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Dec 2019

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The Geneva Association - Public authority liability and the cost of disasters

Source: Asia Insurance Review | Dec 2019

In an ideal setting, a rule of comparative negligence would incentivise the government to take an optimal amount of care. The citizen, being the residual bearer of the loss, would consequently also take optimal care. However, in the specific context of disasters, public authority liability may backfire and lead to more losses than without such liability. Haselt University Professor Jef De Mot and Maastricht University and Erasmus University Professor Michael Faure argue that under some circumstances perverse incentives of citizens may increase with liability, in this academic paper published by the Geneva Association and Springer.

 
 
Recently a lot of attention has been given to the question of how various instruments which are used to compensate victims of a disaster affect ex ante disaster risk reduction. The traditional way of dealing with ex post recovery was to use taxpayers’ money to provide ad hoc compensation to disaster victims. Ad hoc refers to the fact that in some cases, often based on political needs, compensation is provided and in others it is not.
 
In other systems, compensation is provided via a structural compensation fund. These funds also rely on the contributions of taxpayers, but the conditions under which compensation is provided are more or less specified in a structural manner in legislation. Still, the question whether the disaster fund will compensate often depends upon political arguments.
 
Critique against ex post compensation
The general critique is that ex post recovery creates a moral hazard problem: since victims will expect the government to compensate them ex post, there is a weakening of ex ante incentive to seek prevention. There is, however, another potentially perverse effect that may play a role in the case of compensation for victims of disasters. Public choice literature indicates that politicians can gain substantial advantages from ex post compensation, and as a result there will be a tendency to overcompensate ex post and to underinvest ex ante.
 
The problem is that investments in ex ante prevention may not pay off during the term of office of the politician and therefore may not provide sufficient political rewards. But from the victim’s perspective the problem is that this guarantee of politically motivated ex post compensation is only present in the case where the loss will actually be qualified as the result of a disaster. Consequently, a second cause of perverse incentives among victims may emerge: victims have (at least a partial) interest in the damage being relatively large in order to increase the likelihood of ex post government compensation.
 
Hence, this may be an additional argument why victims lack incentives for ex ante investments in prevention or for investing in damage mitigation after the disaster has occurred. In the case of relatively small damages, the political interest to intervene will be lower, thus creating an incentive for victims to contribute to larger damages in order to be able to count on government compensation ex post.
 
Public authority liability affecting the incentives of victims
If there is indeed a problem that victims may have perverse incentives in the sense that they would prefer relatively large damage, one could argue that this tendency could be countered by using public authority liability.
 
The argument would be that many natural disasters are caused through the negligence of public authorities, and as a result, the victims could try to hold the public authority liable for the compensation of their losses. In contrast to ex post recovery, compensation in the case of public authority liability is not limited to catastrophic losses; therefore, on first consideration it might seem that making more use of public authority liability could counteract the potentially perverse incentives of victims in case of ex post recovery.
 
Moreover, since public authority liability would apply in a normal tort context if victims had taken insufficient preventive measures ex ante or had not sufficiently mitigated the damage ex post, it could potentially lead to comparative negligence. In case of comparative negligence, the victim’s right to compensation would be reduced according to their contribution to the loss.
 
In this article, however, we showed that there is a danger that under particular circumstances these perverse incentives of victims may not be reduced by introducing public authority liability. We look at a situation of bilateral care. This is generally qualified in the literature as a situation where the incidence of harm and/or its extent can be limited by investments of both the injurer (here the government) and the victim (here the citizen).
 
In an ideal setting a rule of comparative negligence would incentivise the government to spend an optimal amount on care. The citizen, being the residual bearer of the loss, would consequently also take optimal care. However, public authority liability may backfire and lead to more losses than if there were no such liability.
 
We focus on the circumstances under which perverse incentives of citizens may increase under a system with liability, thereby increasing the cost of disasters. We focus inter alia on: 
  1. the fact that public authorities may be much more inclined to intervene ex post when damages exceed a certain threshold
  2. the possible difficulty of incentivising public authorities through liability rules
  3. specific characteristics of comparative negligence that may make public authorities liable for the lion’s share of the damages
  4. the problem of negative expected value suits for relatively small damages (and the fact that existing instruments to foster small but strong claims are often inadequate)
 
Ex post compensation is problematic
The existing economic literature related to compensation for victims of disasters indicates that ex post compensation by the government is problematic because it has a perverse effect on the incentives for prevention. These incentives may be diluted, since victims will count on government intervention. Moreover, the ex post government intervention may equally dilute incentives to insure.
 
In this paper we discussed an additional problem: victims may have an interest in a relatively large harm precisely to guarantee the solidarity payment from the government, given that governments are typically more likely to intervene when the harm caused by a disaster is relatively large. This may further dilute the incentive of victims to invest in prevention.
 
With public authority liability, suits can also be brought when the harm is relatively low, since there is no particular threshold under liability law. And if victims had underinvested in prevention, this could be corrected via the comparative negligence defence. However, we argued that reality may be much more complex. In countries where solidarity payments are used (such as in the Netherlands, Belgium, Italy and Germany) these payments are most often used when the harm is relatively great.
 
From a political economy perspective, this is also understandable: only when the harm is great and therefore a large number of voters are affected can politicians reap substantial benefits from solidarity payments. We also highlighted that the incentive effects of public authority liability may be relatively low. In practice, judges very often do not apply the comparative negligence defence to the full extent. For individual victims a public authority liability lawsuit may also have a negative expected value or a relatively low positive expected value.
 
As a result, there is no guarantee that the potentially perverse incentives of victims would be corrected through public authority liability. Our paper may provide support for what has often been argued in the literature, namely that the only effective solution for the disaster compensation of victims that keeps incentives intact is the introduction of a comprehensive insurance coverage accompanied by the government’s reinsurance for catastrophic risk. A 
 
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