Outsourcing regulation: how insurance reduces moral hazard.

• Author: Ben-Shahar, Omri
• Position: II. Insurers as Safety Regulators: Examples D. Homeowners' Insurance through Conclusion, with footnotes, p. 223-248

4. Homeowners' Insurance

   Residential property risk is another area where insurers regulate insured behavior. Most homeowners cannot ascertain the quality of the structure they are purchasing or the risks associated with inferior construction, especially risks under high-wind, fire, or earthquake conditions. And yet, except to the extent that the CPSC regulates household products, household risk is largely unregulated by the federal government. (83) Rather, building safety standards are left to state and local governments, which typically adopt some version of the model building codes written by private organizations. (84) Political pressures by the construction industry and short-term financial interests of homeowners operate to inhibit optimal standards and rigorous enforcement.

   Insurance helps to remedy this regulatory inefficiency. First, homeowners' insurers engage in direct ex ante regulation through the use of premium discounts for homes equipped with safety measures, such as smoke detectors or sprinkler systems, which have been found to dramatically reduce the risk of fire-related death and property damage. Similarly, insurers in Florida and in other parts of the country prone to windstorms offer substantial premium discounts to homeowners who make special investments in wind mitigation, such as installing hurricane clips to secure the roof, anchoring the base of the home to the foundation, and using special storm shutters on the windows. (85)

   In addition to such direct regulation, insurers encourage more efficient government regulation of home-building standards. The insurance industry collects information regarding the building codes in different communities and how well those codes are being enforced. It then uses that information to generate building code-effectiveness ratings, which individual insurers may use to price their coverage. (86) The indirect effect of these ratings is to put pressure on state and local governments to tighten their building codes and their enforcement of these building codes. In the absence of such ratings, there is relatively little political pressure on state and local governments to improve building codes and building-code enforcement, except perhaps following natural disasters (such as hurricanes, earthquakes, and wildfires). However, the publishing of these ratings, which clearly indicate how various jurisdictions are doing relative to each other, and the effect these ratings have on insurance premiums, can produce pressure on local regulators to improve both codes and enforcement.

   Homeowners' insurers also do something that government regulators do not: they generate large amounts of risk-related information through large-scale hazard simulations. The industry funds a massive research facility for simulating hurricanes and other perils, and studying how different construction techniques withstand wind, fire, water, and hailstorm damage. (87) Research conducted at this facility is intended to do for home-construction standards and reducing the losses associated with various natural hazards what crash testing conducted by the Insurance Institute for Auto Safety has done for crashworthiness in automobiles. Not only does this research enable the industry to improve its rating of building codes, but it also refines the premium discounts for various safety investments.

5. Environmental Liability Insurance

   Striking examples of how insurance minimizes rather than exacerbates moral hazard problems can be found in the context of environmental liability insurance. (88) Under various federal and state laws, firms face enormous potential liability for the environmental harms they cause, including substantial cleanup costs. (89) Because firms are often insufficiently capitalized to pay for these environmental costs, and because many environmental harms become manifest only after long latency periods, environmental liability or other ex post fines may not provide optimal regulation of care levels and activity levels. However, because environmental liability insurance is prevalent-and in some areas, mandatory--insurance companies assume the role of private (ex ante and ex post) environmental regulators. In fact, specialized environmental insurers have taken over the role of insuring and regulating many environmental risks. That is, environmental coverage is no longer sold as part of the insurance offered under standard commercial liability policies, but rather as a special line of coverage--Environmental Impairment Liability Insurance ("EIL"). EIL is offered by specialized insurance companies that typically write specific EIL policies for specific sectors. (90) These EIL policies are underwritten and issued on a site-specific basis. They generally exclude coverage for gradual pollution, which is more likely to be known or predicted by the insured (and thus more likely to be a source of moral hazard) than sudden, abrupt discharges of pollution. (91)

   Insurance in this area reinforces existing government regulations by inspecting that policyholders comply with licensing conditions and other environmental regulations. Environmental insurance also goes beyond these minimal compliance checks by promoting higher safety standards. For example, insurers offer premium incentives (up to a 30 percent discount) for participation in private Environmental Management Systems that provide stricter codes of environmental compliance, perform on-site auditing, and evaluate performance. (92) Insurers know better than firms how to assess environmental risks and the feasibility of alternative solutions, and offer this expertise to help their clients comply with environmental standards. (93)

   A recent study demonstrated that private insurance improved the safety of fuel storage tanks, compared to the incentives under government cleanup assurance funds. When a change of law forced owners to switch from government to private insurance, a new menu of differentiated premiums and experience rating induced owners of fuel tanks to improve safety, and accidents dropped by more than 20 percent. It was estimated that 3,000 fuel tank releases were avoided in Michigan alone over eight years, representing an aggregate cleanup-cost savings of $400 million. (94)

6. Tax Liability Insurance

   Like environmental insurance, tax liability insurance responds to costs that firms face as a result of government regulations. Here, the cost faced is the cost of uncertain tax laws. This type of insurance covers liability for violations of the tax law, and thus tax insurers inspect and monitor the tax compliance of their insureds. (95) Imagine a taxpayer who wishes to engage in a transaction with highly uncertain tax consequences that depend on how the Internal Revenue Service ("IRS") and ultimately the courts interpret a very complex combination of law and facts. For example, large tax payments can turn on whether a transaction is considered a tax-free reorganization, a determination that cannot be made with certainty prior to the transaction. Uncertainty can be removed by requesting a private ruling from the IRS in advance, but the IRS often declines to do a thorough ex ante analysis of the proposed transactions, imposing on taxpayers the risk of an adverse determination upon auditing.

   Given this legal uncertainty, private insurance offers coverage against the possibility that the intended tax treatment will be denied ex post by the taxing authorities. (96) These policies cover excess taxes that are ultimately assessed against the insured, including grossed-up amounts (such as interest and noncriminal fines), as well as the cost of hiring outside tax experts to help resolve the disputes with the taxing authorities. (97) These policies are not offered on a standard-form basis, but are instead individually negotiated for each transaction that is being insured, based on ad hoc risks as determined by the insurer after an elaborate factgathering process. (98) As part of the underwriting process, the insurer enlists the help of outside tax counsel, often among the very best in the field, to offer an assessment of the likelihood of success of the desired tax treatment. (99)

   Effectively, the insurers become private tax law enforcers. The insurers are able to do what the government cannot afford to do: hire top lawyers to assess the tax validity of complex, fact-intensive commercial transactions before they are undertaken, and issue what amounts to a ruling on the question. The policy concern with this type of coverage, of course, is that, in extreme cases, parties will seek coverage for transactions that are clearly contrary to the tax laws, where the only significant uncertainty is the uncertainty as to detection. This would be the case if, for example, insurers were offering to cover abusive tax shelters. (100) As it turns out, however, insurers have thus far steered clear of offering tax shelter coverage. (101)

   In each of these areas--products liability insurance, workers' compensation insurance, automobile insurance, homeowners' insurance, environmental liability insurance, and tax liability insurance--insurers already serve as quasi-private regulators of risk. (102) Because of their superior access to information and their commercial sophistication, and because of the competitive pressure to find new ways to lower their costs and hence their prices, insurance companies employ a variety of strategies to improve the safety conduct of their policyholders. In many of these examples, the presence of insurance reduces, rather than creates, a moral hazard problem. It is still the case, of course, that some forms of insurance also occasionally create moral hazard and disregard for safety. The purpose of this survey is to highlight a few of the many examples where insurance has the opposite--and often underappreciated--effect.

   3. INSURANCE AS REGULATION VERSUS GOVERNMENT REGULATION

   The preceding Part demonstrated that insurance is...