Monday, 22 June 2015

Boy racer struggles to get car insurance

A few weeks back I read this New Zealand Herald article, about the struggles of a poor disadvantaged boy racer to get insurance for his new car:
The user posted on Reddit, an online message-board website, to ask who would insure a 20-year-old male with a 3.5 litre engine car.
Reddit user Mashayous said he had tried both AA and Tower but both had denied him because of his age and type of car.
"Can anyone help me out," he asked.
"I just got a new car a few days ago (2005 Nissan 350Z) and I'm having trouble trying to find a company that is willing to insure it.
I've tried the major ones like AA and Tower, but both have said that they can't offer any form insurance for my car."
Insurance markets are prone to information asymmetry problems, like adverse selection and moral hazard. Insurance companies have developed sophisticated means of dealing with these problems.

Adverse selection requires private information, and it requires that the informed party must be able to benefit from keeping the private information secret. In the context of car insurance, the classic explanation is that the driver knows whether they are a high-risk or low-risk driver (this is private information that the insurer doesn't know). Higher risk drivers should pay a higher premium. However, because the insurance company can't tell the high-risk and low-risk drivers apart, that leads to a pooling equilibrium. The insurance company must assume that everyone is high risk, and raise premiums for everyone as a result. This forces the low risk drivers out of the market, because the insurance premium is too high. This raises the average risk profile of insured drivers, and the insurance company raises premiums. This forces the medium risk drivers to reconsider, and eventually only the high risk drivers are left buying insurance (if insurance is offered at all).

Now, this isn't quite the situation here. The insurance company knows a bit about 'Mashayous' - they know he is 20 years old and he is trying to insure a 2005 Nissan 350Z. This reveals information about the riskiness of the insurance contract, which should allow the insurer to price the insurance contract appropriately. Given that he was denied by AA and Tower, they must believe that he is too high risk to even bother with, probably because of moral hazard.

Moral hazard is the tendency for someone who is imperfectly monitored to take advantage of the terms of a contract (a problem of post-contractual opportunism). Drivers who are uninsured have a large financial incentive to drive carefully and avoid accidents, because if they have an accident they must cover the full repair cost themselves (not to mention the risk to life and limb). Once a car in insured, the driver has less financial incentive to drive carefully because they have transferred part or all of the financial cost of any accident onto the insurer (though the risk of injury remains, of course). The insurance contract creates a problem of moral hazard - the driver's behaviour could change after the contract is signed. And this is a particularly big problem if the driver is young, inexperienced, and driving a fast car. So no surprises that the insurance companies are passing on the opportunity to insure him.

Previous posts on insurance, adverse selection and moral hazard:

1 comment:

  1. Yes I have read about this before. It makes total sense not to ensure someone who has shifted part or all of his financial burden onto the insurance company and therefore has no real incentive to drive carefully. The insurance company knows this is the case. My wife is an insurance broker so I hear the stories all the time.

    Joshua Duncan @ Focus Insurance Atlanta