The Reasonable Person
Negligence Standard
and Liability Insurance
Vickie Bajtelsmit
Colorado State University
Paul Thistle
University of Nevada Las Vegas
The Liability Insurance Puzzle

Law of negligence



If you don’t meet the standard of care 
you are liable for damages you cause
If you do meet the standard of care  your
victim bears the full cost of his/her injuries.
Implication:

If you take appropriate care, you don’t need
liability insurance
The Liability Insurance Puzzle

$100B+ premiums in 2005


Med mal, CMP liability, CGL non-product,
Other liability
Why?


Intuition: legal errors, mistakes, rogue
agents
Not much research on this question
Reasonable Person standard


Negligence is based on the Reasonable
Person standard
What would a reasonable person do in
similar circumstance?
 Not
the average person
 Embodiment of community standard
Rational
 Well informed
 Prudent
 Concerned for others

Reasonable Person standard

Same for all individuals

“The standard of conduct which the
community demands must be an external
and objective one, rather than the
individual judgment, good or bad, of the
particular actor, and it must be, so far as
possible, the same for all persons, since the
law can have no favorites.” (Prosser &
Keaton on Torts, 1984, pp 173-174)
Objective of the Paper


Reasonable person standard is uniform
People are not

E.g., not all MDs are equally competent
Question 1: Does heterogeneity lead to a
demand for liability insurance?
Objective of the Paper

Negligence rules are deterrent


They create incentives to take care
Insurance covers damages

May weaken deterrent effect of liability law
Question 2: Does availability of insurance
increase social welfare?
The Basic Model

Standard model of accidents


unilateral, between strangers
Risk averse potential injurer (PI)



u – increasing, concave
w – wealth, d – damage, x – expend on care
pG(x), pB(x) – accident probabilities
decreasing, convex
 pG(x) < pB(x), p’G(x) > p’B(x)


qG, qB – proportion of G, B
The Basic Model

Insurance policy



p – premium, q – indemnity
x is assumed to be observable
Expected utility: Ui(pi, qi, x)
= (1 – pi(x))u(w–pi–x) + pi(x)u(w–d–pi–x+qi)
The Basic Model


Potential victims are risk neutral
Courts work perfectly


Insurance market is competitive


Measure expenditure on care without error
Fair premium pi = pi(x)q
Note: Fair premium implies


Full coverage (q = d) is optimal
Care min’s x + pi(x)d
Heterogeneous Risk

Proposition 1:


Assume risk type verifiable by insurer
Then



G’s fully insure (q = d) and spend xG*
if and only if
x* ≥ xG* + pG(xG*)d
Heterogeneous Risk

Interpretation

What’s least cost way to avoid liability?
For informed B’s – meet negligence standard
 For informed G’s – be negligent and insure


What is effect on social welfare?



G’s better off
B’s no change
Victims better off

More accidents but insurance increases
expected compensation
Heterogeneous Risk

What if risk type not observable?


Proposition 2:


Potential adverse selection problems
Assume risk type not verifiable by insurer
and self-selection constraint is binding
Then

(a) G’s less than fully insure (q < d) and
spend more on care ( x̂G > xG*).
Heterogeneous Risk

Interpretation (same as Prop 1)

What is least cost way to avoid liability?
For informed B’s – meet negligence standard
 For informed G’s – be negligent and insure


What is effect on social welfare?



G’s better off
B’s no change
Victims better off

Insurance increases expected compensation
Heterogeneous Cost of Care


Ins. lit. assumes different risk, same
cost of care
Law & Econ lit. assumes common risk,
different cost of care


s = safety
cH, cL = cost of care
Heterogeneous Cost of Care

Proposition 3:



H’s fully insure (q = d) and choose care sG*
if and only if
cHs* ≥ cHsG* + p(sG*)d
Heterogeneous Cost of Care

Same interpretation

What is least cost way to avoid liability?

Same effect on social welfare

No adverse selection

All have same loss prob, same E(loss)
Conclusions
Demand for insurance can result from



Reasonable person standard and
Heterogeneous population
For some, its cheaper to be negligent
and insure than comply
Insurance increases social welfare




Insurance increases E(accidents)
But victims compensated for some
Want a copy of the paper?

Copies are available at


http://ssrn.com/abstract=995816
http://faculty.unlv.edu/pthistle