The Relationship between Voluntary and Involuntary Market Rates and Rate Regulation in Automobile Insurance

Abstract

The Relationship Between Voluntary and Involuntary Market Rates and Rate Regulation in Automobile Insurance Introduction Cross-subsidization from low-cost to high-cost consumers often has occurred in industries subject to price regulation when production costs differ across consumers.(1) The potential for increased political support from engaging in cross-subsidization may help to explain the existence of price regulation in competitively structured industries, especially when nonprice competition is likely to impede the use of price regulation to achieve profits for producers. A possible example is the competitively structured market for private passenger auto insurance, which has long been subject to a two-tiered system of rate regulation. Joskow (1973) suggested a producer protection motive for auto insurance rate regulation (also see Ippolito, 1979). While this motive probably has some historical validity, empirical evidence suggests that rate regulation on average has decreased the ratio of premiums to losses in private passenger auto insurance during the 1970s and early 1980s (Grabowski, Viscusi and Evans, 1989, Harrington, 1984a and 1987, and Pauly, Kleindorfer, and Kunreuther, 1986; also see U.S. General Accounting Office, 1986).(2) The overall market for auto insurance has two components: the voluntary market, in which firms willingly contract with consumers, and the involuntary (residual) market, in which insurers are forced to issue contracts to certain persons. Voluntary market rates are regulated in about half of the states; involuntary market rates are regulated in all states.(3) In principle, involuntary markets may be needed as a result of adverse selection, which conceivably could prevent a viable voluntary market for certain consumers. Whether unregulated markets could fail in some instances due to a lemons phenomenon that could not be overcome by price and quantity competition (e.g., Rothschild and Stiglitz, 1976) is uncertain. However, it is unlikely that adverse selection can explain the substantial size of the involuntary market in a number of states. A more likely explanation is that involuntary market rate regulation produces rate levels that essentially crowd out the voluntary market for some consumers (Mintel, 1983). Involuntary market rate regulation enables regulators to reduce rates for certain consumers. Mandatory pooling ensures that any adverse financial results are spread broadly among companies. The relationship between voluntary and involuntary market rates and rate regulation in auto insurance and, more generally, the property-liability insurance industry has received little attention in the literature. The fact that auto insurance involuntary markets in some states consistently produce substantial accounting losses is well known (see Lee, 1977, Mintel, 1983, and Grabowski, Viscusi, and Evans, 1989). Little is known about the extent to which voluntary market rates are affected by involuntary market results, or whether voluntary market rate regulation affects the relationship between involuntary market results and voluntary market premiums. Previous studies of the impact of voluntary market rate regulation have focused exclusively on the relationship between aggregate premiums and losses for the total market (i.e., for the voluntary and involuntary market combined).(4) This study analyzes the relationship between voluntary and involuntary market rates and rate regulation. A multiple regression model is estimated with cross-state data to provide evidence of the impact of voluntary market rate regulation and a measure of involuntary market deficits (defined below) on the overall ratio of premiums to losses in the private passenger auto insurance market from 1979 through 1981. As in previous work, the results suggest that voluntary market rate regulation reduced the ratio of premiums to losses for the overall market. They also suggest that voluntary market rate regulation reduced voluntary market premiums in states with small involuntary market deficits. …