Ubi lex distinguit, distinguere debemus an economic approach to personal injury compensation

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1 Ubi lex distinguit, distinguere debemus an economic approach to personal injury compensation Matthieu Solignac November 2014 Job Market Paper Latest draft: https://sites.google.com/site/matthieusolignac/recherche/jobmarketpaper.pdf Abstract In most economic models of damage compensation, the indemnity is proportional to the fault and victims have to file the claim. Contrary to the tort law approach, a growing number of reparation mechanisms ignore the fault ( no-fault law ) to compensate damages in their entirety. The Badinter law, which regulates the compensation of damages from traffic accidents in France, is a perfect example. One particular feature of this setting is that the party paying for the damages is likely to have imperfect information on the actual value of the loss and has to make an out-of-court offer. In turn, the victim has the option to accept the offer or to go to court. This study develops a model with these particular features based on the fact that unobserved component of the damages are correlated with observed ones. Estimation of the model is conducted from AGIRA files for settlements between 2004 and I find a negative correlation between observed and unobserved dimensions of damages. The model explains the fact that compensations for each component of the damage is higher in out-of-court settlements, while the total compensation is higher for in-court settlements, mainly chosen by the most injured. Key words: Personal injury compensation; Road traffic injuries; Bargaining model; Litigation and settlement JEL classification: K41, C51 My special thanks go to Frédéric Séraphin and Vincent Le Corre for their initial contribution to this research as part of our final working-group thesis at ENSAE ParisTech. Laurence Rioux et Arnold Chassagnon were also of great assistance. I also thank Xavier d Haultfoeuille and Julien Pouget for their advice, Lionel Potempa for his help, Loïc Piard for his legal insights. This paper benefited from attentive re-reading and remarks from Laurent Gobillon, a useful suggestion from Grégory Verdugo and detailed comments from Nicolas Vaillant, Sebastian Bervoets, Didier Blanchet and Pierre-Philippe Combes. Sciences Po - Department of Economics, https://sites.google.com/site/matthieusolignac

2 The economic approach to justice has developed from tort law (Shavell (1987)). Compensation is set according to the defendant s responsibility for the damage. This widespread approach is particularly suitable for economic analysis of a normative type (Calabresi (1970)). It has also generated studies analysing the compensation process (Bebchuk (1984), Nalebuff (1987), Sieg (2000)) 1. The procedure is initiated when the victim files for compensation damages from the defendant. To the extent that the defendant is responsible for the fault (tort), they may accept the terms of the out-of-court settlement or refuse them, causing the matter to be taken to court. However, this system of compensation is far from being universal for personal injury. It does not necessarily correspond to the usual legal procedures in many countries, particularly for road accidents. Most European civil law countries, New Zealand and some states in the United States and provinces in Canada have different systems: compensation for all the injury suffered by the victim takes precedence over considerations of fault. This is the so-called no-fault law. Here the party required to make compensation is not necessarily from the outset the best informed about the precise extent of the injury. However, they may still be responsible for formulating an out-of-court offer. In formal terms, this negotiating structure may appear fairly similar to that traditionally presented by tort law: the out-of-court offer is made by the less well informed party while the decision to go to court is made by the better informed party. And yet, the reversal of roles is not complete, and the information asymmetry is a different one. Consequently an alternative approach to negotiation needs to be developed that is more appropriate for this procedure. This article proposes an approach to the negotiating process within a framework of full compensation for injury in which the party required to make compensation, having less information than the victim, has to formulate the out-of-court offer. The theoretical framework developed can be used to analyse the role of these information asymmetries in the choice of types of settlement and compensation obtained. This modelling is followed by empirical validation from French road accident data. The 1985 Badinter Act set up a system of full compensation for personal injury that is one of the most extreme examples of a no-fault system. Since the law regulates the entire negotiating procedure, including out-of-court discussions, and extensive data are available on compensation cases, this is a particularly instructive situation to observe. Using data collected by the French association for managing automobile risk information (AGIRA) from 2004 to 2006, this study has produced the first extensive economic analysis of compensation for personal injuries sustained in road accidents in France. Estimates made with a reduced form of the model developed demonstrate its explanatory power with respect to the apparent contradictions observed. Although mean compensation in the courts tends to be higher, 1 For an overview of the literature, see Deffains (1997). 1

3 the monetary value applied to each type of injury is higher out of court, a procedure accepted by 94% of victims. These observed facts are perfectly compatible with individual victim heterogeneity that is unobserved by insurers and correlates negatively with the observed component of the injury. This pattern occurs where an apparently minor injury is more likely to have widely varying repercussions according to the individual. Estimation biases are then partly corrected using the method described by van Praag et al. (2003). A recapitulation of the crucial nature of information asymmetries in negotiating situations is followed by a presentation of the initial analytical elements typical of full compensation models (Section 1). Section 2 is devoted to developing the theoretical approach based on reversing information asymmetries in favour of the victim in the negotiating process. This approach is then applied to the French road accident data presented in Section 3. The potential effect of unobserved injuries on the compensation process initiated by the insurers is presented empirically in Section 4. Inclusion of exogenous levels of heterogeneity by the Heckman and Singer (1984) method is followed by an attempt at correcting the biases engendered by correlating the heterogeneity with the observed injuries. 1 Information asymmetries, key to the compensation process 1.1 Defining liability: a legal choice that generates information symmetry The general principles for compensating the victims of personal injury are laid down by the law. It identifies those liable for compensation who are required to pay the victims a sum calculated by a set of rules. The legal frameworks set up to compensate for personal injury allow for, or even prescribe, a phase of out-of-court negotiation before recourse to legal proceedings. Generally speaking, the regulatory influence of these legal and judicial systems is not restricted to procedures settled in court. Since recourse to an outside arbitration body such as a court is expensive, it is of mutual advantage to both sides to reach an out-of-court agreement. Agreement is only possible where the two parties anticipate a similar result from a court decision. Saving the cost of going to court enables them to find an agreement that is Pareto-superior 2 to any judicial solution. In a situation of perfect information, the courts in theory act only as a background threat that defines the framework of the out-of-court negotiation. party. 2 An agreement where the terms are at least as attractive for both parties and more attractive for at least one 2

4 However, if the law defines liability in order to determine the amount of the compensation, this potentially introduces an information asymmetry between the two parties. Liability for an injury generally falls on the person who has committed the fault and compensation is consequently proportionate to the extent of that fault or tort: this is the system of tort law. Since the total value of the injury subject to compensation is determined by medical examination, the uncertainty concerns the proportion of that injury attributable to the defendant s fault. The party at fault appears to be best placed to know that proportion and therefore able to know exactly how much compensation the law requires of them. Conversely, the victim, who does not exactly know the extent of the error committed by the defendant, generally has only a vague idea how much compensation they might receive in court. These are precisely the reference models developed by Bebchuk (1984) et Nalebuff (1987). They were later used by Sieg (2000) in his analysis of medical malpractice in Florida. In the Bebchuk (1984) et Nalebuff (1987) models, the victim takes the initiative to propose a take it or leave it out-of-court compensation. The defendant can then either agree to pay the victim that amount or go to court. If the latter, the Nalebuff model, relaxing the assumption of an expected higher gain in court, adds the possibility for the victim of abandoning the procedure. The two negotiating models end in an equilibrium and the definition of an optimal amount out of court. The further stage introduced by Nalebuff allows the victim to use the information gained from the defendant s behaviour in the earlier stages (accepting or refusing the out-of-court proposal) and thus partly makes up for the initial information asymmetry Non-universality of tort law economic models In the Bebchuk (1984) and Nalebuff (1987) models, the type and amount of compensation are determined by each party s degree of knowledge of a court s likely assessment of the extent of the defendant s responsibility. In recent arrangements, however, the outcome of the negotiation tends mainly to depend on the total amount of damage incurred. It is the damage suffered by the victim rather than the defendant s degree of fault that decides the amount of compensation. Furthermore, under no-fault law, an insurer or compensation fund often stands in for the defendant. The designation of the body required to pay compensation is specified in law. The compensation procedure thus pits a victim against a party not necessarily at fault but required to pay monetary compensation for the damages suffered in their entirety. This system of no-fault compensation became the rule in New Zealand in 1974 for all personal injury caused by an accident (Vennell (1976)). It is particularly common for road accidents. In most European civil-law countries (Austria, Belgium, France, Germany, Italy, Netherlands, 3 Called The Play s the Thing (Bayesian) process of learning (Rasmusen 2007). 3

5 Spain), the defendant s responsibility is systematically assumed 4. Any challenge to this, strictly regulated, requires the difficult task of proving the victim s negligence. Four provinces in Canada have adopted this type of procedure, as have sixteen states in the United States since 1972 (Devlin (2002)). Practice in Japan partly adopts this approach (Tanase (1990)). France adopted it in 1985 for road accidents and has partially applied it for medical accidents since This altered approach to injury tends to favour the victim when it comes to predicting how much compensation they are entitled to. Consideration of pain suffered and the personal consequences of the injury also do so. Medical reports forwarded to the party responsible for compensation (hereafter, for simplicity s sake, the insurer ) do admittedly provide them with standardised information on each case. But the principle of full compensation for personal injury confers an entitlement to compensation for the most specific and personal aspects, which these opinions do not necessarily reflect. A given degree of injury may have direct and indirect consequences that are specific to the victim and any close associates. Loss of mobility in a finger has different consequences for a professional pianist and a conductor. But the insurer is not necessarily informed to that degree of detail, especially if the victim is not their customer. It is precisely this individual dimension that court proceedings will seek to reveal and by which the judge will set the level of injury compensation. Consequently it is highly likely that there will be differences between individuals suffering the same degree of expert-assessed injury, and this will affect compensation. The monetary valuation of various sorts of injury, on the other hand, may be deemed to be public. Data concerning past settlements, particularly in court, are often available 6 and reports on these matters are regularly published. Furthermore, both victim groups and lawyers ensure that the information is disseminated. Under full injury compensation, the victim certainly appears to have more information than the insurer. I examine the consequences for the compensation process. Compared with fault-based negotiation, full injury compensation may be seen as a reversal of the role and degree of information of the two parties. It is up to the insurer, the victim of information asymmetry, to make the out-of-court offer, while the legal victim can decide whether or not to go to court. In formal terms, the two negotiating structures may appear very similar. In both cases, the out-of-court proposal is made by the less well informed party and the decision to go to court is made by the better informed party. One might therefore suppose that reversing the players in fault-based compensation models would be sufficient to obtain a model suited to full compensation. 4 See European Parliament memorandum on this matter (Renda and Schrefler (2007)). 5 Act of 4 March 2002 on patients rights. 6 For road accidents in France, an exhaustive database of this type - the AGIRA file of compensated victims - is directly available to anyone: initially accessed via the French Minitel it can now be found at victimesindemnisees-fvi.fr/. The empirical work on this AGIRA database is described below and in more detail in the Appendix. 4

6 However, the role reversal is not total, since compensation always consists of a monetary transfer to the victim. Under the fault-based model, the party determining the out-of-court settlement aims to maximise the figure, while under full compensation the insurer attempts rather to minimise it. Also the fact that deciding for or against legal proceedings now belongs solely to the victim is not without implications. Under tort law, the choice of accepting the out-of-court offer is submitted to the compensating party. But, as Nalebuff (1987) observes, actual recourse to legal procedures is in practice subject to approval by both parties: the victim who initially proposed an out-ofcourt settlement may choose to go along with the defendant s decision to go to court or may abandon the case if it is likely to result in a negative outcome. Unlike the opposing party, the victim is free to stop the procedure at any point. The Sieg (2000) and Nalebuff (1987) models are also based on the assumption that the unobserved factors are similarly distributed for all individuals. This assumption of independence between observed and unobserved factors may well be justified for the configuration they examine: the share of responsibility for the injury caused may be deemed to be independent of the total amount of injury. Whether the total injury, assumed to be common knowledge, is great or small has in theory no impact on the share attributable to the defendant s errors. However, that the injury assessed by expert opinion and the level of unobserved injury should be independent is by no means certain under full compensation. Apparently limited injury is more likely to affect a victim s life to a more varied extent than major injury. A detail that may appear insignificant, so much so as not even to have been reported at the outset, may turn out to have a highly disabling effect on some people because of their occupation or leisure activities 7. Major injury, on the other hand, is likely to reduce the effect of individual variation. The contribution of unobserved injury to the amount of compensation may consequently be even greater when the observed injury is limited. So an approach needs to be developed that is more specifically suited to the full compensation process and can take account of the various potential forms of individual diversity. Such a model is described in the next section. 2 Economic model 2.1 General framework Presentation The intention is to model the negotiating process under full compensation with an out-of-court proposal defined by the insurer. The process may end in one of two settlements, denoted J, J {0, 1} (French justice). The first (J=0) is the payment of an out-of-court sum S, and the other (J=1) is the court ordering the insurer to pay a compensation (French indemnisation) denoted I. The process is as follows: 7 As in the case of the injured finger mentioned above. 5

7 1. The insurer makes the out-of-court offer S. 2. The victim accepts or refuses the out-of-court offer. If the victim accepts the offer (J=0), they receive S. Otherwise, the victim goes to court (J=1). 3. The court sets a final amount of compensation I. The victim has a degree of injury X, supported by expert opinion. It is evaluated as a mean amount of D(X) after court proceedings. Both victim and insurer know this value, which is thus common knowledge. Part of the injury specific to each victim and known only to them may, however, have been omitted from the medical report. It is assumed that this heterogenous nature of the victim s injury, unobserved by the insurer, would be given a monetary value by a court of θ plus or minus an error term. The insurer knows only the award conditional on the degree of injury X, unlike the victim, who knows the exact value of θ. Both parties are assumed to be risk-neutral and have only monetary motivations: so the victim is seeking a net maximum compensation. The victim will only go to court if the expected gain is higher than the out-of-court offer In-court compensation Legal expenses Going to court involves expenses for both parties 8 : lawyers fees, experts fees, etc. Denoted ζ v are all the legal expenses incurred by the victim in going to court for compensation. Similarly, denoted ζ a are the expenses of the insurer (French assureur) in defending the case. These expenses are assumed to be constant: they are identical for all victims. However, the victims legal expenses may be paid wholly or in part. Two non-exclusive situations may arise: these expenses are paid for by a third party or may be reimbursed by the opposing party. The existence of individual insurance arrangements 9 or public support (legal aid in France) may exempt the victim from their legal expenses. The victim need in such cases only pay for any residual costs exceeding the reimbursement limit. These costs are in the form Max(ζ v e, 0) where e is the reimbursement limit. In order to generalise the model, these residual expenses are denoted 10 ζ v. Where the insurer reimburses an exogenous amount C, with C ζ v, the legal expenses for victim and insurer respectively are ζ v C and ζ a + C. 8 With no loss of generality, out-of-court negotiating costs are assumed to be zero. 9 Many insurance policies (home, car, bank card, etc.) include cover for legal costs involved in a dispute. 10 This naming convention is a parsimonious way of allowing for the intervention of a third party separate from the victim and the insurer for the payment of legal expenses. The model remains the same, at the cost of a factor that is not directly included in the analysis: the total amount of legal expenses incurred by the victim, a value between ζ v and ζ v + e. 6

8 Compensation The amount I awarded by the court corresponds to compensation for the injury observed by the medical examination and the value assigned to the unobserved injury. So for a victim of type (X,θ), the compensation awarded by the court is I(X, θ, µ) = D(X) + θ + µ (1) The term µ corresponds to the random element in the court s award. It allows mainly for the court s errors of assessment in placing a monetary value on the injury. It is assumed to be zero on average and to depend on neither the case nor the court. It is modelled as a centred normal distribution with a variance of σ 2. The legal compensation award process is common knowledge. For example, the legal award in the case of a victim of type (X,θ) with an error of µ leads to the insurer paying out I(X, θ, µ) + ζ a + C, namely the amount of compensation plus the legal expenses to be paid. The gain for the victim is expressed I(X, θ, µ) (ζ v C), the compensation minus the residual legal expenses. 2.2 Analysis of decisions The three-phase negotiating structure presented in Section starts with the insurer, who is required to propose an out-of-court amount S. They will set it so as to minimise the cost of compensation. But they must allow for the possibility that the victim will go to court and thus for the strategic nature of the negotiation. Courts compensation practice is the yardstick for outof-court negotiation. Any out-of-court arrangement will be defined in relation to the court award expected by the two parties. They will therefore reason by backward induction Probability p 0 of out-of-court settlement Whether the out-of-court offer is accepted or refused is the result of a choice between that and a court case 11. Legal proceedings may be seen as a revealing mechanism the use of which the insurer can only indirectly control. Since the insurer has only imperfect knowledge of the injury, this procedure protects them against an over-evaluated compensation, at the cost of legal fees. However, the option of going to court belongs to the victim: the insurer can only indirectly influence that choice by means of an out-of-court offer of compensation. A victim of type (X, θ) may hope to obtain from the court a net final amount: ( ) E I(X, θ, µ) (ζ v C) X, θ = D(X) + θ (ζ v C) (2) So the victim will only accept the out-of-court offer if it is at least equal to the amount anticipated 11 Phase 2 of the negotiating process presented in

9 ( ) from legal proceedings. In other words, E I(X, θ, µ) (ζ v C) X, θ S. The probability p 0 of this occurring depends on the value of the victim s unobserved injury, for which the insurer only knows the distribution. From the insurer s point of view, the probability that a victim suffering an observed injury X will accept an out-of-court offer S is such that: ( ) p 0 (S, X) = P θ S D(X) + ζ v C X, S (3) For a given out-of-court compensation, the probability of an out-of-court settlement will consequently increase with the value placed upon the unobserved injury in the out-of-court offer (S D(X)) and also the legal fees paid by the victim (ζ v C). However, consideration must also be given to the strategic nature of the insurer s out-of-court offer Out-of-court compensation The amount of out-of-court compensation is set by the insurer at the start of the procedure and submitted to the victim. The insurer s objective is to offer each victim an amount S such that the compensation to be paid is as low as possible. How S is set depends on the information the insurer has at the outset, namely legal fees and the observed level of injury X. For each individual with an observed injury X, this corresponds to the objective function arg min M ( X, S ) where M ( X, S ) S is such that: M ( X, S ) ( ) ( ( )) ) = p 0 S, X S + 1 p0 S, X E (I(X, θ, µ) + (ζ a + C) X, S ( ) ( ( )) ( ) = p 0 S, X S + 1 p0 S, X D(X) + E(θ X) + ζ a + C (4) The distribution of the unobserved heterogeneity θ plays a crucial role in determining the amount S of the out-of-court offer made. For each level of injury X, the solution of objective function 4 depends on the form of this unobserved component of injury, which affects both the amount of the out-of-court offer and the probability p 0 that it will be accepted (Equation 3). Settlement is consequently conducted by considering the various forms of distribution of the heterogeneity. 2.3 Specification of heterogeneity Absence of heterogeneity If the medical report managed to perfectly reflect in its entirety the injury for each victim, the two parties would possess perfect knowledge of the damages (θ = 0). In that case the victims would only be distinguished by their level of injury X. Once S(X) D(X) (ζ v C), all victims of type X will be compensated out of court 12. This lower threshold is the lowest out-of-court offer accepted by all victims with injury X. Any higher offer is a pure loss for the insurer; any 12 θ = 0 implies p 0 = 1 (see Equation 3). 8

10 lower offer causes all victims to go to court (p 0 = 0). This second solution costs the insurer more because of legal fees 13. Consequently, the insurer s optimal strategy is to make all victims of type X an out-of-court offer S(X) = D(X) (ζ v C). This demonstrates a result first mentioned in 1.1: where information is similar for both parties, out-of-court compensation in a Pareto-optimal type of settlement. It provides the victims with the same amount of compensation as an in-court settlement, while being strictly advantageous to the insurer, who saves an amount equal to all the legal fees 13. In the previously stated conditions 14, the following statement may be made: Statement 1: in the absence of unobserved heterogeneity, all cases are settled out of court Discrete heterogeneity Let us now suppose that the victims of injury level X vary according to the level of their unobserved injuries θ k, k [1, K]: call them type (X, θ k ). We assume that each of their levels of heterogeneity is in proportion p θk (X) for a given level of observed injury X. These various values are known to both parties. However, the insurer only knows the distribution of heterogeneity for each level of observed injury X: its exact value θ k for a given victim is unknown to the insurer. In this situation, the insurer has an interest in considering a strategy combining out-of-court and in-court settlements for each level of observed injury. It consists of making an out-of-court offer sufficient for the individuals with the lowest levels of heterogeneity to settle for compensation out of court. This is based on making an out-of-court offer S indexed on a certain level of heterogeneity θ l(x), θ l(x) [θ 1, θ K ]. Such an amount S ( X, θ l(x) ) = D(X) + θl(x) (ζ v C) ensures that court proceedings will be avoided by victims with heterogeneity equal to or below θ l(x) : the offer is at least equal to what they could hope to get in court. If there are any other victims, they will begin legal proceedings after which the insurer will compensate their heterogeneity at its true value. For the insurer, the average cost of such a strategy is thus: ( M(X, S) = p 0 (S, X) S + 1 p 0 (S, X) )(D(X) + k>l(x) ) p θk (X)θ k + ζ a + C avec S = S ( X, θ l(x) ) = D(X) + θl(x) (ζ v C) (6) (5) This is still cheaper than systematically going to court 15. This strategy of combining both sorts of settlement enables the insurer to save at least ζ v + ζ a for all the individuals with the lowest level of unobserved heterogeneity. Solving the objective equation arg min M ( X, S ) amounts therefore to determining the level of S heterogeneity θ l(x) for which the value of M(X,S) is minimal. Following Equation 5, level θ l(x) is ( ) 13 The average cost per victim of in-court compensation is E I(X, 0, µ) + ζ a + C = D(X) + ζ a + C, but only D(X) (ζ v C) out of court, a difference between procedures of ζ v + ζ a. 14 In particular the parties being risk-neutral. 15 Going to court incurs an average expenditure per victim of D(X) + k [1,K] p θ k (X)θ k + ζ a + C. 9

11 preferred to any other level θ t for the out-of-court offer as long as: t < l(x) t > l(x) k t k l(x) ) p θk (X) (θ l(x) θ t + k ]t,l(x)] ) p θk (X) (θ t θ l(x) + k ]l(x),t] ( ) p θk (X) θ l(x) θ k (ζ v + ζ a ) 0 (7) ( ) p θk (X) θ t θ k (ζ v + ζ a ) > 0 (8) The option of more systematically going to court reduces the amounts awarded to compensate the unobserved injury in the out-of-court settlement. This development is illustrated in Inequality 7 by reducing l(x) to t the level of heterogeneity chosen by the insurer in their offer of compensation 16. This concerns in particular those victims with unobserved injuries clearly below this new threshold t: the out-of-court settlement they receive falls by an amount equal to the reduction of the threshold (first term on the left-hand side). The type of settlement only changes for the victims with heterogeneity between the two thresholds (second term). An in-court settlement enables the insurer to avoid any overvaluation of the heterogeneity. Use of legal proceedings as a revealing mechanism has, however, a cost. Within this framework, the probability that the out-of-court offer will be ( accepted is in the form p 0 (X) = P θ θ l(x) 0 X, S ( ) ) X, θ l(x). The victim s decision to go to court depends solely on the difference between their unobserved level of heterogeneity θ and the level of heterogeneity θ l(x) in the insurer s optimal out-of-court offer. Once the actual level of unobserved injury is greater than the one applied in the out-of-court offer, the settlement will involve legal proceedings. However, the strategic nature of the choice of θ l(x) means that the insurer sets it according to the various parameters in Inequalities 7 and 8. The probability of an in-court settlement also depends, therefore, on the distribution of unobserved injuries and legal fees: ( ) p 0 (X) = f(θ, θ l(x) ) = f θ, (θ k, p θk ), ζ v, ζ a X (9) For each level of injury X, legal proceedings tend to be used more often when, conditional on the validity of Inequality 8, Inequality 7 is verified for a lower level of heterogeneity. Two things may increase the use of legal proceedings: a reduction in legal fees to be paid by both parties and a change in the distribution of heterogeneity. At constant average heterogeneity, a slightly higher proportion of cases of lower heterogeneity may be enough to increase the use of legal proceedings. Changes in this distribution may be split in two. First, there is the effect of it being concentrated on a limited number of values, since a reduced number of mass points increases the gap between levels of heterogeneity 17. The advantage of going to court for a higher level is even greater when the reduction in the level of heterogeneity allowed by the insurer out of court (θ l(x) θ t ) is large. 16 Conversely, we may analyse the left-hand side of Inequality 8 as the opposite of the change in the cost M(X, S) caused by raising the level of out-of-court evaluation of heterogeneity from l(x) to t. 17 It also tends to increase the values of the associated non-zero probabilities such as p θl(x) (X), potentially at the expense of the value of k l(x) 1 p θ k (X): this is the second dimension of the alteration in distribution announced and analysed immediately afterwards. 10

12 Second, an increase in frequency of low levels of heterogeneity (i.e., those associated with an outof-court settlement) may also help to make an in-court settlement more attractive. The reason is that a given reduction of the threshold for out-of-court evaluation of heterogeneity will affect more cases, and thus increase this source of savings for the insurer 18. This sort of shift in distribution is thus likely to increase the number of in-court settlements. Deciding between heterogeneity level l(x) and the level immediately below l(x)-1 may help to reveal the various channels affecting the use of legal proceedings for a given level of observed injury. The number of court cases will increase when k l(x) 1 ) ( p θk (X) (θ l(x) θ l(x) 1 p θl(x) (X) ζ v + ζ a) > 0 (10) This situation is verified in the following situations in particular: a reduction in the legal costs ζ v + ζ a to be paid by both parties greater than p θk (X) ) ζ v + ζ a k l(x) 1 (θ l(x) θ l(x) 1 p θl(x) (X) an alteration in the constant mean distribution of θ such that the gap of θ l(x) at the non-zero frequency level of heterogeneity immediately below p θl(x) ) ) (X) increases by (ζ v + ζ a (θ l(x) θ l(x) 1 the frequency k l(x) 1 k l(x) 1 p θk (X) p θk (X) increases by p θl(x) ( ) (X) θ l(x) θ l(x) 1 ζ v + ζ a k l(x) 1 p θk (X) while increasing the total number of court cases. I.e., denoting p θ k (X) the probabilities after alteration 19 p θl(x) + p θ k p θk > 0 k>l(x) k>l(x) where Statement 2 : with unobserved heterogeneity, more use will be made of court proceedings 1. legal fees to be paid by the parties are low 2. the number of different values taken by the heterogeneity is limited 3. the frequency of low values for heterogeneity is high (subject to conditions 20 ) 18 Increase in the first term on the left-hand side of the two inequalities via p θk (X). 19 These alterations in distribution occur at identical mean value. 20 The number of levels of heterogeneity whose type of settlement changes (court proceedings rather than out of court following the alteration in the distribution of heterogeneity) must be higher than any possible reduction in the number of cases of high heterogeneity (level of heterogeneity initially associated with an in-court settlement) from the initial reference situation. 11

13 2.3.3 Heterogeneity correlated with level of injury This theoretical framework can be used to account for stylised facts such as the over-representation in courts of cases supported by medical reports of major injury. The influence of the level of observed injury on the choice of procedure may occur via the three channels described above. The selection of high-injury cases for in-court settlement might therefore be caused by a reduction in legal fees with the seriousness of the injury. This pattern is, however, highly unlikely in practice. Insurers tend to pay their lawyers by number of cases at a standard fee set in advance. If there is a correlation between legal fees and seriousness of injury, it will tend rather to be positive: the victims lawyers may propose that their fees should contain a variable component proportional to the final compensation awarded (payment by results). Consequently, the reason for this overrepresentation in the courts is more likely to be found in the alteration in the distribution of heterogeneity from that of the expert-certified injury. As before, two aspects of this alteration of distribution at constant mean may be distinguished. As the level of observed injury rises, some concentration of levels of heterogeneity is a theoretically possible explanatory hypothesis, as is higher frequency of low levels of heterogeneity as injury becomes more serious (following the form of alteration in the distribution of heterogeneity). This latter hypothesis differs from the other two by the negative correlation it assumes between observed injury and unobserved injury 21. Statement 3 : if a negative correlation is observed between observed and unobserved injuries, we may consider that the frequency of low-heterogeneity cases increases with the level of observed injury. 3 Application to road accidents in France 3.1 An exemplary case of full compensation Since 1985, compensation for injuries caused by road accidents has been regulated by the Badinter Act 22. This is one of the most extreme examples of regulation of the out-of-court negotiation procedure and dismissal of the idea of fault in injury compensation. After a road accident, French law recognises the victims right to compensation for all the injuries they have suffered. It is designed to ensure full financial reparation for victims of personal injury. Once the victim s condition has 21 The other two hypotheses do not involve a relationship between these two values. One might admittedly imagine in the first case a negative correlation between legal fees and observed injury together with a positive correlation between legal fees and unobserved injury. However, the way that lawyers are paid in practice excludes the possibility of this pattern. 22 Act of 5 July 1985 to improve the situation of road accident victims and accelerate compensation procedures (http://www.legifrance.gouv.fr/texteconsolide/aheab.htm) applies to all victims of a traffic accident involving a terrestrial motor vehicle and its trailers or semi-trailers, excepting railway trains and trams travelling on their own tracks. 12

14 been stabilised (maximum medical recovery-mmr) they are examined by a medical expert who evaluates their injuries. After this examination, the insurer is required to make the victim an offer of compensation that covers all the elements of the injury, both economic and psychological. The main headings of compensation are given in Table 1. The victim may either accept the amount offered or take the case to court. Temporary total disability (ITT) Permanent partial disability (IPP-AIPP) Occupational impact Pretium doloris Losses due to the inability to pursue gainful employment during the period preceding MMR (stabilisation of state of health). Following an evaluation at the end of the medical recovery phase, a physical or mental disability likely to last. Wages the victims could not earn for reasons due to the accident. Evaluated on a scale from 0 (none) to 7 (very serious), the physical and psychological distress suffered by the victim as a result of the accident. Disfigurement Physical disfigurement evaluated like pretium doloris from 0 to 7. Loss of amenity Disorders that temporarily or permanently remove or diminish the victim s leisure activities. Table 1: Main headings for road accident compensation The specific feature of the Badinter Act in the French legal system is that it turns away from the idea of cause to focus on involvement (G Sell-Macrez (2007)). Under the latter principle, compensation for the injury will be paid by the relevant insurers, with little concern for the responsibility of their policyholders. So that even if a car involuntarily knocks down a pedestrian who has behaved negligently 23, the driver s insurer is liable for compensating all physical injuries both to the pedestrian and the driver and any passengers. The reason is that car insurance is compulsory, whereas the pedestrian is not necessarily comprehensively insured. If more than one insurer is involved, one is appointed to pay the compensation, but may take action against the other insurers. If an insurer cannot be identified (sole vehicle flees the scene, driver uninsured), the compensation is paid from a guarantee fund. For simplicity s sake, we use the term the insurer for the victim s single opposite number who is liable for the compensation, whether an insurer (who may or may not represent others) or a compensation fund. 23 Decisions on this point by the Cour de Cassation illustrate the extremely limited scope for inexcusable negligence to be a reason for challenging the compensation award (Cour de cassation (1996)). 13

15 3.2 Database Under the Badinter Act, insurers must collect and share data from compensation cases 24. After the compensation procedure, each victim is recorded in a database run by the association for managing automobile risk information (AGIRA). These AGIRA victim compensation files provide information about the type of settlement and compensation awarded for various victims. Each case is characterised by the various injury headings evaluated by the medical examination (Table 1). The victim s date of birth, gender and annual income are also recorded, along with the dates of the accident, maximum medical recovery and settlement. The poor quality of information relating to direct healthcare costs led to focusing this study on compensation mainly for psychological distress and permanent physical injury. This restriction only slightly affects the analysis since immediate care is already paid for by the French social security system and private insurance: the Badinter Act is mainly about compensation for other elements of injury. For each case, the location (département) and local appeal court are known, in addition to the dates of the accident, maximum medical recovery and settlement. The research is based on compensation cases that occurred from 2004 to 2006, as recorded by AGIRA. The annual databases for 2004, 2005 and 2006 were aggregated to form a set of 80,764 usable observations General features of road accident compensation Road accident compensation under the Badinter Act is characterised by a high rate of out-of-court settlements: 94% of cases are settled after the phase of negotiation between victim and insurer. This is similar to what is observed in the United States, particularly in disputes about medical malpractice 26. However, the proportion of in-court settlements increases with the seriousness of the injury (see Figure 1): once the rate of permanent partial disability (IPP) 27 exceeds 7%, more than one case in ten goes to court. For the most serious cases, the rate of in-court settlements is as high as 20%. By the contrapositive of Statement 1 from the theoretical analysis, this observation of actual use of legal proceedings suggests that there is an asymmetry of information between victims and insurers. Within the model developed, this situation is characterised by non-zero individual heterogeneity. Most cases by far are moderately serious: more than 90% of victims have an IPP rate of less than 10% and only 2% of them have injuries over 30% IPP. But the amounts awarded by the courts are higher than those observed in out-of-court settlements: the mean and median compensations 24 Badinter Act, Article 26: Under the control of official authority, a periodical publication shall report the compensations awarded by courts and out of court. 25 See details in Appendix A. Despite the theoretically exhaustive nature of the AGIRA database, some observers suspect under-declaration by insurers in cases of very serious injury. Since these extreme compensations occur particularly when third-party compensation is awarded, these cases have been excluded from analysis (1% of observations). 26 Danzon and Lilliard (2000) et Sieg (2000) report out-of-court settlements rates of 93.2% and 92.6%. 27 IPP compensation alone accounts for more than 40% of the final payment made. Adding ITT and pretium doloris, this comes to 90% (see Appendix A Fig.8). 14

16 Figure 1: Going to court increases with seriousness of injury Rate of cases going to court (%) Increasing seriousness of injury (centiles of IPP rate) In-court settlement Confidence interval (5%) Source: AGIRA databases awarded by courts are over three times higher (see Appendix A Table 8) 28. The descriptive statistics collected are, however, conditional on the type of final settlement. The data on court awards are based only on the cases that were actually settled at that level: no court was called upon to rule on the out-of court cases. More generally, the AGIRA data never show simultaneously the out-of-court offer and the court award. Even for cases settled in court which, by definition, also involved an out-of-court offer, the amount of that offer is not recorded. Since victims injuries vary and the choice of type of settlement depends on parameters which also affect the level of compensation offered, descriptive statistics cannot be directly used to arrive at any conclusion about possible greater generosity in either type of settlement. Before analysing the compensation levels, it is essential to control for the effects from selecting the settlement procedure. 4 Estimation 4.1 General framework for econometric approach The econometric model proposed is based on the simultaneous estimation of three equations corresponding to the various stages in the negotiating process described in A probit-type selection equation models the probability of going to court (Stage 2) and the compensation equations take as explained variable either the out-of-court compensation (Stage 1) or the court award (Stage 3). Figure 2 gives an overview of the approach, which is used to estimate a reduced form of the theoretical model. 28 The observed characteristics of cases by type of compensation settlement are given in greater detail in Appendix A Table 6. 15

17 Figure 2: Econometric approach to sequence of individual decisions Selection equation Choice of type of settlement J 1i = Z 1i α 1 + θ i θ l(x0) (ζ v + ζ a ) + v 1i J 1i 0 J 1i > 0 Compensation obtained y 0i = X 0i β 0 + θ l(x0) (ζ v C) + u 0i Out-of-court compensation equation y 1i = X 0i β 1 + θ i + u 1i In-court compensation equation The compensation equations are intended to measure the influence of various explanatory factors in determining the level of compensation (expressed logarithmically) obtained out of court (y 0i ) and in court (y 1i ). They correspond to the level of the transfers between insurers and victims. The amount y 1i does not take account of any legal fees the victim may have to pay. Denoted X 0, the explanatory factors comprise the various variables produced by the medical examination which define the level of observed injury. Their effects on each type of settlement are measured by parameters β 0 and β 1. Out of court, a level of compensation for unobserved injuries is set at θ l(x0) for each level of observed injury. Only in court proceedings is this compensation awarded on an individualised basis θ i. The decision between out-of-court and in-court settlements is modelled via the probability p 0 (X) presented in Equation 9. For estimation, this process is approximated in the form of a selection equation. This distinguishes between victims i who accept the out-of-court offer (J 1i = 0) and those who go to court (J 1i = 1). The latent variable associated with this equation is denoted J1i : where J1i 0, the case is settled out of court for an amount y 0i. Otherwise, the victim is awarded y 1i in court. The two compensation amounts are never known simultaneously. Willingness to go to court directly depends on the extra compensation expected by the victim compared with the out-of-court offer. The selection equation s function is precisely to take account of the endogenous nature of the observation of an out-of-court or in-court award of a given level of compensation. This is to correct for the biases likely to affect the estimation of parameters in the compensation equations. Although the variables that characterise the level of injury suffered are not assumed to have a direct effect on the choice of procedure, they may still have an indirect effect by being related either to the legal fees or to the distribution of unobserved heterogeneity. The real effect β of the variables on the level of compensation can only be estimated once their potential effect α 1 on the choice of procedure has been controlled for. The explanatory variables Z 1 of the probability 16

18 of going to court therefore include those of X 0 of the level of compensation. The court s error of judgment corresponds to the residual term u 1 in the compensation equation. The other residuals, albeit not with such a structural basis (see 2.1.2), are also assumed to be normally distributed. They are supposed to reflect the effect of the various inaccuracies inherent in the available data. The residual terms in the three equations are thus modelled in the form of a multivariate normal distribution with expected value zero and a variance-covariance matrix such that: ν 1 u 0 u 1 N 0 0 0, 1 ρ 0 σ 0 ρ 1 σ 1 ρ 0 σ 0 σ ρ 1 σ 1 0 σ 2 1 In the variance-covariance matrix, the correlations between residuals u 0 and u 1 in the compensation equations are not identified 29. This correlation is forced to be zero, a choice partly guided by the assumption of heterogeneity in the courts errors of judgment. This type of model is identified by specifying correlations between the residuals of the various equations. However, it is preferable that the selection equation should include at least one variable excluded from the other equations as an identification condition. Finding one such variable affecting the decision to go to court but not determining the level of compensation is particularly difficult because all the known characteristics have been recorded precisely in order to assess the value of the injury to be repaired. Since looking for previous data on which the victims might have based their anticipations was unsuccessful 30, the search for an exclusion variable finally settled on two families of variables: local characteristics and the day of the accident. Location by département was used to introduce highly variable local characteristics likely to affect only the decision to go to court. The distribution of the département population between socio-occupational categories (particularly self-employed shopkeepers) appeared initially to be a potential exclusion variable. However, apart from the difficulty in explaining the mechanism behind such an effect, the variable s effect did not turn out to be as robust as hoped. Replacing the 2004 employment survey data by the census data 31 to obtain the distribution did not support its value as an exclusion variable. Numerous attempts at using other département characteristics 32 met with no success. In line with the chosen modelling, none of the variables for local supply of lawyers and thus possible variations in legal fees turned out to be a credible candidate for exclusion 29 There is one level of compensation recorded for each observation: the cases that went to court were indeed previously the object of an out-of-court offer, but the AGIRA databases only provide the final level of compensation. 30 Use of the 14,576 compensation cases from Population characteristics for the reference year 2006 taken from annual surveys Population density, proportions of rural dwellers, immigrants, retired persons, professionally inactive, unemployed, frequency of theft, etc. 17

19 variable 33. Furthermore, their often non-significant nature appears to confirm the idea that these fees are limited and have a limited influence on the decision whether or not to go to court (cf ). Analysis of the choice of procedure according to the time of the accident revealed a much higher rate of going to court for accidents that occurred at the weekend, especially on Sunday (Figure 3). Having an accident on Sunday is the factor operating solely on the selection equation. Its effect on levels of compensation is non-significant, unlike that on the settlement type equation 34. It more often involves young people 35, less often drivers (23.4% on Sunday, as against over 30% on weekdays). Even after controlling for these factors and other available characteristics, the dayof-accident effect continues to significantly increase the rate of going to court. Among possible explanations, one may suppose that the population selected by Sunday accidents is distinguished by more leisure activities, a greater sensitivity to disfigurement, and so on. At all events, having this exclusion variable strengthens the model identification procedure. Figure 3: Rate of going to court varies by day of week of accident Rate of cases going to court (%) Mon. Tue. Wed. Thu. Fri. Sat. Sun. Day of the week In-court settlement Confidence interval (5%) Source: AGIRA databases The other explanatory variables are common to all the equations. Except for those relating to age, gender, year of accident, status of driver, they directly characterise the level of injury observed in the medical examination. The level of injury under the various headings (IPP, pretium doloris, duration of ITT, disfigurement and loss of amenity), age, gender, and year of dispute settlement are thus used. The level of IPP is cross-referenced with age, disfigurement with gender. When 33 Legal fees occur not only in the selection equation but also in out-of-court compensation (Figure 2). Among the variables introduced: number of lawyers, courtrooms per capita in the département or appeal court jurisdiction, average length of proceedings. Sources: Ministère de la Justice (2005), Ministère de la Justice (2006), Moreau (2006), Observatoire du Conseil national des Barreaux (2008). 34 Potential alternatives such as all public holidays, short weekends or long ones (with public holidays) did not turn out to be as convincing as the indicator associated solely with Sunday accidents. 35 Of Sunday accident victims, 32% are aged 16-29, compared with fewer than 25% on weekdays. 18

20 these variables are introduced into the reduced form of the selection equation, they are supposed to take account of the size of the discrepancy in evaluating heterogeneity between out-of-court compensation and in-court compensation compared with possible legal fees. The unobserved individual heterogeneity is by definition not measured in the medical examination, and no information is directly available about legal fees. Consequently, failing all else, we use as an approximation all the variables available, including the characteristics of the observed injury. This is the framework for estimation with the three-equation model. 4.2 Approach assuming exogenous heterogeneity We first consider a heterogeneity that is exogenous in nature. The distribution of the unobserved injuries is determined by the method proposed by Heckman and Singer (1984), initially intended for duration models. The heterogeneity is modelled taking a set of values θ k (k=1,..., K) and their associated probabilities p θk, setting the value of the first support point at zero. These support points and their frequency are introduced into the selection equation and in-court compensation equation. The latter will be used to identify the various levels of heterogeneity. We assume that the evaluation of observed characteristics is similar out of court and in court (β 0 = β 1 ), and compensation is distinguished only by the evaluation of the heterogeneity and the inclusion of the impact of legal fees to be paid by the victim (Fig. 2). The level θ l of the out-of-court settlement, not isolated, is thus a component of the constant in the out-of-court compensation equation, along with any legal fees to be paid by the victim. Denoting θ = (θ 1,..., θ K ) and p θ = (p θ1,..., p θk ), the estimated model has a likelihood of avec : L(α 1, β 1, θ, p θ ) = i/j 1i=0 [ K ] p θk L 0i (α 1, β 1, θ k ) k=1 i/j 1i=1 [ K ] p θk L 1i (α 1, β 1, θ k ) k=1 L 0i (α 1, β 1, θ k ) = 1 ( y0i X 0i ϕ β )( ( 1 Z 1i α + θ k + ρ0 1 Φ σ 0 σ 0 (1 ρ 2 0 ) L 1i (α 1, β 1, θ k ) = 1 ( y1i X 0i ϕ β 1 θ ) ( k Z 1i α + θ k + ρ1 Φ σ 1 σ 1 (1 ρ 2 1 ) σ 0 u 0i σ 1 u 1i The optimal value K of level of heterogeneity is determined by iteration: first the model is estimated with a single support point 36, then further levels of heterogeneity are added until there is no more obvious improvement in the model s likelihood. The configuration with three support points is selected. The support points are denoted θ 1,θ 2 and θ 3 by increasing value. )) ) (11) The results of the economic model shown in Table 2 tend to support the theoretical approach 36 The distribution of heterogeneity is then described as degenerate, because this support point has by definition a zero value identical for all. 19

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