Contracting around tort defalts: The knock-for-knock principle and accident costs

Tort liability coupled with third party insurance is the prevalent way of regulating harmful activities in our, and other, legal systems. The imposition of tort liability is supposed to discipline actors by prodding them to adopt the socially optimal level of precautions, while the availability of third party insurance guarantees compensation to victims. Together, private liability and third party insurance accomplish the dual goals of deterrence and compensation. Curiously, the gas and oil industry elected to largely opt out of the tort system, as well as of third party insurance and adopt, in their stead, the “knock for knock” principle under which each party bears its own cost in the event of an accident and must insure against its own losses. The “knock-for-knock” principle resurrects contractually the world of first party insurance, one in which tort suits simply do not exist.
In addition to documenting the phenomenon and explaining it, the Essay seeks to assess the efficiency of the knock-for-knock regime. Members of the gas and oil industry firmly believe that the knock-for-knock rule is beneficial from the industry’s standpoint on account of the litigation cost savings it effects. Surprisingly, no one, to date, has sought to determine the desirability of the rule from a societal standpoint. In order to determine the welfare effect of the rule it is necessary to balance the savings to the industry against the loss in deterrence that stems from the rule. The Essay concludes that the knock-for-knock principle is welfare-enhancing only under very specific conditions that are unlikely to obtain in the gas and oil industry. We therefore recommends that knock-for-knock clauses should be tolerated, if at all, only in developed countries where they produce the highest private gains for members of the gas and oil industry, while arguably posing a manageable public risk. By contrast, they should be banned in developing countries where, by the lights of our analysis, they yield modest private gains while posing a significant risk of harm.