When the Buyer of insurance has negligently kept silent or misrepresented a (material) fact to the Seller, one of two rules will determine the extent to which cover will consequently be reduced. The pro-rata rule lowers cover in proportion to how much the Seller would have increased the premium had he been correctly informed; the causality rule provides either zero cover if the omitted fact has caused the insurance event, or full cover if the event would have occurred regardless of the fact. This article explores which rule is more efficient. Using the framework proposed by Picard and Dixit (2003), the article assumes that Buyers may misrepresent, either intentionally or unintentionally, and that the Court cannot distinguish one from the other. A trade-off then arises between risk allocation and deterrence. From the perspective of risk allocation, the pro rata rule is preferable since it subjects the risk averse Buyer of insurance to less variance. This implies that the pro rata rule should apply when there is significant risk for a Buyer of unintentional misrepresentation, and when the incentive to intentionally misrepresent can be curtailed through frequent verification of the Buyer's true type. On the other hand, when the risk of unintentional misrepresentation is small, when verification is costly, and when the Buyer is sufficiently risk averse, the Buyer conceivably may be more effectively deterred from intentional misrepresentation under the causality rule. It is argued that the use of the two rules is consistent with these findings.
|Place of Publication
|SSRN: Social Science Research Network
|Number of pages
|Published - 2012