Consequences of the Act

Cross-Subsidies from Low to High Risks. The limitations on cost-based pricing in the Essential Insurance Act have created subsidies (lower premiums) for some groups and implicit taxes (higher premiums) for other groups. For many rating classes, insurers are able to identify subgroups ex ante that on average will be likely to have different levels of losses, and historical losses for these subgroups will be significantly different. In general, the direction of the resultant subsidies is from drivers who on average have lower expected claim costs to drivers who on average have higher expected claim costs.

The most obvious examples of subsidies in Michigan include: (1) young females subsidizing young males, (2) young married persons subsidizing young single persons, and (3) the tendency for persons who reside in areas with low accident costs to subsidize persons in areas with high accident costs. [39] If cost-based pricing is allowed, the use of sex, marital status, and territory as rating variables significantly improves the accuracy of rate classification. Within reason, these traits can be observed with a high degree of accuracy and for a relatively low cost. [40] While these characteristics may not be readily controlled by the person, their use in rate classification is neither subjective nor arbitrary.

Rates for the MAIPF also are likely to produce a subsidy because they are designed to be competitive with voluntary market rates in certain cases. By law, base rates for the MAIPF in the highest rated territory are set equal to the average of voluntary market base rates for the top five insurers. Base rates for other territories are set from 105 percent to 120 percent of the average voluntary market base rates for the top five companies, with the higher rated territories receiving the lower percentage increases. Since many drivers in the MAIPF will not meet the law's requirements for a mandatory offer of voluntary market coverage, the average driver in the MAIPF will tend to have significantly higher expected accident costs than drivers who are insured voluntarily. Prior approval regulation of MAIPF rates also may constrain rates below expected costs for some groups of drivers. The overall system tends to produce a subsidy to drivers who on average have higher expected accident costs, and the subsidy will tend to be greatest for drivers in the Detroit area due to the restrictions on MAIPF base rates in territories with the highest voluntary market rates. While the magnitude of the assessments paid by insurers to cover operating losses of the MAIPF has been small relative to premiums in recent years, the expected cost of assessments increases rates in the voluntary market. [41] Moreover, a relatively large market share for the MAIPF in Detroit (see below) or any other area is likely to reflect regulatory constraints on cost-based pricing rather than inadequate competition.

Drawbacks of Subsidies. Subsidies make coverage more affordable to some drivers. They also make it more likely that some drivers buy mandatory coverage as opposed to driving uninsured. However, restrictions on cost-based pricing essentially require persons who on average have lower expected accident costs to share losses with persons who on average have higher expected costs. While some persons regard such subsidies as fair, others will not. Moreover, the higher premiums made necessary to finance subsidies make insurance less affordable for drivers who bear the cost of subsidies. The general public also may not be aware of the nature and magnitude of cross-subsidies in Michigan and other states. In some instances, the consequences of restrictions on underwriting and rate classification, such as a larger involuntary market, may be incorrectly attributed to inadequate competition and used to support proposals for additional regulation.

If large numbers of drivers pay a modest increase in premiums to finance significant premium reductions for a relatively small group, overall affordability may in some sense be improved. However, even in this case, a significant drawback of restrictions on cost-based pricing is that they alter the incentives for many drivers to take precautions to control accident costs with the result that the total cost of accidents and accident prevention will increase. [42] Restrictions on cost-based pricing also are likely to increase accident frequency and severity. Persons whose rates are made lower will tend to buy more extensive coverage (e.g., choose lower deductibles) and undertake fewer precautions to reduce expected accident costs. While persons whose rates are increased will tend to buy less coverage and take greater precautions, it is likely that the overall effect will be fewer precautions and greater accident frequency and severity. [43] As a result, any overall improvement in auto insurance affordability from subsidies is likely to diminish over time. [44]

As suggested earlier, regulation associated with restrictions on cost-based pricing also can contribute to higher claims costs after losses occur. Losses incurred by drivers insured in the MAIPF are divided among all insurers in the state. Servicing insurers for the MAIPF are required by statute to employ the same claim settlement methods as used in the voluntary market. Nonetheless, the fact that expenditures on claim settlement are borne by the servicing carrier (in exchange for receiving stipulated fees expressed as a percentage of premiums) while the losses paid are spread among all insurers may dilute the incentive of the carrier to minimize the sum of claim costs and loss adjustment costs. [45] While the effect could be minor in the MAIPF given its modest size, it would become more pronounced if any policy were adopted thatsignificantlyincreased the size of the MAIPF or changed the involuntary market mechanism to a reinsurance facility.

Subsidies for drivers who on average have higher expected accident costs also are likely to reduce temporarily the pressure on policymakers to deal with the underlying causes of high premiums. High premiums indicate that claim costs are high. If the government attempts to spread claim costs more broadly in the population through cross-subsidies, public pressure for actions that efficiently reduce claim costs and thus premiums initially is likely to decline. However, if cross-subsidies increase growth in claim costs and thus aggravate affordability problems over time, subsidies will only delay public pressure for substantial action to reduce premiums.