Third-Party Moral Hazard and the Problem of Insurance Externalities
![handle is hein.journals/legstud51 and id is 95 raw text is: Third-Party Moral Hazard and the Problem of
Insurance Externalities
Gideon Parchomovsky and Peter Siegelman
ABSTRACT
Insurance can lead to loss or claim creation not only by insureds but also by uninsured third
parties. These externalities-which we call third-party moral hazard-arise because insurance
creates opportunities both to extract rents and to recover otherwise unrecoverable losses. Us-
ing examples from health, automobile, kidnap, and liability insurance, we demonstrate that
the phenomenon is widespread and important and that the downsides of insurance are greater
than previously believed. We explain the economic, social, and psychological reasons for this
phenomenon and propose policy responses. Contract-based methods that are traditionally used
to control first-party moral hazard can be welfare reducing in the context of its third-party
analog, so new approaches are required.
1. INTRODUCTION
The problem of moral hazard has preoccupied insurance economics: it
has been the subject of almost 1,600 scholarly articles since the path-
breaking analysis of Arrow (1963), and the term has appeared in more
GIDEON PARCHOMOVSKY is the Robert G. Fuller, Jr., Professor of Law at the University of
Pennsylvania School of Law and the Wachtel, Lipton, Rosen, and Katz Professor of Cor-
porate Law at Hebrew University. PETER SIEGELMAN is the Phillip I. Blumberg Professor
of Law at the University of Connecticut Law School. For excellent comments and sugges-
tions we thank Matt Adler, Emad Atiq, Ronen Avraham, Ian Ayres, Roy Baharad, Tom
Baker, Oren Bar-Gill, Jonathan Borowsky, Rick Brooks, Giuseppe Dari-Mattiacci, John
Donohue, Yoav Dotan, Lee Epstein, Michael Frakes, Brian Galle, Michele Graziadei,
Ehud Guttel, Paul Heaton, Daniel Hemel, Louis Kaplow, Gary Klein, Peter Kochen-
burger, Alexandra Lahav, Adi Leibovitch, Daryl Levinson, Adi Libson, Daniel Markovits,
Pat McCoy, Ittai Paldor, Mitch Polinsky, Ariel Porat, James Quiggle, Arti Rai, Barak
Richman, Dan Schwarcz, Rick Swedlof, Al Sykes, Kristin Underhill, Abe Wickelgren,
Eyal Zamir, and participants in seminars at the law schools of Villanova, Duke, Harvard,
Stanford, Yale, and Hebrew Universities and the 2019 American Law and Economics As-
sociation annual meeting. The editor and two referees made extensive suggestions from
which we greatly benefited. Special thanks go to Steve Shavell for substantive comments
[Journal of Legal Studies, vol. 51 (January 2022)]
© 2022 by The University of Chicago. All rights reserved. 0047-2530/2022/5101-0004$10.00
93](ViewImageLocal?handle=hein.journals/legstud51&div=8&collection=&method=preview&ext=.png&size=3)
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Third-Party Moral Hazard and the Problem of Insurance Externalities
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