– Srujan Sangai

Introduction

Industrial progress historically brought workplace risks, necessitating legal frameworks for worker protection. In India, this evolution is marked by a crucial transition from the Employee’s Compensation Act, 1923 (hereinafter “EC Act”), an early colonial-era statute based on direct employer liability for occupational injuries, to the Employees’ State Insurance Act, 1948 (hereinafter the “ESI Act”). Enacted post-independence amidst global shifts in social welfare thinking, the ESI Act signified a paradigm shift towards a contributory social insurance model, aiming for more comprehensive security. This article analyzes the significant shift from this employer-liability model to the social insurance framework of the ESI Act. The author(s) contends that the ESI Act, despite its own implementation challenges, represents a conceptually superior and economically more rational framework for worker protection. Through a law and economic analysis of the shift from compensation to insurance model, the article will argue that the ESI Act’s design more effectively rectifies market failures and enhances legal protections and hence, is a more efficient model. It also considers the limitations of the given approach and concludes by providing a justification for the shift. 

Historical Context and Foundation

The early 20th century witnessed the rapid expansion of industries in India, such as textiles, mining, and railways. This growth, however, was often accompanied by hazardous working conditions and a high incidence of industrial accidents. The existing common law system provided little recourse for injured workers or their families, as employers could readily invoke defences like the doctrine of common employment, contributory negligence, and volenti non fit injuria (assumption of risk). It was against this backdrop and similar legislative developments in Britain and other industrialized nations, that the Workmen’s Compensation Act, 1923, was enacted. As Merton C. Bernstein discusses in the context of American workmens’ compensation laws, these early statutes were a response to the “particular exigencies existing at the end of the nineteenth century and in the early twentieth”. Their core principle was to impose upon employers “absolute liability for income loss and medical expense caused by work-related injuries or illness,” in return for which the employer was relieved of common law liability based on fault, and the compensation amounts were typically limited. 

The Indian EC Act mirrored this line of thought. Its preamble explicitly states its objective as “An Act to provide for the payment by certain classes of employers to their [employees] of compensation for injury by accident.” Section 3(1) of the EC Act enshrined the employer’s liability for personal injury caused to an employee by an accident “arising out of and in the course of his employment.” This established a form of ‘no-fault’ liability regime, a significant departure from the fault-based common law system. However, this was tempered by provisos, notably in Section 3(1)(b), which excluded employer liability for injuries (not resulting in death or permanent total disablement) directly attributable to the employee being under the influence of drink or drugs, willful disobedience to safety orders, or willful removal of safety devices. The Act’s initial scope was restrictive. As Ravi Ahuja notes, the scope of workmen’s compensation in colonial India was “defined much more narrowly than, for instance, in Britain,” with exemptions for crucial sectors like agriculture and small-scale industries. The definition of ’employee’ under Section 2(1)(dd) and the specific list of covered persons in Schedule II confined its application largely to organized industrial settings and hazardous occupations. Coverage for occupational diseases (Schedule III) was also an integral, if initially limited, part of the Act. Bernstein observes that in many workmen’s compensation systems, coverage for occupational diseases “creep into the laws” much later and often cautiously.

A Law and Economics Analysis of the Shift from Compensation to Social Insurance

The transition from the EC Act’s employer liability model to the ESI Act’s social insurance framework can be strongly justified from a law and economics perspective, which evaluates legal rules and institutions based on their efficiency, impact on resource allocation, and ability to minimize societal costs. 

Economic Inefficiencies and Transaction Costs of the Employer Liability Model (EC Act)

The EC Act, while aiming to provide relief, suffers from several economic inefficiencies. First, information asymmetries and high adjudication costs. Determining whether an injury “arose out of and in the course of employment” (Section 3(1) of EC Act) and the precise quantum of compensation under Section 4 of the EC Act often involves significant information asymmetry between the employer and the employee. The employee, typically less resourced, bears a substantial burden of proof. This asymmetry, coupled with conflicting interests, leads to disputes requiring adjudication by Commissioners. Such individualized adjudication for each contested claim generates high transaction costs, including investigation, legal fees, expert testimony, and the administrative costs of the adjudicatory machinery. As Bernstein argues, such systems, contrary to their intent, often perpetuate litigation and its associated costs. This represents a diversion of resources from direct benefits to dispute resolution. 

Second, inefficient risk bearing and externalization of costs. The EC Act places the full financial risk of compensation on the individual employer. From an economic perspective, this is an inefficient way to manage risks that, while arising in individual workplaces, are statistically predictable across industries. Smaller employers, or those in volatile sectors, might find it difficult to bear the cost of a catastrophic accident or a series of claims. While Section 14 of the EC Act addresses employer insolvency by giving employees rights against insurers, this protection is contingent on the employer having (adequate) insurance. If an employer is uninsured or underinsured and becomes insolvent, the cost of the injury is effectively externalized, borne by the injured worker, their family, or public/charitable support systems, rather than by the enterprise that generated the risk. This misallocation of costs distorts the true economic cost of production. 

Third, moral hazard and disincentives for optimal precaution/rehabilitation. The EC Act model can create certain moral hazards. On the employer side, if the probability of being held liable or the expected payout is perceived to be low (due to litigation complexities or ability to contest claims successfully), there might be suboptimal investment in workplace safety – a deviation from the ‘cheapest cost avoider’ principle where the party best placed to prevent the harm (often the employer) should be incentivized to do so. On the employee side, the structure of benefits, particularly lump-sum payments for permanent disability, (Section 4(1)(b) & (c), and commutation under Section 7 of EC Act) while providing immediate liquidity, could, in some cases, reduce incentives for active rehabilitation and a swift return to productive employment if the compensated sum is perceived as a final settlement for future earning capacity.

Fourth, limited scope and unaddressed negative externalities. The EC Act’s narrow focus on specific employment injuries and a limited list of occupational diseases (Schedule III of EC Act) leaves many common causes of worker incapacity, such as general sickness or non-scheduled occupational illnesses, unaddressed. The economic consequences of such uncovered risks, lost wages, medical expenses, reduced productivity, are borne by the individual worker or society, constituting significant negative externalities not internalized by the production process.

Economic Rationale and Efficiency Gains of the Social Insurance Model (ESI Act)

The ESI Act’s social insurance model offers several economic advantages over the direct employer liability system. First, superior risk pooling and spreading. The core economic strength of the ESI Act lies in its mechanism for pooling and spreading risks. The creation of the ESI Fund (Section 26 of ESI Act) financed by mandatory contributions from a large base of employers and employees (Section 39 of ESI Act), embodies the core principle of insurance. As Kenneth Arrow highlighted in his work on risk-bearing, insurance markets function to transfer risks from those less willing or able to bear them to entities (like an insurance pool) that can manage them more efficiently due to diversification and the law of large numbers. This collectivization of risk makes the financial impact of individual contingencies (sickness, injury, maternity) manageable and predictable for both employers (through fixed contributions) and employees (through assured benefits). 

Second, reduction of transaction cost. A centralized administrative body like the Employees’ State Insurance Corporation (hereinafter “ESIC”), responsible for benefit provision and management, can achieve economies of scale and scope, potentially reducing average transaction costs per claim. Standardized benefit structures (Section 46 of ESI Act) and claims procedures can minimize disputes over quantum. The statutory presumptions regarding employment injury (Section 51A of ESI Act) and specialized ESI Courts (Section 74 of ESI Act) are designed to streamline adjudication. While large bureaucracies can have their own inefficiencies, the ESI model, in principle, moves away from the high costs of individualized litigation inherent in the EC Act. Deakin and Wilkinson, referencing Coase, argue that in a world of positive transaction costs, legal rules matter for efficiency. They contend that “unregulated markets are characterised by high transaction costs…and which produce mismatches between effort and reward. The law has a role to play in underpinning institutions…in order to facilitate effective coordination of economic resources.” The ESI Act is such an institution. Early law and economics (Schwab’s ‘Era One’) emphasized market efficiency with minimal intervention, but later approaches (‘Era Two’) recognize the role of law in correcting market failures, a category into which the ESI Act squarely fits.

Third, internalizing externalities, externalising risk and investing in human capital. By providing comprehensive medical benefits (Sections 56-59 of ESI Act) and sickness benefits (Section 46(a) of ESI Act), the ESI Act internalizes some of the health-related externalities that the EC Act ignores. Investment in worker health is an investment in human capital, a concept central to the work of economists like Theodore Schultz. A healthier workforce is more productive, has lower absenteeism (a key concern for efficiency as noted by Ahuja in the Indian context), and contributes more effectively to economic growth. The ESI Act’s provision for maternity benefits also supports workforce participation and family well-being, which has positive economic spillover effects. The power of the ESIC to promote health and rehabilitation measures (Section 19 of ESI Act) is a direct investment in maintaining and enhancing this human capital.

Fourth, addressing asymmetric information and adverse selection. Compulsory participation in the ESI scheme for covered establishments (Section 38 of ESI Act) is crucial for overcoming adverse selection, a market failure where voluntary insurance schemes attract disproportionately high-risk individuals, leading to unsustainable costs. By mandating coverage, the ESI Act ensures a broad and diverse risk pool. Furthermore, the provision of standardized information regarding benefits and entitlements can help reduce information asymmetry between the insured and the insurer (ESIC). Lastly, mitigating moral hazard (potentially better aligned incentives). The ESI Act’s structure of periodical payments for disablement and sickness, often contingent on continued medical certification and supervision (Section 64 of ESI Act), can create better incentives for recovery and discourage malingering compared to the potentially distorting effects of lump-sum payments under the EC Act. The focus on providing medical care directly, rather than just reimbursing expenses, also allows for better management of treatment pathways and costs. 

Arguing in Favour of Shift

The move towards the ESI model aligns with several established principles in law and economics. First, social insurance is generally considered more efficient for allocating risks that are widespread, difficult for individuals to self-insure against, and where private insurance markets may fail due to issues like adverse selection or catastrophic risk concentration (as could happen with a single employer under EC Act). Second, as per Guido Calabresi’s work on accident law, the underlying principle of minimizing the sum of accident costs and accident prevention costs is relevant. The EC Act primarily focuses on compensating for accident costs post-facto, with uncertain incentives for prevention. The ESI Act, by pooling resources and potentially investing in health and safety promotion, alongside providing compensation and medical care, offers a more holistic approach to reducing overall social costs. While it shifts the direct cost from the ‘cheapest cost avoider’ (the specific employer in an accident) to a collective pool, the system ideally creates a broader framework for managing these costs. Third, private markets for health and disability income insurance for low-wage industrial workers are often characterized by significant failures (adverse selection, moral hazard, high administrative costs for small policies, affordability issues). State-mandated social insurance like the ESI scheme is a classic response to such market failures, aiming to achieve broader and more equitable coverage than the market alone would provide. Fourth, from a welfare economics perspective, the ESI Act, by providing a safety net against multiple risks, has the potential to lead to a Pareto improvement (making some better off, the workers,  without making others worse off, assuming employers’ contributions are seen as a fair cost of business or are offset by productivity gains) or at least a Kaldor-Hicks improvement (where the gains to the beneficiaries are large enough that they could theoretically compensate any losers).

The shift, therefore, was not just a matter of expanding social justice but also of adopting a system with a stronger economic rationale for managing the risks inherent in industrial employment and promoting the well-being and productivity of the workforce. 

Limitations of Law and Economics Approach

While the law and economics analysis strongly supports the conceptual superiority of the social insurance model embodied in the ESI Act, its actual trajectory in India reveals a significant gap between theoretical benefits and practical realization. Ravi Ahuja’s research critically highlights that the ESI Act, despite any universalist rhetoric or aspirations influenced by global models like the Beveridge Plan, became a key instrument in the making of the formal sector in India.

The Act’s application, initially limited to factories and extended only gradually and selectively, meant that its comprehensive benefits reached only a minority of the Indian workforce. This created and solidified a structure of graded entitlements, where formally employed workers received a certain level of social security, while the vast majority in the agricultural and unorganized/informal sectors remained excluded. The exclusion represents a major economic inefficiency from a societal perspective, as the unaddressed risks (illness, injury, income loss) in the informal sector continue to impose heavy burdens on individuals, families, and public resources, hindering broader human capital development and economic progress. Furthermore, the administrative machinery of the ESIC, while theoretically capable of achieving economies of scale, has faced its own challenges regarding efficiency, quality of service delivery (especially in medical care), and bureaucratic hurdles, which can dilute some of the anticipated economic gains. One major issue is the lack of outcome measuring. The system tends to focus on process and rules rather than on actual results like improved health outcomes for beneficiaries. ESIC lacks modern information and risk management systems, and it doesn’t prioritize transparently reporting on customer experience, grievance resolution, or health outcomes. This is compounded by the fact that ESIC’s reserves are substantial, larger, in fact, than the Union government’s entire healthcare budget, yet they remain unspent, indicating a major resource management problem. The ESIC system is also plagued by a governance birth defect. The ESIC, is an autonomous government agency with a large executive body of 59 members, making meaningful discussion and decision-making nearly impossible. Moreover, the system suffers from a lack of competition, with mandated contributions giving it hostages rather than clients. This lack of competition means there is little incentive to improve service quality, leading to high levels of dissatisfaction among beneficiaries. These systemic issues are starkly illustrated by real-world examples. A key finding from a “Safe in India” report (CRUSHED 2025) is that a significant proportion of injured workers only receive their ESIC e-Pehchaan card after an accident, despite it being a mandatory requirement from the first day of employment. This practice is more prevalent in Maharashtra (77% of cases) than in Haryana (60% of cases) and has not shown significant improvement over the years. This is often due to employers hiding workers from payrolls or delaying the issuance of cards to save on administrative costs and prevent workers from accessing benefits like sickness leave or maternity benefits. The practice of registering workers post-accident is illegal, yet the penalties are so minimal they are not a deterrent. This negligence can lead to workers being taken to private hospitals first, which may delay proper treatment within the critical ‘golden hour’ and result in a greater disability. The case of Ranjay Kumar, who waited eight years for his ESIC pension due to a lost file, poignantly highlights how systemic inefficiency and a lack of accountability prolong a worker’s suffering and financial burden. The ‘teething troubles’ and employer resistance to contributions that Ahuja documents in the early years of the ESI Act also point to the practical difficulties in implementing such a large-scale social insurance scheme.

Conclusion 

From a law and economics perspective, the legislative transition from the Employee’s Compensation Act, 1923, to the Employees’ State Insurance Act, 1948, was an unequivocally rational and economically justifiable development for India’s industrial workforce. The ESI Act’s social insurance model offered superior mechanisms for efficient risk pooling and spreading, potential reductions in transaction costs associated with dispute resolution, internalization of health externalities, and a framework for investing in human capital. However, the profound economic benefits that social insurance can yield are contingent upon the breadth and depth of its application. In the Indian context, the ESI Act’s most significant economic limitation has been its restricted scope, which, as argued by Ahuja, contributed to segmenting the labor market rather than fostering universal social protection. The ‘horizon of expectation’ for comprehensive security that the ESI Act created remained unfulfilled for the majority of Indian workers. Therefore, while the shift itself was economically sound in principle, the challenge for India has been, and continues to be, the extension of such rational social insurance mechanisms to the vast swathes of its working population still grappling with risks largely unmitigated by formal statutory protection. The economic arguments that favored the ESI Act over the EC Act for the organized sector remain potent justifications for further reforms aimed at achieving more inclusive and universally effective social security for all, a goal also emphasized by international bodies like the ILO in promoting social protection floors.