Making Decisions About Liability And Insurance: A Special Issue of the Journal of Risk and Uncertainty

133 Pages·1993·2.996 MB·English

by  Colin Camerer, Howard Kunreuther (auth.), Colin Camerer, Howard Kunreuther (eds.)

MAKING DECISIONS
ABOUT
LIABILITY AND INSURANCE
A Special Issue of the Journal of
Risk and Uncertainty
edited by
Colin Camerer
Howard Kunreuther
Reprinted from the Journal of Risk and Uncertainty
Vol. 7, No.1 (1993)
....
"
SPRINGER-SCIENCE+BUSINESS MEDIA, B.V.
JOURNAL OF RISK AND UNCERTAINTY
Vol. 7, No.1 (1993)
MAKING DECISIONS ABOUT LIABILITY
AND INSURANCE
A Special Issue of the Journal of Risk and Uncenainty
Making Decisions about Liability and Insurance: Editors' Comments
..... Colin Camerer and Howard Kunreuther 5
Intuitions about Penalties and Compensation in the Context of Tort
Law ..... Johathan Baron and Ilana Ritov 17
Framing, Probability Distortions, and Insurance Decisions
..... Eric J. Johnson, John Hershey, Jacqueline Meszaros, and
Howard Kunreuther 35
Transaction Analysis: A Framework and an Application to Insurance
Decisions ..... Baruch Fischhoff 53
Insurer Ambiguity and Market Failure
..... Howard Kunreuther, Robin Hogarth, and Jacqueline
Meszaros 71
Ambiguity and Risk Taking in Organizations
..... Zur Shapira 89
Insurance for Low-Probability Hazards: A Bimodal Response
to Unlikely Events ..... Gary H. McClelland, William D. Schulze,
and Don L. Coursey 95
The Risky Business of Insurance Pricing
..... W. Kip Viscusi 117
Library of Congress Cataloging-in-Publication Data
A C.I.P. Catalogue record for this book is available from
the Library of Congress.
ISBN 978-94-010-4971-9 ISBN 978-94-011-2192-7 (eBook)
DOl 10.1007/978-94-011-2192-7
Copyright CO 1993 Springer Science+Business Media Dordrecht
Originally published by Kluwer Academic Publishers in 1993
Softcover reprint of the hardcover 1st edition 1993
All rights reserved. No part of this publication may be reproduced, stored in
a retrieval system or transmitted in any form or by any means, mechanical,
photo-copying, recording, or otherwise, without the prior written permission of
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Printed on acid-free paper.
Making Decisions About Liability and Insurance:
Editors' Comments
COLIN CAMERER
University of Chicago Graduate School of Business, 1101 East 58th Street, Chicago, 1L 60637
HOWARD KUNREUTHER
University of Pennsylvania, The Wharlon School, 1303 Steinberg Hall-Dietrich Hall, Philadelphia, PA
19104-6366
Two related trends have created novel challenges for managing risks in the United
States. The first trend is a series of dramatic changes in liability law. Tort law has ex
panded to assign liability to defendants for reasons other than negligence. Recent doc
trines include joint and several liability, retroactive liability, probabilistic causation, and
unlimited duration of liability. Many of these legal changes have added unpredictability
about future damage claims (and about further changes in the law), making it difficult for
firms to assess risks and for risks to be shifted effectively from firms to insurers (Commit
tee for Economic Development, 1989).
For example, insurers now worry whether courts will interpret contract language dif
ferently than was originally intended. A vivid illustration is insurance policies written in
the 1970s and early 1980s to cover damages from environmental pollution. Most policies
explicitly limited insurance protection to events that were "sudden and accidental" so as
to exclude groundwater contamination and other forms of gradual pollution. However,
in the mid-1980s some courts interpreted this clause to mean that damages that oc
curred, though they were not sudden, were unintended and unexpected by the insured
firm and should therefore be covered (Doherty, Kleindorfer, and Kunreuther, 1990).
Many think the unpredictability of future costs induced by changes in tort law is
primarily responsible for the second major trend, the "insurance crisis" -the disappear
ance of liability protection in markets for particularly unpredictable risks, like vaccines or
environmental pollution (see Priest, 1987).
The articles in this special issue study decisions people make about insurance and
liability. Understanding decision making may help explain why the insurance crisis re
sulted from new interpretations of tort law, and what to do about it.
The articles cover three kinds of decisions: decisions consumers make about the insur
ance they buy; decisions insurers make about the coverage they offer; and decisions
citizens make about the liability rules they prefer, which are reflected in legislation and
regulation. For each of these three kinds of decisions, normative theories, such as ex
pected utility theory, can be used as guides for sensible decisions, and as benchmarks
against which actual decisions are judged.
Consumers. Using subjective expected utility theory, consumers determine how much
they will pay for different amounts of insurance coverage against losses from specific
6 COLIN CAMERER/HOWARD KUNREUTHER
hazards by evaluating the probability of different states of nature and the resulting
consequences. Then they determine the utility of different levels of coverage, including
not purchasing any insurance. Their calculations are assumed to obey standard laws of
probability.
Insurance companies. Economic models also provide a useful reference point for
judging the performance of insurance markets. In the standard economic model
linking buyers with sellers, the party facing a specific risk pays a premium to an
insurance firm, which then agrees to cover specific losses to the insured party if a
prespecified set of events occur. Insurers decide what premiums to charge for different
levels of coverage by assessing their risks and using the normative benchmark of ex
pected profit maximization.
Liability. The American system of tort laws has been developed for two principal
purposes: (1) to encourage individuals, groups, or firms to undertake actions that mini
mize the sum of accident losses plus prevention costs and (2) to compensate innocent
victims harmed by these activities. The normative benchmark for developing these laws
is maximization of social welfare (Shavell, 1987; Landes and Posner, 1987).
Figure 1 shows some relations among the decisions made by consumers, insurance
firms, and three other groups that play important roles in the liability system for products
that have some risk associated with them: producers, courts, and government through
Congress and regulatory agencies. Inside each box is written the major decisions each
group must make. The arrows connecting the boxes show what the members of each
group exchange with members of other groups as a result of their decisions.
To illustrate, consider a specific product such as an automobile. The producer must
determine how safe the automobile should be and then attempt to purchase liability
insurance to protect itself against losses should there be a product defect. The consumer
must decide which automobile to purchase and then pay money to the producer. She
then determines how careful she will be in using it and what type of insurance she should
purchase against possible damage to the vehicle.
If there is an accident, a suit may be filed by the consumer against the producer. The
courts must determine who is liable for the damage and the amount of liability by using
specific rules such as strict liability or negligence. Their rulings will be affected by existing
legislation and government regulations specifying how safe the product should be.
Figure 1 is also relevant for activities of industrial firms, such as the operation of an
underground storage tank or the disposal of their wastes in a landfill where there is a risk
associated with groundwater contamination. In this case, there is no specific consumer
who purchases the product, so this box is not relevant for characterizing the social
decision. Rather, the producer would like to purchase insurance, knowing that it may be
held liable by the courts for pollution damage. Existing legislation and regulations will
determine the nature of the liability that faces firms, although there may be considerable
uncertainty as to the magnitude of the losses and damages.
Figure 1 is designed to serve as a guide for the articles in this issue as they relate to
consumers, insurance companies, and citizens' decisions. In the last section of this over
view, we will raise a set of open questions that address issues involving the other parties
depicted in figure 1.
MAKING DECISIONS ABOUT LIABILITY AND INSURANCE: EDITORS' COMMENTS 7
INSURANCE
COMPANIES
Decision:
What price?
risky product
PRODUCERS CONSUMER
& CITIZENS
Decision: Decision'
How safe? $ Buy product?
How careful?
COURTS
Decision: suits
Who's liable? 1'4-----------------~ Decision:
Damages? regulations in force How safe?
Figure 1. A social decision model for risky products.
1. Consumer decisions
The standard economic model of consumer decision making about insurance derives
from Bayesian probability and subjective expected utility theory (SEU). In SEU, buying
insurance is an act that reduces the harmful consequences-monetary losses and suffer
ing-when an accident occurs. Under SEU, consumers are presumed to form probability
judgments about the likelihood of losses and to value their consequences, and then to
choose the coverage that maximizes probability-weighted value.
Much research, mostly using artificial laboratory tasks designed to test the Bayesian
and SEU theories sharply, indicate that judgments of probability, determination of
value, and choices among different risks deviate systematically from the benchmark
theories (Kahneman, Slovic, and Tversky, 1982). For example, conjunctions of two
events are sometimes mistakenly judged to be more likely to occur than either of the two
event alone (Tversky and Kahneman, 1983). In valuing risks, the public's concern about
hazards is influenced by dimensions other than statistical likelihood of loss. Feelings of
8 COLIN CAMERER/HOWARD KUNREU1HER
dread and unknowability also affect attitudes toward certain risks (Savage, 1993). For
example, laypersons think nuclear power is more dangerous than many experts do; the
reverse is true ofx-rays (Slovic, 1987).
In choosing between risks, people frame outcomes as gains and losses from a refer
ence point; they also tend to dislike losses more than they like equal-size gains, and to
seek risk over possible losses while avoiding risk over gains. Framing and different treat
ment of gains and losses taken together imply that changing the reference point can
influence the choices people make. In addition, the "ambiguity" about the likelihood of
an event, or the degree of uncertainty one has about the event's likelihood, seems to
affect choices among risks. Consumers pay more for insurance against events where the
probability is ambiguous and the loss amount is more uncertain.
Researchers often wonder whether these laboratory violations of Bayesian subjective
expected utility will persist when people make important decisions with substantial fi
nancial stakes-consumers buying insurance, for example. The articles by Johnson et aI.
and McClelland, Schulze, and Coursey in this issue address this question by extending
laboratory work on choices in abstract environments to insurance settings.
Johnson et aI., for instance, discover consistent violations of the conjunction principle
in insurance coverage: subjects will pay more for insurance coverage against vivid specific
risks (like death from an airplane crash due to terrorism) than for general risks that
include the specific ones (an airplane crash due to any cause).
They also report experiments that manipulate the attractiveness of insurance policies,
while holding their actuarial value constant, by changing the consumer's reference point
and exploiting features of the valuation process. Low-deductible policies are popular, for
instance, because high deductibles are framed as additional losses that the insured must
bear when an accident occurs (even though premiums are significantly reduced by in
creasing the deductible). End-of-policy rebates are popular because the rebate is framed
as a bonus gain (even though the gain is effectively prepaid through higher premiums for
such policies).
The most striking result of Johnson et aI. is a dramatic reversal in preference for
car insurance with different levels of right-to-sue limits (an example of inherent
preference for the "status quo" reported by Samuelson and Zeckhauser (1988)).
Subjects who were given limited rights as a default option and were asked to pay
more for unlimited rights were willing to pay relatively little, compared to the amount
subjects demanded in order to accept limits when they were given unlimited rights as a
default. In a field quasi-experiment that fortuitously replicated the laboratory design, the
neighboring states of Pennsylvania and New Jersey actually adopted different default
options; consumer choices in those states corresponded rather closely to the experimen
tal findings.
McClelland, Schulze, and Coursey studied bidding behavior in simple experimental
markets for insurance. Their subjects were given monetary risks (e.g., a .01 chance of a
$40 loss), but could bid for insurance to cover monetary losses if these occurred. The
lowest four bids bought insurance; the other four subjects were forced to risk a loss. If
subjects are risk averse-as in the standard theory-then they should bid more for
insurance than the expected loss (more than $.40 in the example).
MAKING DECISIONS ABOUT LIABILITY AND INSURANCE: EDITORS' COMMENTS 9
Most did bid more than the expected loss, but an interesting bimodality appeared,
especially when the probability of a loss was very low (.01); many subjects bid nothing
ignoring the risk or acting as if it could not happen to them-and others paid several
times the expected loss in order to be certain they were one of the four bidders to be
insured. (Their actual insurance payment was less than what they bid, since it was deter
mined by the fifth highest bidder in a "Vickrey auction.") It is interesting to speculate
whether individuals would continue to bid such a high value for insurance if they were
actually forced to purchase it at their asking price. McClelland et al. note that field
studies of hazards also show bimodality in perceptions of risks.
Both articles on consumer choices are first steps that borrow rich experimental para
digms from psychology and economics and demonstrate the ability of those paradigms to
produce surprising insights about insurance in natural settings. The psychological exper
iments in the Johnson et al. article predicted the remarkable difference between auto
insurance purchases in New Jersey and Pennsylvania. The economic experiments by
McClelland, et al. parallel the persistent bimodality-either dismissal or overreac
tion - in peoples' perceptions of natural risks. Further work in these two paradigms
could establish the predictability and causes of these phenomena, and how they are
affected by familiarity with a risk, learning, incentives, education, regulation, and
policy tools.
2. Insurance firms' decisions
In the standard economic model of competitive insurance markets, firms price insurance
coverage to earn a competitive ("normal") rate of return by assessing the probability
distribution of losses of different magnitudes. The implicit assumption in this model is
that there are sufficient data on the past to estimate each risk accurately. Data are often
available for frequent events like fire damage or car accidents, but data are scarce for
hazards like earthquakes, leaks from underground storage tanks, and defects in new
products. For these risks the probability of an accident occurring is ambiguous, and the
magnitude of any resulting loss is uncertain.
The articles by Kunreuther, Hogarth, and Meszaros and by Viscusi in this issue ex
plore the impacts of ambiguity on premium-setting by insurers. Kunreuther et al. exam
ine whether ambiguity influences the pricing decisions of actuaries, underwriters in
primary-insurance companies, and underwriters in reinsurance firms. They construct
a set of scenarios for different hazards (including a neutral scenario for an unnamed
peril) in which the probability or the loss is either well specified or ambiguous. In some
cases the losses were independent of each other, while in others they were perfectly
correlated.
The actuaries and underwriters were asked in a mail survey to price insurance in each
scenario. They said they would charge considerably higher premiums for risks in which
the loss probability is ambiguous or the loss amount is uncertain. There were no inter
esting differences among the groups of subjects.
10 COLIN CAMERER/HOWARD KUNREUTHER
Further research should attempt to explain the source of the actuaries' and underwrit
ers' ambiguity aversion. The explanation could lie at many levels. Studies with individual
subjects find similar degrees of ambiguity aversion (Camerer and Weber, 1992); perhaps
the actuaries and underwriters are just thinking like normal people. Or actuaries and
underwriters may be responding rationally to the perception that managers will blame
them for bad outcomes of decisions made with ambiguous information. Finally, Mayers
and Smith (1990) argue that companies should be averse to very large risks because of
the costs of bankruptcy.
Viscusi measures the reaction of insurance firms to ambiguity in a different way. He
used the product liability ratemaking files for 1980-1984 of the Insurance Services Office
(ISO ) (which correspond roughly to "list prices" for various kinds of insurance). Viscusi
takes the amount of dispersion in losses within a product line (e.g., property and casu
alty) as a measure of risk ambiguity.
He concludes that risk ambiguity lowers the recommended ISO rates. However, using
actual rates charged by insurance companies for the period 1982-1984, Viscusi found no
clear evidence that risk ambiguity affected rates. (The strongest evidence he found for
ambiguity aversion was for insurance against bodily injury.) He suggests insurance ad
justers may take into account the uncertainty with respect to bodily injury, particularly if
the manual rates have excluded outliers.
The Kunreuther et al. and Viscusi findings appear to be contradictory. However,
risks such as underground storage tank leaks and earthquake coverage (studied by
Kunreuther et al.) are likely to be more ambiguous than product liability risks (stud
ied by Viscusi). In fact, there has been limited interest by the insurance industry in
marketing coverage where there is large ambiguity regarding the risk. As Doherty
and Posey (1992) have shown, insurers with multiple lines will tend to restrict cover
age and revise prices upwards on those lines of insurance where risks are most
uncertain.
Several factors account for restricted coverage and higher premiums when there is
ambiguity and uncertainty. An important factor is the unpredictability in the liability
system, which may affect the actual payouts (claims) on many policies simultaneously. (A
court ruling that affects all product liability claims makes the outcomes of claims highly
correlated, like damages from an earthquake.) Another factor is the lack of data on
which to estimate risk: there are few past data on which to estimate risks from new
products or new technologies (e.g., environmental liability). For low-probability-high
consequence events, it is difficult to get feedback on losses, by definition, unless there are
many risks in the field.
These two articles raise questions as to what factors influence insurers' decisions on
what coverage to offer, what prices to charge, and whether there are aggregate con
straints on capacity that affect these decisions. On the prescriptive side, there is a set of
issues regarding the appropriate role of risk assessment in providing better data to
evaluate probabilities and outcomes. Furthermore, is it appropriate for the government
to playa role in providing protection against catastrophic losses so that insurers can offer
certain coverage at lower premiums?
MAKING DECISIONS ABOUT LIABILITY AND INSURANCE: EDITORS' COMMENTS 11
3. Citizens' decisions
In the economic model of liability law (Landes and Posner, 1987; Shavell, 1987), laws are
crafted as if judges and juries intend to efficiently deter unsafe behavior by firms and
consumers. Unhappy consequences are alleviated by compensation and deterred by the
threat of liability. This consequentialist view of behavior presumes that compensation
and deterrence are the essential functions of liability law.
Decisions by citizens about liability impact the legal process in several ways. Some
citizens become lawyers and judges, then make law or apply it. Citizens also shape law in
their role as jurors, and as voters who elect judges or legislators. Therefore, the intuitions
citizens have about the proper role of compensation and deterrence are important.
The article by Baron and Ritov studies intuitions about compensation and deterrence
experimentally, in the context of accidents from birth-control pills and vaccines. The
approach of these authors, as in the other articles, is to ask whether people think com
pensation should depend on variables that are relevant and irrelevant according to the
normative (consequentialist) model. For example, many subjects think that if identical
accidents are caused by people (instead of natural causes), or by actions (instead of
omissions, or failures-to-act), then compensation should be higher, even though accord
ing to the economic theory of liability these differences should be irrelevant to conse
quences and hence should not affect compensation.
The presence of these intuitions by the public helps explain why the liability crisis
occurred. For example, subjects in the experiments show a strong desire for pure retri
bution; . they act as if a firm whose product caused an accident should be punished
financially, even if the penalty causes the firm (and other firms) to stop making products
that are generally safe and valuable. Huber (1988) documents several examples where
companies, fearful of liability, stopped making useful products (e.g., birth control de
vices, vaccines).
Baron and Ritov also studied whether subjects thought about compensation and de
terrence in the way that consequentialist theory suggests they should. They appear not
to. Very few subjects changed their attitudes toward retribution even when they were
told that the penalties would have no deterrent effect on future behavior.
Baron and Ritov's article in this issue, coupled with their earlier work, is the first direct
test of whether people think about compensation and deterrence the way the economic
theory of liability presumes they should. Similar analyses might explain many related
crises at the crossroads of politics-where citizens' voting decisions help shape policy
and economics.
Superfund legislation is a good example. The objective of Superfund legislation is to
clean up past waste efficiently while deterring future pollution by firms. The intuition
that underlies the current liability rules is the "polluter pays" principle, embodied in
rules establishing several degrees of liability: retroactive liability, strict liability, and joint
and several liability.
These liability rules have caused enormous problems because there is considerable
controversy about who is responsible for the pollution. One issue is whether companies