The Effects of Regulated Premium Subsidies on Insurance Costs

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Weiss, Mary A.; Tennyson, Sharon; Regan, Laureen
Journal of Risk and Insurance, September 1, 2010, Vol. 77, No. 3, 597 – 624.



Marking Scheme

|Component |Weight (%) |Marks Awarded | |Imagination and innovation |10 | | |Summary of main message |15 | | |Critical evaluation |30 | | |Implications |20 | | |Research |15 | | |Presentation |10 | | |Total |100 | |

Summary of Main Message

This article is mainly about having the state regulation of rates 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. 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.

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. 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.

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.

This article also used a panel of annual state-level data on automobile insurance markets to investigate whether distorting insurance prices through rate regulation has a significant impact on automobile insurance loss costs and claim frequency. Insurance claim frequency is examined in addition to loss costs because some of the incentive distortions hypothesized to be created by rate...
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