The Role of Private Insurance in Governing Work-Related Risks: A Law and Economics Perspective

1 Introduction

This contribution focuses on the governance of two types of work-related risks: industrial accidents and occupational diseases. The term governance here refers to the prevention of such risks ex ante and to the compensation of employee-victims ex post. ^[1] Private actors often play an important role in these governance mechanisms, in addition to public actors such as enforcement agencies and regulators. These private actors may include (representatives of) employers and employees, as shown e.g. by the ‘collective labour agreements’ in the Netherlands ^[2] or the globally operating value chains, but may also include private insurers. Especially in jurisdictions where there is a shift away from public compensation of work-related risks and where employers are still exposed to employers’ liability, one would expect liability insurers to step in to offer (supplementary) insurance coverage. In this contribution we therefore examine one particular form of privatisation, being the shift towards an increasing role of liability insurers. Policy-makers often expect that liability insurers will via risk differentiation monitor employers’ behaviour and thus contribute to safety at work. The question however arises whether that is indeed the case.

The main research question addressed in this paper is therefore whether liability insurers are indeed able to contribute to the prevention of industrial accidents and occupational diseases. Following the existing law and economics literature, it is expected that this crucially depends on the possibilities insurers have to control moral hazard and adverse selection. Both moral hazard and adverse selection are (insurance) market failures caused by information asymmetry between the insured party and the insurer. Moral hazard occurs when the behaviour of the insured party changes as soon as the risk is removed from him. Adverse selection occurs when only persons with above-average risks buy insurance. The essence of controlling moral hazard and adverse selection lies in obtaining information about the behaviour (level of care) and characteristics of the insured parties. In the case of work-related risks, this includes information on the investments made by employers to prevent work-related injuries and diseases and information on the care taken by employees to prevent injuries. When such information is not available, insurance companies may resort to using indirect information, for example about the type of company, industry sector, or past injury rates. On the basis of the information obtained, insurance companies can classify risks and adapt premiums accordingly (first best solution) and/or impose deductibles or upper limits on benefits (second best solution).

Insurers can engage in many different ways in providing compensation for work-related risks. An important role for insurers lies in providing supplementary cover, i.e. in addition to public compensation schemes (provided via the social security system) for disability. Our focus will be on one particular form of insurance: insurance of employers’ liability which provides supplementary compensation in addition to basic (public or private) disability insurance. Many countries have excluded employers’ liability, with important exceptions being the Netherlands and the United Kingdom. It is for that reason that we will take those legal systems as case studies to analyse in more detail how liability insurers contribute (via particular policy conditions) to safety at work.

It is important to note here that the need for victims to rely on private tort law (and liability insurance) will be related to the cover provided by the social security system. That is, to the extent that social security covers a major part of all costs inherent with disability risks, the exposure to liability of employers may be relatively limited. Even though we cannot fully analyse the scope of the social security cover in this paper, we will address the correlation between public compensation schemes and the exposure to liability. More specifically, we will argue that the marginal benefits for insurers of investing in risk differentiation may be limited when other institutions (more particularly the public compensation schemes) have a higher financial interest in investing in prevention.

The paper is structured as follows. In section 2 we will first recapitulate the economic theory of (first and third party) insurance to the extent that it relates to work-related risks. In that respect we will also examine in more detail, and from a theoretical perspective, how the moral hazard risk can be addressed by insurance companies, e.g. via risk-related premiums and experience rating. Next, section 3 will present a (multidisciplinary) literature survey, which addresses the question of whether there is any evidence of the effects insurance arrangements have had on the governance of work-related accidents and diseases (e.g. on work-related injury rates, working conditions or the behaviour of insured parties). In that survey, which draws from available studies across western jurisdictions on the effects of insurance for work-related risks, we take a broad approach, taking into account both the effects of direct monitoring efforts (of which, as it turns out, there are very few examples) and the effects of premium differentiation on the basis of companies’ characteristics or past accident records. ^[3] We then turn to the specific situation of the Netherlands and the United Kingdom in section 4, by focusing more closely on the liability insurance policies offered for employers’ liability in those legal systems. These jurisdictions were selected because in both the Netherlands and in the United Kingdom employer liability and liability insurance play a relatively large (supplementary) role in the compensation of work-related damage, compared to jurisdictions where employers enjoy immunity from tort liability. The reason to focus on those two legal systems is that they are among the few systems where employers are not immune from liability; moreover, the case studies provide an opportunity to look at specific liability insurance policies in order to examine how insurers try to incentivise employers towards safety at work via specific conditions in the policy. This is particularly important as the literature review presented in section 3 teaches us that the monitoring efforts by insurers generally have been rather modest, ^[4] which raises the question whether this (somewhat surprising) result also holds for work-related risks and more particularly for employers’ liability.

Having addressed the above questions, section 5 will provide a conclusion both on the possibilities insurance companies have to offer additional coverage for work-related risks, and on their actual involvement in the governance of work-related risks. We will argue that the way in which liability insurers monitor the behaviour of employers does not always correspond to the expectations formulated in the theoretical law and economics literature. It is this dichotomy between on the one hand the expectations concerning insurers’ behaviour as expressed in the literature and on the other hand their behaviour in practice that has not been addressed in a detailed way in the existing literature. It is on this point that we contribute to the literature, more particularly through the two case studies which allow us to focus on the contents of liability insurance policies.

2 Theoretical framework: insurance for work-related risks from an L&E perspective

Insurance for work-related risks can be viewed from different angles, as insurers can intervene in many different ways. The starting point for the economic perspective is that, no matter which form of insurance is chosen, insurance provides protection (compensation) to risk-averse parties. Yet, the compensation mechanism should also aim at minimising costs and at providing incentives for optimal care-taking by all stakeholders that could prevent work-related risks, in other words employers and employees. With incentives in this context we refer to legal and policy instruments (regulation, sanctions, liability rules, taxes) that steer the behaviour of stakeholders towards an optimal prevention of accidents at work and occupational diseases. There is a wide variety of mechanisms that play a role in the prevention of work-related risks, an important one obviously being ex ante government regulation. Based on Shavell’s well-known criteria for regulation, workplace safety regulation by the government may be the primary instrument to provide incentives for optimal prevention (Shavell 1984). However, effective enforcement of workplace safety regulation is often lacking in practice (Faure/Tilindyte 2010). Therefore, other instruments than government regulation, more particularly private law mechanisms, such as liability and insurance, also play a role in providing those incentives for prevention (Diamond 1977).

In addition to this ‘primary goal’ of legal instruments (i.e. ex ante prevention of work-related risks), law and economics literature also pays attention to the various mechanisms that can be used for ex post compensation. Most legal systems rely on mechanisms of social security to provide at least a basic compensation of healthcare costs and of lost income. ^[5] In some legal systems (such as the Netherlands and the United Kingdom, discussed in section 4 below), victims have the additional possibility to bring private law suits against employers if the conditions of tort liability are fulfilled. That is, as explained in the introduction, also the reason why we focus only on those two legal systems in section 4. In other legal systems (like Germany and Belgium) the possibilities to still use tort law are more limited as employers enjoy partial immunity from tort liability; tort liability is then often limited to cases where the employer was grossly negligent or cases involving intentional harm. Depending upon the scope of employers’ liability, there is still a (larger or more limited) role for liability insurance to back up the employers’ liability. The intervention of liability insurers will provide an important guarantee against the insolvency of the employer, thus guaranteeing victims effective compensation to the extent that they are dependent on payment by the employer. In addition, insurers may promote work safety by imposing a particular occupational health and safety culture via premium conditions.

There is, in other words, a variety of different ways in which private insurers can be involved in the compensation of work-related risks. There are specific idiosyncrasies of the different legal systems that may explain the extent to which private insurers intervene. To the extent that the compensation provided via social security or so-called workers’ compensation mechanisms is limited, private parties (either employers, but also the potential victim, the employee) may have a demand to take out additional (mandatory or voluntary) insurance. If the potential victim takes out insurance to cover himself, this will be referred to as first party insurance. Employers may also take insurance cover to the benefit of the employee; this is referred to as direct insurance and is often the model used in workers’ compensation. Finally, as mentioned, under some legal systems there may be employers’ liability and employers may seek insurance to cover their liability risks. That mechanism is called third party liability insurance. The latter is the main focus of our contribution.

No matter which specific mechanism is followed, insurance companies will be involved in the market of work-related risks in each of those cases. However, insurance companies are only willing to offer insurance cover if several criteria are fulfilled. ^[6] For a particular risk (like the risk of an industrial accident or occupational disease) to be ‘insurable’, it is essential that insurance companies can predict risks. That is, insurers need sufficient data to be able to assess the probability and magnitude of these risks. Only on that basis can insurance companies calculate an actuarially fair premium. In addition, it is important that insurance companies can control the problems of adverse selection and moral hazard. Both problems result from an asymmetry of information between the insurer and the insured. Moral hazard generally refers to the problem that the demand for a certain service (like healthcare) may increase because the price for the service is reduced or eliminated. Moral hazard arises in healthcare as soon as full insurance cover is available (Arrow 1963), but moral hazard is in fact present in any insurance mechanism. In the context of OHS, moral hazard relates to employers taking insufficient measures to prevent accidents at work and occupational diseases as a result of being fully insured. Employers can play an important role in promoting safety at work through an appropriate prevention strategy, but moral hazard would imply that employers refrain from those investments as the additional costs they would suffer from accidents at work or occupational diseases would be fully covered by insurers. Adverse selection refers to the phenomenon that insurance is always attractive for the individuals who constitute the highest risks. If insurers are not able to identify who these high risks are, the adverse selection problem will emerge. It is therefore a consequence of the classic asymmetric information problem (Akerlof 1970). Adverse selection in the context of accidents at work relates to the fact that employers’ liability insurance would become particularly attractive for high-risk firms. Especially when liability insurance is voluntary, adverse selection would imply that employers with the highest risk would benefit most from insurance and would thus seek insurance coverage.

The classic ‘first best’ response to adverse selection and moral hazard, according to the law and economics literature, is to adapt insurance premiums to risks. Such risk differentiation can be done ex ante, by charging different premiums to different risk groups, or ex post on the basis of experience rating ^[7] and monitoring the behaviour of the insured. The former, i.e. ex ante risk differentiation, is particularly relevant when addressing adverse selection; insurance companies generally attempt to classify employers or employees in different (smaller) groups, adapting premiums to the average risk of that particular group. The latter, i.e. ex post risk differentiation via experience rating and monitoring, seems more suitable for controlling moral hazard. A ‘second best’ option for controlling moral hazard is to partially expose the insured to the risk, for example through deductibles or caps. This is obviously a second-best solution, as part of the risk is shifted back from a risk neutral party (the insurance company) to risk-averse parties (employers and/or employees) (Shavell 1979).

It follows from the above that, since both adverse selection and moral hazard are in essence resulting from an information asymmetry, the control of those phenomena lies in obtaining information. For example, for the specific case of the insurance of employers’ liability for accidents at work and occupational diseases, insurers need information about the efforts made by employers to prevent work-related injuries and diseases and the care taken by employees to prevent accidents (Faure 2007: 145). An easier but indirect way to collect such information, is to focus on accident /injury rates from the (recent) past. Alternatively, as a second best solution, insurers can impose deductibles or an upper limit on benefits. An assumption in the economic literature is therefore that insurers will strive to use particular instruments to control adverse selection and moral hazards and that they actually are able to access sufficient information which enables them to exercise this control. This raises the question of what instruments insurers of work-related risks actually use to control the moral hazard risk and whether these instruments have been effective in reducing the number and costs of injuries.

The above shows that, although insurance may often be demanded to provide compensation and protection against an uncertain future (either by employers to cover their liability risk or by employees to cover health risks or risks of income losses), insurance may also have a positive incentive effect. Precisely to remedy the problems of adverse selection and moral hazard referred to above, insurers should obtain information about the work-related risks they are covering and impose specific conditions upon the stakeholders, with the aim of risk reduction. In that way insurers could contribute to increasing the safety at work. The economic approach is therefore based on the assumptions: 1) that insurers can obtain information and are able to control adverse selection and moral hazard and 2) that, through this control on employers’ occupational health and safety, risks will be reduced.

Yet, empirical research in other domains has shown that, even though this risk differentiation by insurers in general, but specifically for liability insurance, is an important (theoretical) instrument to promote safety, insurers do not always engage in such a control of moral hazard to the full extent. In some cases regulation (e.g. on non-discrimination) prevents them from differentiating risks to the full extent; in some other cases a lack of competition in the insurance market reduces the incentives for insurers to engage in costly risk differentiation (Faure/Van den Bergh 2002). The result is that the moral hazard risk is not sufficiently remedied and insurance can even have a negative impact on safety at work (Shavell 1982). For that reason it is first important to verify the existing empirical literature in order to gain insight generally in the effectiveness of the tools of risk differentiation in reducing occupational risks in practice (3). Section 4 then focuses specifically on the tools applied for risk differentiation to remedy the moral hazard risk by liability insurers in the specific cases of the Netherlands and the United Kingdom.

3 Risks in practice: a literature survey

4 Insurance of employers’ liability for OHS

We will now focus on one specific type of insurance, being the insurance of employers’ liability for occupational hazards. We will do so by examining the liability insurance policies in two jurisdictions in more detail: the Netherlands (4.1) and the United Kingdom (4.2). In these jurisdictions, employer liability plays a relatively important role (at least on paper) in the compensation of work-related damage, in addition to the compensation provided to victims via social security arrangements. This provides us with the possibility to examine whether private insurance companies in these jurisdictions offer additional voluntary insurance of damage caused by work-related risks and whether they are actively involved in the monitoring of their insured, as predicted by economic theory. The added value of this focus on these two legal systems is that it allows us to focus on one specific type of involvement of the insurer, being employers’ liability insurance; a more detailed examination of insurance policies also enables us to verify to what extent insurers do insist on promoting work safety via the conditions in the liability insurance policy.

5 Conclusions

As shown in section 2, law and economics theory predicts that insurers will apply premium differentiation (first best solution) and introduce deductibles or caps (second best solution) to reduce the problems of moral hazard and adverse selection. Applying this to work-related risks, the underlying causal relationship that is assumed is that the insured employers or employees are thereby incentivized to invest in the prevention of work-related injuries, because by doing so they will benefit financially, by having to pay lower premiums or own contributions. Hence, this also assumes that the investments made by employers or employees actually lead to a reduction in the number of accidents and diseases. Most of the empirical studies presented in section 3 of this paper confirmed that experience-rated premiums (as applied in workers’ compensation systems) may lead to lower injury rates or better claims management, while some others concluded that these effects are non-existent. Also, some authors pointed to negative side-effects on employee-victims of aggressive claims handling by insurers.

An earlier literature study by Faure and Van Boom (2013) taught us that in several markets insurers, despite the lessons from law and economics, do not apply much risk differentiation. We found that, at least to some extent, the same conclusion can be made for insurance against harm caused by industrial accidents and occupational diseases. As shown in section 3, in all jurisdictions examined there, some basic forms of experience rating take place: generally, premiums are adapted to the degree of risk of the sector or type of company; and in most jurisdictions historical accident records are also a relevant factor. ^[45] Sometimes (as in the workers’ compensation systems in the US), other criteria such as company size are taken into account.

In section 4 we focused on employers’ liability insurance as practiced in the Netherlands and the United Kingdom and found that insurance companies may exclude certain types of risks from compensation ex ante, as shown by the practice of the private insurers in the Netherlands. We did not find much evidence of direct monitoring by insurers of health and safety investments by employers, but various sources indicated that at least in the United Kingdom insurers conduct surveys of their insured’s premises and may adapt premiums on that basis. From this it follows that to a large extent, as the theory (in section 2) predicted, liability insurers do take measures aimed at the control of adverse selection and moral hazards, but the desired results of increasing occupational health and safety are not always obtained. It is almost impossible to show how the specific conditions in the insurance policy would concretely affect the behaviour of employers and employees with respect to work safety. Information about the exact premium conditions and premium calculations is not always available and may require in-depth interviews. But the desired results of premium differentiation (to the extent it does take place) is not always clearly translated in increased work safety. That may be related to the assumptions of the economic approach, inter alia that employers are not always aware of the benefits (for example in reduced premiums) of investments in prevention. The lack of information on the side of employers and the complexity of the premium differentiation mechanism may, especially in the case of medium-size companies inhibit the desirable effects of the measures taken by insurers to control adverse selection and moral hazard.

A possible next step for research in this area would therefore be to look beyond the (often non-specific) information available on the internet and in the literature, by interviewing private liability insurers or their insured employers ^[46] on the topic of premium differentiation.

An interesting finding from the case studies presented in section 4 related to the Netherlands and the United Kingdom was that the way in which liability insurers control adverse selection and moral hazard seems to some extent to deviate from the theoretical expectations presented in section 2. Insurers seem to prefer ‘imperfect’ premium differentiation on the basis of easily observable characteristics (such as type of industry, historical accident record, firm size) rather than full premium differentiation based also on direct monitoring of their insured. This can potentially be explained by one or more of the following lines of reasoning: ^[47]

• The complexity of occupational safety and health policy: it would be too difficult and costly for insurers to monitor the actual behaviour of insured employers or employees. Hiring experts to monitor employers in order to apply full premium differentiation may in that case be more costly for insurers than accepting that some form of moral hazard remains, making it rational to apply only partial premium differentiation.

• Insurance companies may prefer to trust in public regulation (including the monitoring done by labour inspectorates) to take care of the prevention of work-related injuries, or may simply think that the moral hazard risk is not very serious in this particular insurance market. Indeed, we should not forget that liability insurance is only one of the instruments in the governance of work-related risks, next to public regulation, private regulation, liability rules and suasive instruments (Philipsen 2018). The absence of activities by insurers to fight moral hazard is therefore largely contextual: in a legal system where the public sector already imposes regulation and insures the largest part of disability risks, any activities to control moral hazard by private liability insurers may be crowded out. This is to some extent not surprising as earlier literature showed that adverse selection and moral hazard are largely driven by institutions (Cohen and Siegleman 2010).

• Insurers are not interested in full premium differentiation, because it is easier for them to simply increase insurance premiums generally in cases where the average costs of work-related injuries go up, rather than differentiating between premiums for individual employers. This argument is likely to hold only if the insurance market is not sufficiently competitive.

• Insurance premiums and other insurance conditions are regulated by law, so individual liability insurers cannot apply full premium differentiation (for example because legal rules do not allow them to discriminate between particular types of insured parties).

Of course, the aim of this paper was not to go deeply into these possible explanations for the absence of (full) premium differentiation, but rather to show that liability insurers in practice often behave differently than assumed in the law and economics theory. This may be related to the fact that the (basic) theory assumes that insurers have optimal information on the measures to reduce adverse selection and moral hazard and that these tools can be employed in such a way that they also provide adequate incentives for prevention to employers. Information deficiencies and other practical problems (such as the costs of monitoring) may explain the deviations we found in practice, compared to those theoretical assumptions. Moreover, given that public regulation and social security carriers (other than liability insurers) already invest in prevention, the absence of experience rating and monitoring activities can also be understood from the perspective that the marginal benefits of these mechanisms may be limited.

We do not want to claim here that insurers of employers’ liability should be engaged in full premium differentiation: after all, they may not be the best-placed party to prevent work-related injuries. ^[48] Then again, if the legislator relies heavily on private insurance mechanisms for compensation (for example via the insurance of employers’ liability like in the Netherlands and the United Kingdom), one should realize that the moral hazard risk is at least partially shifted to insurers – and if efficiency is a goal of the compensation system, then this needs to be addressed.

Our paper has shown that this particular case of risk privatization (the shift of responsibilities to employers and their insurers) may have been based on the assumptions (1) that insurers are able to provide incentives to employers to promote occupational health and safety via the control of adverse selection and moral hazard, and (2) that employers react to those incentives by investing more in prevention. It appears, however, that insurers of employers’ liability do not always exercise that control in textbook form and that employers do not always respond to the tools employed by insurers in the expected manner.