Despite Government, Insurance Innovation

by David Griffus
by David Griffus

I recently bought a new (to me) car and decided that it would be a good idea to shop around again for car insurance. Until now, I had always been insured with my local independent insurance agent, but with the proliferation of direct insurers like Geico and Progressive, I thought that I could save a little money by cutting out the middleman. I was right. I saved a lot. It doesn’t feel great to tell someone with whom you’ve had a wonderful eight-year business relationship with that you’ve decided to go with another company, but for me, insurance is just a numbers game. During this process, I discovered a concept, if allowed to be widely used, that has the potential to change the auto insurance industry as we know it.

Progressive Direct has a new program called TripSense, which is a small electronic device that the driver plugs into the diagnostic port underneath the dash on his vehicle. Made by the same company that designed the "black boxes" in cars that provide investigators with data to help recreate traffic accidents, this device collects data about driving habits, including the time of day, the length of trip, the number of miles, speed, sudden starts / stops, etc. Participation in the program is voluntary. While the "Pay as You Drive" (PAYD) idea is not entirely new, TripSense represents the first real consumer application of this technology in the United States.

For insurance companies, this is the ultimate way to accurately assess a driver's risk profile and price a policy. This goes way beyond simply checking credit scores and driving and claims histories. This actually monitors the manner in which a person drives, which has the potential to revolutionize the car insurance industry.

We know from the teachings of Mises and Rothbard that an insurable risk is an example of class probability, meaning that, "We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class." In other words, while we cannot predict individual accidents, we can attempt to know the number and cost of accidents that will occur within a particular class of drivers that share some common characteristics (e.g., type of car, age, credit score, miles driven, marital status, etc.)

Economics tells us that the further we are able to sub-divide the classes of drivers into more homogeneous groups, the more we would expect insurance prices to more accurately reflect each group’s actuarial risk. In other words, drivers that demonstrate qualities that place them into a "safe" class will tend to pay less for insurance than drivers that demonstrate "risky" qualities. In a free market, programs like TripSense will help reward safe drivers and penalize riskier ones.

Of course, risky drivers don’t like programs like this, nor do the government bureaucrats. Risky drivers, like anyone else, want to pay as little as possible for insurance. Government bureaucrats, sensing a "market failure," want to make the system "fair" by ensuring that insurance is "affordable" to everyone. The PAYD concept undermines these two positions, which will probably lead to the implications of Woods’ Law: "…whenever the private sector introduces an innovation that makes the poor better off than they would have been without it, or that offers benefits or terms that no one else is prepared to offer them, someone – in the name of helping the poor – will call for curbing or abolishing it." In other words, the government in some places will regulate it or abolish this practice in the name of "privacy" or "fairness."

Use this scenario to imagine the power of the Pay as You Drive idea: a poor man, who is required to purchase car insurance in order to drive a vehicle in his state, has a poor credit score and is unfairly targeted for traffic violations by his local police because of his dilapidated car. Under the old system, insurance companies would have no additional information on how to place this person into a class and would likely classify this person as risky, with a high insurance premium. With a program like TripSense, the driver knows for certain that he can earn a discount by exhibiting good driving habits because the insurance company is constantly monitoring him. He might think twice about driving late at night or suddenly braking as each negative event will reduce his discount. Pay as You Drive programs provide direct incentive for individuals to be good drivers and to make the roads safer. The insurance companies win by having to pay out on fewer claims and the driver wins by paying less for car insurance. Seems like a no-brainer, right?

It is not surprising to us libertarians, then, that state regulations encourage exactly the opposite behaviors. States require safe drivers to subsidize risky drivers by forcing insurance companies to insure all drivers, even those that they would classify as too risky to insure. Our basic training in economics tells us that if we subsidize something, we are going to get more if it (in this case, bad drivers). Some states prohibit the use of certain personal characteristics (like credit scores) in determining rates, even if the insurance companies believe that this particular characteristic is useful in placing drivers in different risk classes. Again, insurance companies are forced to subsidize risky drivers.

The positive aspects of PAYD do not necessarily mean that in a free market every insurance company would have a program like TripSense. We can certainly imagine that some drivers might not want to participate in a program that monitors their driving habits all of the time because they view it as too intrusive. To fill this consumer want, there might be a company that makes the program optional (as does Progressive) or does not offer it at all. However, if a company that offers a PAYD device is able to offer substantially lower rates to safe drivers and is able to win the business of these consumers, the non-discriminating firm might have a difficult time attracting the safer drivers, which might increase the class risk of the remaining pool of drivers and subsequently place downward pressure on its profits. One thing seems clear: this technology, if allowed to be implemented, will likely decrease rates for safe drivers and encourage responsible behavior.

For now, TripSense is only offered in Michigan, Minnesota, and Oregon. For safe drivers in over-regulated and over-burdened states like New Jersey and New York, who face some the nation’s highest auto insurance rates, this program could not come soon enough. If government allows insurance companies to reward safe driving, we’ll get safer roads. I just hope that government steps out of the way and allows the market to work its magic.

August 15, 2007

David Griffus [send him mail] holds a Bachelor of Business Administration from the University of Michigan and currently works as an analyst in Ann Arbor, MI.

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