The Judgment Proof Problem

Parties who cause harm to others may sometimes turn out to be ‘judgment proof,’ that is, unable to pay fully the amount for which they have been found legally liable.’ This possibility is an important and realistic one. Certainly individuals may readily be imagined to cause personal injury or property damage resulting in judgments that exceed their assets plus any liability insurance coverage; and the same is true of firms.2 To understand the nature of this problem, a theoretical model of the occurrence of accidents is studied here. Using the model and assuming that potential injurers’ assets are less than the harm they might cause, questions about the effects of liability on their behavior and on their purchase of liability insurance are considered.3 The conclusions reached may be summarized as follows. (a) Liability does not furnish adequate incentives to alleviate risk. (See Propositions 1 and 2.) An injurer will treat liability that exceeds his assets as imposing an effective financial penalty only equal to his assets; an injurer with assets of $30000, for example, will treat an accident resulting in liability of $100000 identically with an accident resulting in liability of only $30000. Hence, injurers’ expected penalties may be less than the expected losses for which they are liable. This has two implications. First, injurers may engage in risky activities to a socially excessive extent.4 (An electric utility company may decide to build a nuclear power plant that could cause losses in the billions of dollars just because its expected financial penalty is limited by its assets of only a hundred million dollars.) Second, injurers may have too little incentive to take care to reduce risks given their level of activity. (The utility may invest too little in safety given that it builds the nuclear facility.) This problem, however, is less pronounced under the negligence rule than under strict liability, owing to the sharpness of incentives under the former rule;” namely, taking proper care allows injurers to escape liability entirely under the negligence rule, whereas it merely lowers the likelihood of liability under strict liability. (b) The motive to purchase liability insurance is diminished. (See Remark 2 and Proposition 2.) Because their assets are less than the harm they might cause, part of the premium injurers would pay for liability insurance would be to cover losses that they would not otherwise have to bear. If the injurer with assets of $30000 bought full