Outsourcing regulation: how insurance reduces moral hazard.

• Author: Ben-Shahar, Omri
• Position: Introduction to II. Insurers as Safety Regulators: Examples C. Auto Insurance, p. 197-223

This Article explores the potential value of insurance as a substitute for government regulation of safety. Successful regulation of behavior requires information in setting standards, licensing conduct, verifying outcomes, and assessing remedies. In various areas, the private insurance sector has technological advantages in collecting and administering the information relevant to setting standards and could outperform the government in creating incentives for optimal behavior. We explore several areas that are regulated more by private insurance than by government. In those areas, the role of the law diminishes to the administration of simple rules of absolute liability or no liability, and affected parties turn to insurers for both risk coverage and safety instructions. This Article examines the methods used in regulation-through-insurance, and then explores the potential regulatory role of insurance in additional, yet unutilized, areas: (1) consumer protection, (2) food safety, and (3) financial statements.

TABLE OF CONTENTS INTRODUCTION I. REGULATORY TECHNIQUES IN INSURANCE A. Ex Ante Regulation 1. Underwriting Risk: Differentiated Premiums 2. Deductibles and Copayments 3. Refusal to Insure 4. Coaching Safer Conduct 5. Implementing Private Safety Codes 6. Research and Development of Safety Methods 7. Influencing Government Regulation B. Ex Post Regulation 1. Claims Management 2. Mitigation of Loss 3. Exclusions 4. Ex Post Underwriting II. INSURERS AS SAFETY REGULATORS: EXAMPLES A. Products Liability Insurance B. Workers' Compensation Insurance C. Auto Insurance D. Homeowners' Insurance E. Environmental Liability Insurance F. Tax Liability Insurance III. INSURANCE AS REGULATION VERSUS GOVERNMENT REGULATION A. When Government Action Alone Is Required B. Safety Standards: Mandates Versus Menus C. Pigouvian Taxes: Pricing the Externality D. Converting Standards into Rules E. Stricter Codes of Safety F. Outsourced Monitoring G. Disseminating Information IV. EXPANDING THE ROLE OF REGULATION THROUGH INSURANCE A. Consumer Contracts B. Food Safety C. Financial Statements Insurance CONCLUSION INTRODUCTION

Legal regulation of behavior requires information. Someone--a regulator or a judge--has to inspect the conduct of the regulated party and determine the legal consequences that will attach. Acquiring information about the conduct, setting benchmarks by which the conduct is measured, and establishing the correct scale of payoffs are costly and require expertise and motivation. Thus, economic theories of rulemaking are often based on the relative informational advantages that different regulatory bodies have and how this information can be harnessed to enhance incentives and thereby improve welfare. (1)

There are plenty of reasons to worry that government regulators will make mistakes. First, they are not paid for performance and thus may lack adequate incentives. They are not disciplined by market forces and only imperfectly disciplined by career concerns and the political process. Moreover, they commonly lack the most advanced tools for information acquisition, aggregation, and prediction. Courts, for example, do not search for information independently but rather receive only what parties present to them through the litigation process, which is costly, ad hoc, and as a result often bypassed by crude settlements. Courts are also ill equipped to recognize the distribution of characteristics from which any given case is sampled. Government agencies too have limited resources to monitor and anticipate patterns in the behavior of sophisticated industries, often inspecting only a small sample of the regulated conduct. They may be plagued by internal principal-agent problems, and they are often outpaced and outsmarted by the regulated parties. This raises the following question: can anyone regulate risky behavior better than the government?

This Article develops the claim that in a variety of areas private insurance companies can, and already do, replace or augment the standard setting and safety monitoring currently performed by government. And they do so in ways that may increase overall social welfare. Insurance is often thought of as an institution intended only for ex post indemnification, working to reduce the costs of risky activities through risk pooling and risk shifting. But insurance also performs other important functions: risk reduction and risk management. (2) Insurance arrangements--by using such tools as deductibles, exclusions, and experience rating--give private parties the incentive to reduce risks. Insurance is a business that specializes in risk management. Insurers assemble large actuarial databases and use them both ex ante in underwriting (that is, in classifying and pricing) the risks they insure and ex post in verifying claims by separating valid from frivolous ones.

To most readers, this claim--that insurance regulates safety--seems remarkably counterintuitive. In much of the economic literature, insurance is seen as antithetical to risk reduction. Indeed, one of the cornerstones of the economics of information, regarded by many as axiomatic, is the moral hazard problem--the idea that a party who is insured against risk has a suboptimal incentive to reduce it. Rivers of ink have been spilled discussing the moral hazard problem of insurance and ways to mitigate it. (3) A fundamental insight of this literature is that insurance must be partially pared down to give people incentives to prevent harms. (4) Copayment requirements and deductibles are thus ways to reduce insurance coverage in order to stimulate precaution. This Article develops the opposite proposition--that insurance can reduce and in some cases solve, rather than create or exacerbate, the moral hazard and related incentive problems. When people create risk to others (or themselves), insurance is the mechanism that converts concerns about loss or the vague threat of liability into a concrete set of harm-reducing measures. It supplies both the incentive and the know-how that individuals and firms often lack, resulting in a more efficient level of accidents.

To appreciate the role of insurers in reducing moral hazard, the methodology this Article pursues is comparative: we line up insurers versus government as regulators of safety. We show that insurers perform tasks that are comparable to the public regulation of safety. Like a regulator setting standards of conduct and monitoring behavior, insurers have to assess the distribution of harm and determine the desirability of safety measures. And like courts adjudicating liability and awarding damages, insurers have to administer claims, verify harms, and determine the comparative causation of other parties. If insurance has better information and better incentives to set efficient standards of conduct and enforce them, it would be beneficial as a matter of comparative institutional competence to "outsource" to the insurance sector various regulatory functions that are ordinarily performed by government. (5)

Regulation-through-insurance is a notion that has been widely recognized in the literature. Steven Shavell's work on the relationship between insurance and tort liability demonstrated the potential for insurers to create optimal incentives for care. (6) Kenneth Abraham coined the term "surrogate regulation" when describing the (then new) regulatory role being foisted on liability insurers to regulate toxic tort and environmental risks. (7) Tom Baker, Victor Goldberg, Howard Kunreuther, and others have written about the various regulatory methods that liability insurers use to reduce the risks that they insure. (8) In addition, scholars have made proposals to increase the role of particular forms of insurance as substitutes for specific types of agency-based government regulation. (9) And others have gone so far as to assert that, since private insurance companies share some of the objectives of the state (such as the reduction of risk and the sorting of people into patterns of conduct), private insurance can be understood as an implicit form of government. (10)

Our claim in this Article builds on that prior work, but is different. We develop the claim that private insurance companies, utilizing the methodologies of actuarialism, private contracting, and ex post claim investigation, can and already do perform some rulemaking and adjudication, thereby replacing or complementing government regulation. We further show that, where insurance is offered, it develops templates to regulate behavior in ways that are potentially more finely tuned and information sensitive than some forms of government control. Moreover, even when government regulation is needed to overcome insurance market failures, the private insurance industry sometimes provides the necessary information and motivation to induce government regulators to act.

We contend that private insurance markets can and sometimes do outperform the government in regulating conduct because of both superior information and competition. In many areas, insurance markets are fiercely competitive, especially with respect to price. (11) Insurers that can offer more coverage at lower premiums will attract customers, even when they require customers to modify their conduct in a costly way. As long as the standards imposed by the insurers are efficient, customers should be lured by the discounts. Moreover, insurers' concern with affordability--increasing the pool of its clientele--is another force pushing for increased conduct regulation. Safe behavior by insureds reduces the cost of premiums and increases the size of the insurers' market.

This does not mean, of course, that insurance companies are always superior to government agencies and courts as safety regulators. In some situations, insurers' incentives will not be aligned with those of society generally. The profit motive is not a panacea. However, in a remarkable range of...