The Economics and Politics of Automobile Insurance Rate Classification
Harrington, Scott E., Doerpinghaus, Helen I., Journal of Risk and Insurance
Austin, Regina, 1983, The Insurance Classification Controversy, University of Pennsylvania Law Review, 131: 517-583.
Baumol, William J., 1991, Technological Imperatives, Productivity and Insurance Costs, Geneva Papers on Risk and Insurance, 16: 154-165.
Becker, Gary, 1983, A Theory of Competition Among Pressure Groups for Political Influence, Quarterly Journal of Economics, 98: 371-400. The Risk Classification Debate
The pooling of losses in private insurance markets allows risk averse individuals and businesses to achieve valuable reductions in risk. Market-determined risk classification schemes and associated insurance prices affect the societal allocation of the cost of risk. Market classification also affects the magnitude of the cost of risk by influencing the types and amounts of risky activities that are undertaken and the level of precautions taken to reduce losses for any given level of risky activity. The cost of risk also depends on insurer claim settlement practices, including the incentives for insurers to pay contractually specified claims and to detect and control fraud, and on numerous laws and institutions that affect the frequency and severity of accidents and insured claims.
The efficacy of risk classification in private passenger automobile insurance markets has been debated for at least two decades. A number of states have significantly restricted certain types of information that can be used by insurers, such as age, sex, marital status, and territory; and they have set limits on discretionary underwriting, established requirements that involuntary market insureds without accidents and convictions be charged rates similar or identical to voluntary market insureds, and adopted other constraints (see Mintel, 1983) that cause involuntary market rates to fall below the expected cost of providing coverage. Advocates of these limitations characterize certain types of market classification as unfair, arbitrary, or both (see Shayer, 1978, and Abraham, 1985, 1986; also see Federal Insurance Administration, 1974; Koston, 1979; Underwood, 1979; Austin, 1983; Wortham, 1986; and Butler, Butler, and Williams, 1988). For example, market classification in the automobile insurance industry is said to produce rates that are unaffordable to many buyers and to reflect characteristics that are not causally related to losses, that are not within the buyer's control, that provide little or no incentive for increased safety, or that are socially inadmissible.
In contrast, the actuarial community generally argues that pricing and classification should be cost-based; that is, the price charged to a buyer should reflect the estimated expected value of claim costs under the contract plus a loading to cover administrative costs and to provide compensation for bearing the risk. Much of this literature deals with technical aspects of pricing and classification to achieve predictive accuracy. The actuarial literature responds to criticisms of insurers' risk classification methods by stressing the importance of achieving the most homogeneous rate classes possible given imperfect and costly information on expected losses (e.g., Walters, 1981; also see Casualty Actuarial Society, 1988; Stanford Research Institute, 1976; and National Association of Insurance Commissioners Advisory Committee, 1979). Thus, each rating class should contain no clearly identifiable subsets of buyers with different expected losses. This literature also emphasizes that risk classification must consider the accuracy of information used and the cost of obtaining information. It is argued that affordability problems should not be addressed by regulatory restrictions on pricing and classification and that, given the costs of information, competitive pricing and risk selection produce the greatest possible degree of homogeneity.
Economic analysis of insurance classification generally focuses on the efficiency of market classification. …