Search Costs, Switching Costs and Product Heterogeneity in an Insurance Market

Abstract

Search Costs, Switching Costs and Product Heterogeneity in an Insurance Market Abstract An insurance market is modeled as a game with two types of players: incumbent insurers and new entrants. Insurer service-quality characteristics are examined as a Hotelling-type of spatial equilibrium. That is, insurers realize that consumers have varying tastes and choose differing product characteristics in order to carve out niches in the market. Insurers then set prices, cognizant of the prices of their competitors, modeled here as a Bertrand-Nash equilibrium. The addition of a cost to consumers for switching insurers is shown to give incumbents a degree of monopoly power in setting prices. Adding costly consumer price search further reduces the market share of new entrants. However, those consumers that do switch to a new insurer have strong preferences for that insurer and, as a result, it is possible that new-entrant prices will exceed those of incumbent insurers. The existence of price dispersion in insurance markets is well-known. For example, Jung (1978) found a large discrepancy between the highest and lowest price quoted on an identical automobile liability policy in the city of Chicago. Similarly, Matthewson (1983) has shown that a large amount of price dispersion exists in the market for life insurance. Several models have been developed in order to explain this price dispersion in insurance markets. A recent paper by Berger, Kleindorfer and Kunreuther (1989), for example, considers price dispersion as a natural consequence of the diffusion of price information. Their model considers the market as being in disequilibrium. Most other models, however, show how price dispersion can persist in a long-run equilibrium, e.g. Dahlby and West (1986), Carlson and McAfee (1983) and MacMinn (1980). The above models, with the exception of Berger, Kleindorfer and Kunreuther (1989), all focus on search costs as the raison d'etre for price dispersion. The purpose of the current article is to add two other factors into a model of price dispersion; namely product heterogeneity and switching costs. Product heterogeneity is often overlooked because the insurance contracts that exist in many markets are either identical, or very nearly identical. For example, in their empirical study of the automobile insurance market in Alberta, Canada, Dahlby and West (1986, p.419) claim . . the insurance policy that we examine, compulsory third-party liability insurance, is homogeneous, making the premiums charged by different firms directly comparable. This view, which is quite prevalent in the literature, seems to equate the insurance contract with the insurance product. However, the insurance product is itself a service, and the quality and attributes of such a service can and do vary among insurers. Cummins, et al. (1974) reports that 40 percent of over 2,400 individuals surveyed felt that the particular insurance company was the most important factor in choosing an automobile insurer. This compares to 27 percent who felt that price is the most important consideration. In another article, Schlesinger and Schulenburg (1990) find empirical evidence of perceived product heterogeneity in the West-German insurance market. These perceptions are also examined in a recent poll of 904 consumers by the Gallop Organization (summarized in Best's Review: P/C Edition, September 1989, pg. 11), which evaluates various service-quality characteristics. The perceived quality of service is only one of the attributes that can distinguish between two seemingly identical insurance contracts. Probability of insurer insolvency, bonus/malus types of adjustments to annual insurance premiums, the convenience of the claims service, the availability of a local agent (or a 24-hour toll-free number? …