Why people buy liability insurance under the rule of simple negligence

If people take due care, they will not be found negligent under the Rule of Simple Negligence. Moreover, under this rule, investment in due care is privately and socially optimal. These results jointly imply that liability insurance should not exist. But it does. One explanation relies on errors in the administration of tort law or in the imperfect observation of care. We offer an alternative explanation. Our model is one of symmetric uncertainty where establishing due care requires information on the individual's risk type, which is a random variable. Even though we assume that information on type is costless, we find that, by pooling across risk classes, liability insurance permits risk averse individuals to avoid the classification lottery that arises from establishing type. Insurance also has subtle effects on an injurer's private costs, which depend on the concavity or convexity of the demand for precaution. Given parameter variability across individuals, one would expect to observe a segmented market with some insuring while others choose to become informed and take due care. Moreover, we show that the voluntary purchase of liability insurance is Pareto improving.