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THIRD PARTY MORAL HAZARD
GIDEON PARCHOMOVSKY, Robert G. Fuller, Jr. Professor of Law
The problem of moral hazard — as defined as the transfer of risk from the policyholder to the insurer — has long absorbed scholars’ attention when studying insurance law and economics, but few have considered the consequences of third party moral hazard. In their forthcoming paper, “ Third Party Moral Hazard and the Problem of Insurance Externalities,” to be published in the Journal of Legal Studies, Gideon Parchomovsky and Peter Siegelman of the University of Connecticut Law School break new ground by developing and characterizing this phenomenon.
Defining third party moral hazard as “the influence of insurance on the loss-creation or claiming behavior of non-parties to the insurance contract,” the authors demonstrate “that third party moral hazard is both widespread and significant” before identifying causes and consequences and suggesting potential solutions.
Third Party Moral Hazard in Action
To begin, Parchomovsky and Siegelman review existing empirical data to confirm the gravity of third party moral hazard. In doing so, they point to a significant number of documented cases falling within liability, automotive, health, and even kidnapping insurance. They write that the cases they identify “span a range of insurance contexts and offer abundant evidence that the phenomenon is worthy of attention.”
For example, the authors find that, “[e]ven though no-fault [auto insurance] operates as first-party insurance, it offers substantial opportunities for third party moral hazard.” Noting that data is difficult to obtain and verify, they instead comb through the abundance of anecdotal evidence to detail a number of well-organized schemes. These range from an MRI facility in Michigan that was encouraged by a lawyer to “exaggerate the severity of injuries detected in MRI scans of patients,” to medical fraud mills in New York that staged car accidents to collect insurance payouts.
“Estimates of the magnitude of third party moral hazard in no-fault insurance vary substantially,” write Parchomovsky and Siegelman. “A widely-cited insurance industry report put no-fault fraud losses in New York at $230-$240 million in 2009 . . . almost all of which is probably third party moral hazard.”
The authors explain that due to its overreliance on insurance, the healthcare industry is especially prone to third party moral hazard. For-profit drug rehab centers, for example, offer financial incentives to brokers to recruit addicts whose treatment can be billed to their insurer.
“Their business model is to bring in patients for ‘treatment’ that is completely ineffective, precisely so as to generate a relapse and readmission shortly thereafter,” write Parchomovsky and Siegelman. “The availability of generous insurance payments has helped create an entire industry of phony rehabilitation programs whose purpose is precisely not to cure addiction, but rather to maintain it as a source of ongoing revenue.”
Less common, at least in the United States, is kidnapping insurance. Previous studies have shown that the number of kidnappings in an area will increase when the expected ransom increases.
“The question of interest to us is whether the presence of insurance enhances victims’ willingness or ability to pay ransoms,” write Parchomovsky and Siegelman. “If so, the availability of insurance would likely cause more kidnaps.”
This appears quite likely as countries including Venezuela, Colombia, and Italy have all banned kidnap insurance due to a belief that it provokes would-be kidnappers. “And anecdotal evidence suggests that kidnaps fell in the aftermath of such bans, although the causal link is unclear,” the authors write.
The Mechanisms of Third Party Moral Hazard
After detailing these and other examples of third party moral hazard, Parchomovsky and Siegelman then produce four possible causes for why it prevails. The first, which the authors refer to as “deep pockets,” is the most straightforward explanation.
“[I]nsurers are much wealthier than policyholders, making them more attractive targets for ripping-off, simply because they can cover larger losses,” they write.
“Depersonalization” is another mechanism promoting third party moral hazard. Since insurance companies are not human and are understood by many to exist for the sole purpose of paying out claims, a third party might “feel less inhibited when dealing with an insurer than with an individual who has to come up with the funds from her own bank account,” write Parchomovsky and Siegelman.
The authors also point to “poorer detection” or “worse bargaining,” which infers that an insurance company is less able — and less motivated — to sniff out fraud than an individual.
“If insurers are subject to treble damages for wrongly failing to pay a claim,” write Parchomovsky and Siegelman, “they will at the margin be induced to pay some questionable claims that an individual paying out of his or her own funds would have been willing to contest.” However, the opposite can also be true as processing a high volume of claims can make an agency better suited to spot patterns of fraud. “And it is likely that there are economies of scale in fraud-detection that insurers are better-placed to take advantage of than are individual payors,” they add.
Finally, the authors identify “spillovers from ordinary moral hazard,” as the fourth possible cause of third party moral hazard. This occurs when a third party assumes the insured will be less cautious due to traditional moral hazard.
“If thieves know that most jewelers have [generous] coverage,” write Parchomovsky and Siegelman, “they may be more likely to commit robberies, since they expect that first party moral hazard on the part of jewelers will make theft easier.”
Policy and Welfare Implications
The authors acknowledge that insurers successfully employ tools to confront moral hazard, “[b]ut these mechanisms are inoperative or ineffective when applied to third party moral hazard.” Techniques such as deductibles, exclusions, underwriting, and experience rating “are of little use in constraining the loss-causing behavior of third parties,” they write. Meanwhile, loss control, ex post auditing, and monitoring can work in some contexts, “but they pose significant problems for public policy that are unique to third party moral hazard.” For example, training policyholders to avoid excessive MRI usage is unreasonable, as is expecting insurers to monitor third parties as they might policyholders.
Instead, Parchomovsky and Siegelman propose new solutions. For third party moral hazards that are independent crimes, such as fraudulent car accident schemes, they suggest enhanced law enforcement.
“State intervention does risk crowding-out some private enforcement efforts,” they write. “But because governmental actors do not face the same profit motives that insurers do, public enforcement can complement private efforts.” They also suggest incentivizing insurers to share information across firms to better combat fraud trends and standardize the technology they use for record-keeping.
Lastly, the authors propose insurance qui tam suits, which would offer a bounty to any plaintiff attempting to recover a loss on behalf of someone else. For example, a doctor at a medical fraud mill would receive a percentage of whatever is recovered on behalf of the insurer if they pursued litigation against their co-conspirators.
“While qui tam liability is not without controversy, the evidence in health care and elsewhere suggests that it has been effective,” write Parchomovsky and Siegelman. “Our proposal would extend this mechanism to private insurers and to other areas of insurance.”
The takeaway, they conclude, is that “these insurance externalities are difficult to manage with the contractual tools that insurers have long used to control standard moral hazard problems. We thus need to begin thinking about insurance in a broader general equilibrium framework that encompasses actors beyond just the insurer and policyholder.”
