Policy Documents

The Causes and Consequences of Rate Regulation in the Auto Insurance Industry

Dwight M. Jaffee and Thomas Russell –
January 1, 1998

The extent and detail of state regulatory control over the auto insurance industry has increased markedly in the last ten years. In many cases, this change in the regulatory environment has come about as a consequence of well-organized, grass roots, consumer activism. The passage of California's Proposition 103, a voter initiative which, among other provisions, enacted a roll-back of insurance premium rates and a limit on the actuarial information which could be used in setting these rates, is a case in point. Proposition 103, however, is by no means unique; following its passage in November 1988, 44 states considered similar regulatory changes, and similar legislation passed in the states of Nevada, New Jersey, South Carolina, and Pennsylvania (see Rosenfield [1991]).

These "populist" moves to regulate auto insurance rates are based on the view that the insurance industry uses "unfair and discriminatory pricing practices".Two forms of regulation have been imposed. One form restricts the factors that insurance companies are allowed to use in defining risk categories --this is called rate compression. A second form restricts either the overall level of premiums or the rates applied to particular categories -- this is called rate
suppression; see Harrington [1992] for a discussion of this term. We use the term rate regulation to refer to compression and suppression together.

Rate compression is illustrated by California's Proposition 103 which stipulates that, without the additional approval of the insurance commissioner, passenger automobile insurance rates may apply only the following three factors:

(1) the driver's safety record,
(2) the number of miles driven annually, 
(3) the number of years of driving experience.

Such characteristics as the driver's place of residence, age, sex, and marital status could no longer be used without the approval of the insurance commissioner. These factors were frequently used by insurance companies prior to the passage of Proposition 103.

Rate suppression is used in Massachusetts, where premiums in many categories are explicitly set below the actuarial cost--a system called tempering. Blackmon and Zeckhauser [1991] report that in Massachusetts, expected costs vary across drivers by a factor of 4.4, but premiums vary by only a factor of 3. Expected costs vary across territories by a factor of 2.7, but premiums vary by only a factor of 2.

Insurance companies, of course, have an incentive to reject customers who must be charged suppressed rates. Since auto insurance is mandatory in all states, rejected customers still need insurance, which is generally provided through assigned risk pools. Drivers who are denied auto policies are placed in the assigned risk pool, and charged a premium that may be below the actuarial costs. Each auto insurance company in the state is then required to take a share of the assigned risk pool equal to its share of the overall market. 

Standard welfare economics provides no simple explanation for regulatory pressures in this market. There are two factors which may work in the direction of welfare enhancement. First, in a world of imperfect information and costly sorting, rate compression could work to curtail a tendency to form (socially) too many risk categories. Second, by lowering premiums, rate suppression could induce previously uninsured drivers to purchase coverage, thus eliminating externalities associated with uninsured motorists. On the other hand, as with any cross-subsidization scheme, there are obvious welfare losses associated with rate regulation. Drivers who are charged premiums above their true costs will underconsume driving, auto insurance, or both, and vice versa. The net welfare effect of regulation is thus far from clear.

Given this, the question arises why the auto insurance industry has emerged as a primary target for increased regulation. The main goal of this paper is to try to answer this question by linking the possible sources and consequences of rate regulation. The agenda of the paper is the following. Section 2 develops the economics of auto insurance for an unregulated industry. Section 3 outlines the details of Proposition 103. Section 4 explores the various sources of demand for rate regulation, including the populist sentiments already mentioned Section 5 looks at the economic effects of rate regulation. Section 6 provides empirical results that evaluate the welfare effects of auto insurance regulation. Section 7 provides corresponding empirical results concerning the voting record on Proposition 103. Section 8 provides conclusions and topics for future consideration.