The Effects of Regulated Premium Subsidies on Insurance Costs: An Empirical Analysis of Automobile Insurance

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ABSTRACT

State regulation of rates is sometimes used as a means to make automobile insurance more affordable to consumers by restricting insurer profits and pricing practices. Incentive distortions arising from this type of rate regulation might lead to higher accident rates and higher insurance loss costs. Annual state-level panel data for the time period 1980-1998 are used to investigate these effects, using empirical methods that recognize the endogenous determination of states' regulatory choices. Results suggest that rate regulation that systematically suppresses (some or all) drivers' insurance premiums is associated with significantly higher average loss costs and higher insurance claim frequency.

INTRODUCTION

Automobile insurance is a compulsory purchase for most drivers in the United States and represents a significant expense for many. Partly because of this, many states regulate automobile insurance prices. Although there are several stated goals of automobile insurance regulation, the objective of much rate regulation is premium affordability (e.g., Harrington, 1987; Grabowski, Viscusi, and Evans, 1989; Bouzouita and Bajtelsmit, 1997). In particular, regulators are interested in auto insurance rates that are adequate, so that insurance is readily available in the market, but not so high that insurance is unaffordable to drivers.

Several mechanisms might be used to make automobile insurance rates affordable to drivers. Regulators may intervene in automobile insurance markets to reduce premium levels for high-risk drivers, to limit average rate increases for all drivers, and/or to reduce premium variation across drivers. One widespread mechanism involves suppressing insurance premiums for the highest risk drivers and financing these lower rates through surcharges to low-risk drivers. This leads to high-risk drivers paying less, and low-risk drivers paying more, than they would under a purely cost-based pricing system.

If only a small proportion of drivers in a state are high risk, or if only a small proportion of high-risk drivers receive a premium subsidy, then the distorting impact of regulated pricing is likely to be insignificant. Similarly, if subsidies paid to high-risk drivers are just a small portion of low-risk drivers' premiums, incentive distortions for low-risk drivers may be minimal. On the other hand, it is possible that regulatory intervention will lead to premium pricing that is far removed from each driver's expected loss costs. In this case, the combined effects of regulatory incentive distortions may be substantial.

To the extent that they are present in a market, some distortions to driver incentives that are created by regulated insurance pricing will have the effect of increasing the expected costs of insurance relative to a cost-based system of pricing. For example, if high-risk drivers' premiums do not reflect their higher expected accident costs, they may be expected to drive more and to purchase more insurance coverage (Blackmon and Zeckhauser, 1991; Harrington and Doerpinghaus, 1993). Similarly, because low-risk drivers pay relatively more for coverage they may drive less and perhaps choose lower insurance limits. In combination, these changes to insuring and driving decisions would lead to an insurance pool in which high-risk drivers are more heavily represented and thus to higher average insurance costs. Economic theory also predicts that the safety investments of all drivers may be diminished when premiums are not fully based on accident experience (Shavell, 1982). Similarly, regulatory pricing that weakens the links between claim experience and insurance premiums may reduce the disincentives to filing fraudulent claims. These effects of regulation on safety and claiming decisions would lead to higher rates of accidents and claims and thus to higher average insurance costs.

Research on other insurance markets such as workers compensation has documented a significant adverse impact of regulatory premium distortions on insurance costs. …