Harmful "adverse selection" in auto
insurance and why insurers resist the remedy

Patrick Butler, Ph.D.

Insurance Project Director

National Organization for Women

September 25, 2003

Inquiry: A US transportation department official questioned the reason insurance companies give for dragging their feet on offering cents-per-mile choice. (Sept. 13, 2003 by e-mail.)

"While technology has been an often-cited barrier to pay-as-you-drive insurance, I believe that willingness/interest of insurance companies to offer this has been the greater barrier."  

Our reply: You are right to conclude that industry resistance is the real barrier to cents-per-mile choice. (The car's odometer is the only technology needed.) In fact, insurers obviously fear that if they made this choice available, their traditional fixed-premium, vehicle-year risk pools would suffer from "adverse selection" by customers shifting their lower-mileage cars to the new per-mile risk pools.

NOW's breakthrough analysis is the first to apply the adverse selection phenomenon to solve a decades old dilemma: Automobile insurers charge the highest premiums in low-income zip codes.

Traditional auto insurance risk pools are inherently unstable because they are tied to car ownership, even though the cost-producing activity is car use. (Every mile a car is driven has a risk of accident and so transfers a statistical but real cost to the car's insurer. This cost would not exist if the mile had not been driven.) Nevertheless, most risk pools do not suffer major adverse selection because enough people can afford to keep full time insurance on cars not driven much. Because these cars bring more premium than cost to the risk pool, insurers call landing their business "skimming the cream." Insurers may use this excess of premiums over costs to compete by holding premiums down for target customers with many insurance needs. Some owners thus pay too much for the miles of insurance protection their cars use, while others pay too little.

Adverse selection by low-income car owners. Major adverse selection against risk pools, however, does take place in the low-income market, which insurers call "hard to serve." An explanatory essay we wrote for a university textbook begins: 'Although forty-eight states make automobile insurance mandatory, tens of millions of cars still go uninsured. Why? Because today's pay-per-car insurance system charges the highest premiums for cars whose owners reside in low-income neighborhoods where many people, by necessity, must economize on insurance by piling all the miles they need to drive on fewer insured cars. Insurance companies defend the high premiums by defaming these people and labeling them "high-risk" drivers. The reality is that the low-income high-risk driver is not a driver at all. It is simply a car that drivers are sharing in order to economize on insurance.' [Essay in pdf]

With cents per mile choice, low-income drivers could keep the cars they need and keep them legally insured.

Prospective adverse selection. However, companies fear that, if allowed the choice, customers in middle and upper income markets with cars driven less than the risk-pool average (cars that insurers now call cream) would switch them to the matching cents-per-mile pool. Those cars would take more premium than miles from the traditional pool. As a result, the traditional pool's average mileage would increase, raising the premium, and causing even more cars to be switched to the new cents-per-mile pool.

Although the prospective upward spiral of average miles and premiums in traditional risk pools is why insurers are afraid to offer a choice, it is identical to the adverse selection that occurs in low-income areas today. Drivers who need to economize have no choice but to take less-driven cars out of traditional pools, and either sell them or drive them illegally. (Enhanced enforcement just makes it riskier to drive an uninsured vehicle and shifts even more miles to those kept insured. This raises per-car costs and premiums even more, which forces more cars out of the insurance pool.)

Confronting the barrier.  To overcome the industry's unspoken fear of adverse selection induced by competition from cents-per-mile choice, we need a public critique of two harmful practices that such competition would end. One is skimming the cream in middle and upper income areas. The other is forcing low-income drivers needlessly to sacrifice cars in response to the adverse selection spiral induced by the industry's own pay-per-car system.

So despite the turmoil and harm it causes, why are companies so set on protecting today's pay-per-car system? Auto insurers are increasingly dependent on costly marketing campaigns, paid for by customer premiums, to sell a "good driver" vs. "high-risk driver" pricing mystique. But cents-per-mile choice would cut out the emotional stereotypes and make auto insurance a commodity like gasoline. The lavish effort to persuade prospective customers that they can magically save "fifteen percent or more" by switching insurers would disappear, along with the extra profits made on this useless expense.

#745, 76x words

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