In this Article, we uncover a paradoxical phenomenon that has hitherto largely escaped the attention of legal scholars and economists, yet it has far-reaching implications for insurance law: loss-creation by uninsured parties caused by the presence of insurance. Contrary to the conventional wisdom, we show that insurance can create significant negative externalities by inducing third parties to engage in antisocial, illegal and unethical activities in order to extract money from insureds or insurers. Moreover, as the amount and scope of insurance grows, so does its distortionary effect on third parties. We term this phenomenon the paradox of insurance. The risk and harm-causing effects of insurance are ubiquitous. They can be seen in a myriad of contexts, from medical insurances to automobile liability insurance to kidnapping insurance to directors’ and officers’ liability insurance, and even life insurance. It may even have played a role in the 2008 financial crisis. We also explain the economic, social and psychological reasons for this phenomenon. Our analysis suggests that the downside of insurance is far greater than previously believed; in extreme cases, it may even offset the social benefits of insurance.
Against this backdrop, we advance normative recommendations for handing the problem. We start by explaining why the standard techniques that insurers use to curb opportunistic behavior by insureds (deductibles, co-pays, and loss-control or mandatory precautions) are ill-suited to address third party moral hazard; hence, it presents a formidable challenge. We then move on to construct a comprehensive legal response, comprising a combination of self-help, regulatory and technological measures, as well as qui tam suits that allow members of the public to sue opportunistic actors who seek to misappropriate insurance proceeds. Together, these interventions should reduce the incidence of third party moral hazard.
Parchomovsky, Gideon and Siegelman, Peter, "The Paradox of Insurance" (2020). Faculty Scholarship at Penn Law. 2158.