"If there is an "incident" where the CFI in the airplane does not have a medical; then the CFI will get hammered by the FAA. The FAA will not buy into the "semantics game" of who is really the PIC."

Absolutely not. It is clear in the regulations when an instructor needs a medical and when he/she does not. There's no game. Only one pilot can ACT as PIC and it does NOT need to be the instructor. The FAA cannot hammer an instructor when something goes wrong if the instructor is not ACTing as PIC. Now, the insurance company and lawyers are a different thing. Read FAR 61.23(b)(5):

"(b) Operations not requiring a medical certificate. A person is not required to hold a medical certificate:

(5) When exercising the privileges of a flight instructor certificate if the person is not acting as pilot in command or serving as a required pilot flight crewmember."

I think that's pretty clear. If the instructor is not ACTing as PIC then they are not exercising the privileges of ANY pilot certificate, so NO medical is required.

Here's a legal interpretation supporting this issue:

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MR. WILLMOT E. WHITE

Dear Mr. White:

This is in response to your letter of August 13, asking whether a certificated flight instructor (CFI) would be permitted to perform certain instructing duties without a valid medical certificate. You also state that the flight instructor would not necessarily have to act as pilot in command.
Section 61.3(c) of the Federal Aviation Regulations provides, in pertinent part, that no person may act as pilot in command or in any other capacity as a required flight crewmember of an aircraft under a certificate issued under part 61, unless that person has in his or her personal possession an appropriate current medical certificate issued under Part 67. Section 61.19(d)(1) provides that a flight instructor certificate is effective only while the holder has a current pilot certificate and a medical certificate appropriate to the pilot privileges being exercised.
Accordingly, a CFI giving flight instruction need not possess a valid medical certificate if the instructor is not exercising pilot privileges as pilot in command or a required crewmember.
It would be necessary for the CFI to act as pilot in command if the person being instructed were not qualified to do so, eg. if that person had not and the biennial flight review required by Section 61.57(a). similarly, the type certificate of the aircraft on which instruction is being given requires more than one pilot crewmember, the CFI would have to act as a required crewmember, unless another qualified pilot is in the aircraft.
We trust this satisfactorily answers your question.

Sincerely,

Original Signed by Carl B. Schellenberg
CARL B. SCHELLENBERG
Assistant Chief Counsel
Assistant Chief Counsel
Regulations and Enforcement Division
Office of the Chief Counsel

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It is a misconception that you need a second-class medical to instruct (whether or not you get paid). You need a commercial certificate to get the flight instructor's certificate. By instructing you are not exercising the privileges of your commercial certificate.