Moral Hazard in Liability Insurance

This article considers moral hazard in the specific context of third-party risks. It argues that in the case of liability insurance, moral hazard takes on dimensions that are generally absent in first party insurance and that this, in turn, generates extra layers of uncertainty which contribute substantially to the difficulties that insurers experience with liability exposures. For the purpose of the discussion, moral hazard is divided into four forms, which are described as "policyholder hazard", "claimant hazard", "jurisprudential hazard" and "underwriting hazard". Policyholder hazard refers to the possibility that the policyholder, knowing that he is insured, will change his behaviour in a way that produces undesirable outcomes: in particular, he may become more careless. This is moral hazard in the classic sense, and is the form that led early commentators to question the legality of liability insurance and attempt to suppress it on grounds of public policy. Claimant hazard concerns the effect that the existence of liability insurance might have on actual or potential claimants, i.e., third parties. For example, they may be encouraged to target those who are insured in preference to those who are not, collude with policyholders in order to tap insurance funds, or launch unmeritorious suits in the hope that insurers will pay rather than risk incurring heavy defence costs. Jurisprudential hazard concerns the extent to which lawmakers, including courts of law and legislative assemblies, might be influenced in the application, modification or expansion of liability rules by the existence of liability insurance in a particular case, or by the general availability of such insurance. Underwriting hazard is the risk that, in the case of some liability exposures, such as long-tail risks, underwriters may be encouraged to lower their normal standards. The article concludes that moral hazard, in the way that we have defined it, arises in particularly acute and complex forms in the case of liability insurance. It is argued that, as a consequence of this, some areas of the tort/liability insurance system are likely to be inherently unstable.