Liability Insurance: Equilibrium Contracts under Monopoly and Competition

In liability lawsuits (e.g. patent infringement) a plaintiff demands compensation from a defendant and the parties often negotiate a settlement to avoid a costly trial. Liability insurance creates bargaining leverage for the defendant in this settlement negotiation. We study the characteristics of equilibrium contracts in settings where this leverage effect is a substantial source of value for insurance. Our results show that under adverse selection, a monopolist offers at most two contracts, which under-insure low-risk types and may inefficiently induce high-risk types to litigate. In a competitive market, only a pooling equilibrium with under-insurance may exist.<br>