Sunday, 9 September 2018

Car insurance, adverse selection and gender

Car insurance has an adverse selection problem. The uninformed party (the insurer) cannot tell those with 'good' attributes (low-risk people) from those with 'bad' attributes (high-risk people). To minimise the risk to themselves of engaging in an unfavourable market transaction, it makes sense for the insurer to assume that everyone is high-risk. This leads to a pooling equilibrium - low-risk people are grouped together with the high-risk people and pay the same premium, because they can't easily differentiate themselves. This creates a problem if it causes the market to fail.

To see how the car insurance market fails, consider this from an earlier post about health insurance (it applies just as well to car insurance):
In the case of insurance, the market failure may arise as follows (this explanation follows Stephen Landsburg's excellent book The Armchair Economist). Let's say you could rank every person from 1 to 10 in terms of risk (the least risky are 1's, and the most risky are 10's). The insurance company doesn't know who is high-risk or low-risk. Say that they price the premiums based on the 'average' risk ('5' perhaps). The low risk people (1's and 2's) would be paying too much for insurance relative to their risk, so they choose not to buy insurance. This raises the average risk of those who do buy insurance (to '6' perhaps). So, the insurance company has to raise premiums to compensate. This causes some of the medium risk people (3's and 4's) to drop out of the market. The average risk has gone up again, and so do the premiums. Eventually, either only high risk people (10's) buy insurance, or no one buys it at all. This is why we call the problem adverse selection - the insurance company would prefer to sell insurance to low risk people, but it's the high risk people who are most likely to buy. 
In order to solve an adverse selection problem, the uninformed party can try to reveal the private information - this is referred to as screening. Car insurance companies engage in screening by collecting information about every person who applies for insurance, including their demographic details and accident and insurance history. The insurers know that this information provides some clues as to who is higher risk and who is lower risk to insure. They can then separate the higher-risk and lower-risk groups, and we move from a pooling equilibrium to a separating equilibrium. Higher-risk drivers will pay higher car insurance premiums, and lower-risk drivers will pay lower premiums.

One of the key demographic variables that is associated with car insurance risk is gender. Women drivers are less risky to insure. On average, they have accidents at lower speeds, which are less costly to repair. So, female car owners pay lower car insurance premiums on average. Gender works as one screening tool because it is difficult to fake. Or it was, until this story from CBC in Canada in July:
He wanted a brand new car — a Chevrolet Cruze with all the trimmings.
As a man in his early 20s, he knew his insurance costs would be high.
So he became a woman, though only on paper.
"I have taken advantage of a loophole," said the man — we're calling him David — who spoke on the condition that his identity be kept confidential because of the potential repercussions...
After doing some research, he realized he needed a doctor's note to show the government he identifies as a woman, even though he doesn't.
"It was pretty simple," he said. "I just basically asked for it and told them that I identify as a woman, or I'd like to identify as a woman, and he wrote me the letter I wanted."...
David shipped the note and other paperwork off to the provincial government. And, a few weeks later, he received a new birth certificate in the mail indicating he was a woman.
"I was quite shocked, but I was also relieved," he said. "I felt like I beat the system. I felt like I won."
With the new birth certificate in hand, he changed his driver's licence and insurance policy.
All to save about $91 a month.
"I'm a man, 100 per cent. Legally, I'm a woman," he said.
"I did it for cheaper car insurance."
"David" may have just raised the cost of car insurance for all women in Canada. If car insurers can no longer believe from a drivers licence that an insurance applicant is a woman, then every gender will be pooled together as being the same risk. That means higher premiums for women (and ironically, lower premiums for men, which is what David wanted!).

[HT: Marginal Revolution]

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