(1) Insurers can observe the level of care:
- Thus, they can reduce premiums to reflect risk reduction that care engenders.
- Insureds will thus purchase full coverage to cover risk and
- Insureds will take care to avoid risk in order to keep premiums as low as possible.
The outcome will be socially optimal: risk-averse injurers will be fully protected against risk and victims will be protected against risk by strict liability rules. Because of this, liability is socially desirable in this situation. In other words, without insurance, victims would be just as well off, but injurers would be worse off because they would bear too much risk (and would modify their actions in socially undesirable ways that do not benefit society as a whole).
(2) Insurers cannot observe the level of care:
- Insureds will purchase incomplete care because full coverage would be too expensive (since there is no way to account for different levels of risk, everyone has to pay to cover risky behavior).
- This results in lessened risk that induces less than optimal precautions.
This is thus not socially ideal because (a) injurers are only partly protected against risk, and their level of care is less than optimal; but (b) victims are still protected by strict liability.
Steven Shavell, Foundations of Economic Analysis of Law, pp. 262-263 (2004).