The 1977 report by the Insurance Bureau and the earlier work by the Federal Insurance Administration exaggerated problems in the insurance market and did not devote sufficient attention to the benefits of competitive underwriting, risk classification, and claim settlement. Substantial restrictions on underwriting and rating adopted in the Essential Insurance Act and in other states have significant drawbacks. [29]

Competitive Underwriting and Risk Classification. Many factors affect the expected costs of accidents for a given driver. The probability and likely cost of damages from an accident will depend on factors such as traffic density, road conditions, the cost of hospitalization, and the cost of vehicle repair parts. They also will be affected by the precautions taken by persons to avoid accidents and to reduce the cost of accidents that do occur. Possible precautions include deciding not to drive, deciding to drive less, purchasing a more crash worthy vehicle, maintenance of vehicle safety, driving more slowly, not driving after consumption of alcohol, paying close attention to traffic conditions and traffic controls, etc. A driver's expected accident costs also depend on his or her honesty and integrity. Drivers are likely to vary significantly in their tendency to create fraudulent losses, inflate claim costs following an accident, or both.

The major economic justification for allowing insurers substantial discretion in underwriting and risk classification is that it provides incentives for drivers and insurers to control claim costs in an efficient manner. [30] Insurance is a loss-sharing mechanism. Policyholders in a given group with greater than average claim costs during the coverage period essentially have their claims paid by their own premiums and by a portion of the premiums of policyholders with lower than average claim costs. While it is customary for the insurer to bear the risk of unanticipated changes in the average cost of losses for a given group during the coverage period, anticipated changes in the cost of coverage over time will be reflected in premiums and thus borne by policyholders. Underwriting and risk classification determine the scope of loss sharing among policyholders.

Competitive pressure and policyholder preferences provide insurers with the incentive to sort policyholders into the most homogeneous groups possible subject to constraints on the availability and cost of information. The desire by policyholders for the lowest possible premium creates the incentive for insurers to reduce rates for drivers with lower than average expected accident costs. As a by-product, premiums for drivers who on average will have higher accident costs will increase. Any insurer that did not engage in risk classification to sort policyholders into the most homogeneous groups possible would lose customers with lower than average expected costs to competitors, attract customers with higher than average expected costs, or both. The insurer would need to raise rates, engage in classification, or both to survive.

Competitive risk assessment does not produce perfect accuracy in the sense that each policyholder pays a premium commensurate with his or her expected loss. Due to inherent constraints on knowledge and the cost of information, some heterogeneity will exist in any rating class (i.e., expected accident costs will not be identical for all policyholders in the class). However, competitive underwriting and rate classification will produce the greatest possible accuracy given such constraints. The resultant system of "cost-based pricing" has a persistent tendency to achieve two related results over time: First, in any rating class it will not be possible ex ante to distinguish drivers with higher than average expected accident costs from drivers with lower than average expected accident costs at a cost that would justify obtaining the information necessary to do so (assuming that such information existed). Second, actual losses will differ significantly between rating classes, but on average it will not be possible ex post to identify subgroups within a class that have experienced significantly different losses using information that could have been obtained at low cost prior to the period of coverage. As such, competitive risk classification operates over time to eliminate "cross-subsidies" among policyholders to the extent that it is cost efficient to do so.

Given discretion, some insurers will engage in "subjective" underwriting. Some of the characteristics that are related to expected accident costs or underwriting expenses are difficult to measure or quantify with objective tests. Examples include an applicant's proclivity to engage in fraud or the likelihood that an applicant will pay subsequent premium installments. In a perfect world, subjective underwriting would not exist, but then neither would claims fraud or nonpayment of premiums. While many observers regard any form of subjectivity as objectionable, it is important to stress that competition will only reward subjective judgment to the extent that it helps to identify policyholders who on average will have either higher or lower claim costs. Erroneous judgments either will be penalized by adverse loss experience (e.g., if the subjective assessment understates expected claim costs), or they will result in an unnecessary loss of sales for the insurer and agent (e.g., if the assessment overstates expected claim costs). As a result, competition will prevent the widespread use of arbitrary underwriting and rating criteria over time. Moreover, subjective underwriting that does occur in states that allow insurers a large degree of discretion in underwriting and rate classification does not result in a large involuntary market (see below).

Significant restrictions on risk assessment are likely to be costly because they distort incentives for claim cost control by drivers, insurers, and policymakers. First, cost-based pricing provides desirable incentives for policyholders to take precautions to reduce expected accident costs. Second, if an insurer bears sole responsibility for the claim costs of its policyholders, it has a strong incentive to minimize the sum of claim costs and the cost of claim settlement. [31] As is discussed further below, reinsurance facilities and joint underwriting associations, which involve pooling of claim costs among insurers, are likely to reduce the incentive for efficient claims settlement. These mechanisms are more likely to be used if restrictions on underwriting and rate classification are adopted. Third, when confronted with rising claim costs and affordability problems, policyholders and insurers have incentives to influence legislation to control claim costs and thus premium growth in efficient ways. [32] Substantial restrictions on underwriting arid rate classification also distort these incentives.

Causes of Large Involuntary Markets. Given substantial discretion in underwriting and rate classification, almost all policyholders are able to obtain coverage in the voluntary auto insurance market, and cyclical fluctuations in prices and the supply of coverage are likely to have only a minor impact on the proportion of drivers insured in the involuntary market. [33] Instead, there are two principal causes of large involuntary markets: (1) inadequate involuntary market rates that compete with and crowd out the voluntary market, and (2) voluntary market rate regulation that produces inadequate rates and thus makes insurers unwilling to write coverage voluntarily. [34]

Table 5

Involuntary Market as a Percent of Total Market in 1987
(Private Passenger Auto Liability)

Selected States

Frequency Distribution

State

Percent

Range

Number of States

Massachusetts

58.47%

50 to 60%

1

New Jersey

44.03%

 

 

South Carolina

32.85%

40 to 50%

1

New Hampshire

30.52%

 

 

North Carolina

22.52%

30 to 40%

2

New York

15.64%

 

 

District of Columbia

15.53%

20 to 30%

1

Rhode Island

12.48%

 

 

Connecticut

9.45%

10 to 20%

3

Delaware

7.25%

 

 

 

 

5 to 10%

2

Michigan

3.04%

 

 

Illinois

0.08%

3 to 5%

7

Indiana

0.06%

 

 

Ohio

0.01%

1 to 3%

6

Pennsylvania

2.17%

 

 

Wisconsin

0.06%

.l to l%

13

 

 

 

 

Countrywide

6.75%

0 to .1%

15

Note: Percent of liability insurance car-years insured in the involuntary market.

Source: AIPSO Circular RMC 89-14, April 14, 1989


Table 5 presents information on the size of the involuntary market in Michigan and other states in 1987. Seventeen states had involuntary market shares (of total insured car-years for liability coverage) greater than or equal to three percent. Michigan ranked 17th with an involuntary market share of 3 percent. Twenty-eight states had less than one percent of insured vehicles in the involuntary market. Fifteen of these states (including the neighboring states of Illinois, Indiana, Ohio, and Wisconsin) had less than one tenth of one percent of insured vehicles in the involuntary market. The five states with the largest involuntary market shares each have substantial restrictions on underwriting and rate classification, restrictive voluntary and involuntary market rate regulation, or both. Most of the other states with greater than one percent of insured vehicles in the involuntary market regulate voluntary market rates or are likely to hold involuntary market rates below the expected cost of providing coverage for some groups.

The 1977 report by the Insurance Bureau emphasized an increase in the number of applications in the Michigan assigned risk plan, but it did not mention the share of vehicles insured in this plan.[35] Figure 3 shows the percentage of vehicles insured in Michigan's involuntary market each year from 1973 to 1987. As can be seen, the percentage increased sharply in 1977. However, at its peak in 1978, the involuntary market accounted for just over four percent of total insured vehicles. The involuntary market share declined to just over two percent by 1980, the year prior to the effective date of the Essential Insurance Act. [36]

Between 1975 and 1977, the involuntary market share in Illinois increased from 0.44 percent to 1.04 percent. It declined in 1978. Ohio's involuntary market share increased from 0.18 percent in 1975 to 0.20 percent in 1977; it declined in 1978.[37] Why was Michigan's involuntary market share and the increase in its share larger than for its industrial neighbors during this period? The most likely causes are either lags in voluntary market rate approval during a period of rapid growth in claim costs, inadequate involuntary market rates, or both. [38]