Experience-Rating of Automobile Insurance: A Good Idea that Won't Work
This article first appeared on page A21 of the October 16, 2003 Calgary Herald, and then in the summer 2003 issue of the Expert Witness.
Imagine you have two drivers who drive the same kind of car, live in the same city, and have the same driving record over, say, the last three years. Doesn’t it make sense that they should pay the same automobile insurance premiums?
Apparently, it made sense to the provincial government’s Automobile Insurance Reform Implementation Team. Yesterday, they recommended legislation that will require automobile insurance companies to use “experience rating.”
In a nutshell, experience rating refers to a system in which the only factor that determines your premiums is your driving record. All drivers who have no “experience” of accidents, speeding violations, drunk driving charges, etc. pay the same, relatively low base premium. Then, as they experience one or more of these events, their premiums rise accordingly – and, as they have additional years in which they do not experience these events, their premiums decline.
Experience rating has two highly desirable characteristics. First, the individual driver has complete control over his or her premiums. If you drive cautiously, avoiding accidents and driving violations, your premiums will decline to the lowest available rate.
Most importantly, your rate will not be higher than anyone else’s just because you happen to belong to a group, like young males, that has a relatively high accident rate.
Second, it has been shown consistently that when insurance premiums are related to experience, accident rates fall. When individuals know that they can reduce their premiums significantly by driving more carefully, they do so. And, of course, if the number of accidents decreases, so will insurance premiums.
It seems like experience rating is a win-win proposition. If so, then why hasn’t it been introduced before? The simple answer is that it results in a situation in which insurers know they will make substantial profits on some classes of customers and lose money on others. Thus, it gives them a strong incentive to refuse to insure the money-losing group.
In the scheme proposed by the government, that group will be composed primarily of young males.
Insurers will lose money on them because the number of accidents a driver has had in the past is only loosely related to the number that they can be expected to have in the future. What decades of statistics tell us is that a nineteen year-old male with a perfect, three-year driving record is more likely to have an accident in the next year than is a forty-year old male with the same driving record.
And a nineteen year-old who had an accident last year is more likely to have an accident next year than is a forty-year old with the same experience.
This means that insurers will expect to pay out more claims to nineteen year-old drivers than to forty year-old drivers.
Assume, for example, that 10 percent of nineteen year-old drivers who have had a clean record for three years will have an accident in the next year; whereas only 5 percent of forty year-olds with a similar record will have an accident next year. If the average accident costs the insurance company $10,000, then it will expect to pay out an average of $1,000 for each nineteen year-old and $500 for each forty year-old.
If the government forces insurers to charge the two groups the same premium, they will have to charge something between $500 and $1,000 just to cover their expected claims costs. For example, if the two groups were the same size, the premium would be $750 (the average across the two).
But this means that they will expect to make a $250 profit on the average driver in the older group and a $250 loss on the average driver in the younger group.
As insurance companies are out to make profits, we can expect that they will respond by doing their best to attract older drivers – and to turn away younger drivers.
The stakes are high. Those companies that find themselves with a relatively high percentage of young drivers will lose money and will soon be forced out of the market. Companies will use every loophole at their disposal to attract as many drivers in the older age groups as possible.
Advertising will be focused on older drivers – ads will appear primarily in magazines that appeal to middle-aged consumers, for example, and music in TV ads will be taken from the 1960s. Agents will be instructed to make it difficult for younger drivers to obtain insurance. And incentives, like toaster ovens for new clients, will be offered that will appeal primarily to older drivers.
The result is that the government will have to introduce ever-stricter regulations, to ensure that all drivers are able to obtain insurance. It will be interesting to see whether this degree of interference in the private sector is something that a market oriented government is willing to countenance.