premium adjustments or by making them a condition of coverage.
Although insurers do engage in some direct regulation (as discussed in more detail below), they do surprisingly little of it, given the potential benefits. And the reason for this, or one potential reason for it, is surprising as well: Insurers’ incentive to engage in direct regulation of their insureds’ risky behavior may be inhibited by a concern about potential tort liability. Under well accepted common law principles of tort, if a party undertakes to render a service that is expected to reduce the risk of harm to a third party, then the party providing the service has a duty to take reasonable care in engaging in this undertaking. 2 Some states have enacted statutes that eliminate this duty as it applies to insurance companies, or as it applies to a subset of insurance companies such as workers’ compensation insurers.
Most states, however, have no such “insurer Good Samaritan laws,” but have instead left in place the common law cause of action, sometimes referred to as the tort of “negligent inspection.” What’s more, in most of those states, the doctrine of negligent inspection has in fact been applied to insurance companies. Therefore, existing tort doctrine in most states does in fact pose a risk to insurers who engage in direct regulation of their insureds: if they regulate poorly, they may be held responsible for the consequences.
Whether or not exposing insurers to such tort liability is a good thing depends on tradeoffs that are familiar to the economic analyst of law. On the one hand, it can be argued that applying the negligent inspection rule to insurers has at least two potentially negative effects: insurers are discouraged from engaging in socially desirable regulation of risk; and insurers who do engage in such regulation find it necessary to raise their premiums to cover the additional tort risk to themselves, thereby pricing some insureds out of the market for coverage. If these to effects are large, perhaps more states should enact insurer Good Samaritan laws. On the other hand, it can also be argued that applying the negligent inspection rule to insurers enhances efficient deterrence by encouraging those insurers who undertake to provide safety inspections the incentive to do so in a reasonable way, an incentive that the market alone does not provide (for reasons to be discussed further below). If that is so, perhaps the existing insurer Good Samaritan statutes should be repealed.
Of course, enactment or repeal of insurer Good Samaritan statutes are not the only two options.
There are both more extreme and less extreme alternatives. For example, if it is the case that insurers Restatement (Third) Torts: Liability for Physical and Emotional Harm § 42. The Third Restatement is a revision of the language from the Restatement (Second) Torts § 324A.
are in the best position to prevent certain accidents from happening—if insurers are the “cheapest cost avoiders”—it is conceivable that courts or legislatures could create an affirmative duty on the part of insurers to regulate—to provide specific safety recommendations or mandates when doing so would constitute reasonable care. Such a rule could be seen as a major expansion of traditional tort law, which generally imposes no affirmative “duty to rescue” others who are in danger, not even when doing so would impose little risk to the rescuer. Alternatively, a duty imposed on insurers to regulate could instead be seen as a hybrid of the existing exception to the no-duty-to-rescue rule, specifically, the exception for situations in which the tort defendant has a “special relationship” with the victim.
This Article explores all of these possibilities. Part II provides a more detailed discussion of why insurers might be viewed as effective private regulators of the risks posed by their insureds. Part III surveys the existing doctrine dealing with negligent inspection liability, as applied both to trade associations and insurance companies—both examples of private risk regulators. Part IV addresses the normative questions: how would insurers respond to various alternative tort rules with respect to direct regulation by insurers of their insureds and what rule or combination of rules would create the optimal incentive structure. This Article builds on a number of literatures, including the previous work on tradeassociation and insurer liability for negligent standard setting and negligent inspections 3 as well as the literatures on vicarious and gatekeeper liability 4 and the duty to rescue. 5
II. Insurers as Private Regulators
Economic theories of regulation seek to identify the situations in which market failures give rise to the need for government intervention in the economy and what sort of interventions make the most sense, whether it be command-and-control regulations, performance standards, cost-internalizing taxes, Two important articles on the liability of trade associations are Ralph G. Wellington & Vance G. Camisa, The Trade Associations and Product Safety Standards: Of Good Samaritans and Liability, 35 WAYNE L. REV. 37 (1988); and Peter H. Schuck, Tort Liability to Those Injured by Negligent Accreditation Decisions, 57 LAW & CONTEMP. PROB. 185 (1994).
There have been a number of articles written on negligent inspection liability of insurers. James F. Reddoch, Jr., Insurer’s Liability for Negligent Performance of Voluntary Safety Inspections 3 CUMB. L. REV. 118 (1972); Michael Braden, An Insurer’s Liability to Third Parties for Negligent Inspection, 66 KY. L. J. 919 (1977); Victor Goldberg, Tort Liability for Negligent Inspection by Insurers, in RESEARCH IN LAW AND ECONOMICS: A RESEARCH ANNUAL 76 (Richard O.
Zerbe, editor) (1980); Amy Schulman, Recent Developments in Self-Insurance and Risk Management, 32 TORT & INS.
L. J. 479 (1995); John Dwight Ingraham, Liability of Insurers for Negligent Inspection of Insured Premises, 50 DRAKE L.
REV. 623 (2002).
See, e.g., Alan O. Sykes, The Economics of Vicarious Liability, 93 YALE L. J. 1231 (1984); and Renier Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J. L. E. & O. 53, 57 (1986).