The Design of Auto Insurance Systems:

Transcription

1 The Design of Auto Insurance Systems: Research and Implications for Ontario Sharon Tennyson Associate Professor Department of Policy Analysis and Management Cornell University Mary Kelly Associate Professor School of Business & Economics Wilfrid Laurier University Anne Kleffner Associate Professor Haskayne School of Business University of Calgary FINAL REPORT TO INSURANCE BUREAU OF CANADA August 23, 2012

2 Summary This study aims to provide guidance in auto insurance system design and considerations for achieving a well functioning automobile insurance system in Ontario. Such a system is characterized by a number of desirable features, including fair compensation, deterrence, efficiency, and fairness. However, because system features designed to achieve one of these features may make it harder to achieve some others (e.g., compensation and deterrence, efficiency and fairness), trade offs are often required to balance conflicting objectives. Different stakeholders may also have conflicting objectives; for these reasons, establishing whether an auto insurance system is functioning well is not a simple task. The report describes a variety of combinations of the basic design features of auto insurance systems are used in Canada and elsewhere, and compares the performance of auto insurance systems in Canada based on the measures that characterize a well functioning system. This comparison demonstrates that Ontario s auto insurance system performance is worse than those in other provinces on many dimensions and much worse in the areas of affordability and sustainability. However, although the Ontario automobile insurance system exhibits a number of problems, the evidence does not suggest that the design of the system is fundamentally flawed. Background research on Ontario s insurance system and the history of insurance reforms is presented to shed light on the factors that explain this poor performance. That analysis yields several key findings. First, reform policies in Ontario appear to have affected outcomes in the short run, but in many cases inflationary trends quickly reappeared. Second, Ontario claim frequency and severity are higher than those in other provinces in almost all cases and all years, and the increases over time in both claim frequency and claim severity have been substantially greater in Ontario than in other provinces. This is despite having the lowest fatal accident rate and one of the lowest rates of accidents causing injury of all provinces. A final insight obtained from this analysis is that the claims growth in Ontario i

3 stems primarily from the Greater Toronto Area (GTA) rather than reflecting province wide problems. Inflationary trends are highest in the GTA, due to increases in both claim frequency and claim severity. Thus, while the auto insurance product is sustainable across most of Ontario, premiums in the GTA are insufficient to cover the cost of auto insurance claims in the GTA. Based on this review and on analysis of problems and solutions in other insurance systems, key issues in the design of a well functioning auto insurance system are discussed. The overall conclusions of the report are as follows: Insurance provides many benefits to individuals and to society, but also may increase incentives to drive, reduce driving precautions, and lead to benefit seeking or even outright fraudulent claiming. The specific design features of an insurance system affect these behavioural incentives. Incentive problems are greatest when insurance benefits are generous and pricing is socialized so that premiums do not reflect individual risk of loss. A well functioning insurance system must recognize and attempt to counteract these incentive problems. When insurance availability and affordability to all consumers are important objectives, adjusting the insurance system to address cost problems is difficult because many solutions will reduce availability and/or affordability for some. In jurisdictions in which driving is not considered a right or an economic necessity, the public policy problems in auto insurance are less complicated. Auto insurance does not operate in a vacuum: it interfaces with the private and public health systems, road safety and driver licensing mechanisms, the legal system, demographics and economics of a region. Recognizing this, policy makers should consider problems and solutions that lie outside of the insurance system along with those internal to the system when addressing auto insurance issues. In the aggregate, rising costs are the source of rising insurance premiums. Because the link between cost increases and premium increases is not transparent, there is often pressure to reduce premiums without recognition that the underlying problem is one of cost. However, suppressing premiums does not lead to cost reductions and may even exacerbate cost increases. Insurer or public policy responses aimed squarely at underlying cost and incentive problems are more effective and more permanent responses. ii

4 Because of the threshold, excessive claiming behaviour is more problematic in partial no fault systems than in pure no fault systems because benefit overuse arises due to attempts to breach the tort threshold. The tort threshold, the magnitude of additional benefits available if the threshold is breached, and the penalties for fraudulent claims should be constructed so that the lottery aspects of partial no fault are minimized. These considerations suggest that the following principles should be observed when enacting auto insurance reform: It is important that policy makers clearly articulate the objectives of the insurance system and the trade offs that must be made, recognizing that trade offs exist between different design options. Generous first party insurance, and partial no fault systems, lead to benefit seeking behaviours which must be monitored and controlled. Claimants have incentives to over claim when first party benefits are generous. Measures to reduce fraudulent claiming and reduce claims costs should be established at the industry level with support of government enforcement mechanisms. These measures could include harsh penalties for fraudulent healthcare providers, better use of analytics to detect fraud, and consumer education. If affordability is addressed via premium subsidies these should be based on income and not on risk: full premium subsidies should be available to low risk and low income individuals. Subsidies available to low income but high risk individuals should reflect the underlying poor driving record or accident experience. The provision of insurance reduces incentives to take care. Incentives for safe driving and responsible claiming are better aligned if premiums paid by drivers are commensurate with their risks. Low risk drivers should be provided with opportunities to distinguish themselves from highrisk drivers in the rate classification system. High risk drivers should be identified by a system of experience rating that incorporates both driving record and at fault claims. Cost controls on healthcare services are important to prevent cost shifting to the auto insurance system. The long run success of changes to system design to achieve policy goals, whether it is compensation levels, or benefit provision or pricing structure, are impacted by consumer knowledge of insurance and societal beliefs about fairness and societal attitudes towards excessive or fraudulent claiming behaviours. iii

5 Government insurance providers have often been more successful than private insurers in containing claims costs due to their greater control over compensation and indemnification schedules. However, the trade off involves potential under indemnification if benefits to those most seriously injured are capped (as, for example, in Quebec), and the loss of consumer choice of products and providers. Moreover, the full costs of the auto insurance system are not reflected in premiums if the government insurer runs a deficit. Specific additional considerations with respect to Ontario auto insurance include the need to realign premium structure to reduce cross subsidization across the province. Although in theory premiums are risk based, decades of prior approval rate regulation have created cross subsidies across driving record classes and across territories. It is also imperative to develop a distinct pricing mechanism that is fair to new drivers and maintains incentives for safe driving. iv

6 Contents Summary... i 1 Introduction Background on Automobile Insurance Economics of Automobile Insurance Objectives of an Automobile Insurance System Design Considerations of an Automobile Insurance System Mandatory Insurance Coverage Residual Markets Public versus Private Insurance Public Intervention in Private Insurance Markets Tort versus No fault Compensation Systems Pricing Mechanisms Automobile Insurance Systems Design and Performance Insurance Systems in Canada Comparing System Performance Automobile Insurance in Ontario The Current Product The History of Auto Insurance Reform in Ontario Bill 68 (1990) Bill 164 (1994) v

7 5.2.3 Bill 59 (1996) Bill 198 (2003) Elimination of Designated Assessment Centres (2006) Reforms of Ontario Claim and Cost Trends Bodily Injury Liability Claims Compulsory Property Damage Claims Statutory Accident Benefits System Performance Summary and Interpretation Experience from Other Jurisdictions Insurance Systems in Other Countries Summary of Case Studies Policy Considerations for a Well Functioning Insurance Market Policy Considerations for Ontario Pricing Mechanism Design Benefit Provisions Claims Cost Controls Consumer Education Larger Policy Issues References Appendix: Case Studies of Other Jurisdictions Alberta, Canada vi

8 9.2 Massachusetts, U.S.A Michigan, U.S.A vii

9 1 Introduction Automobiles and driving have a fundamental role in our society. Although driving is not a right according to various courts of law in Canada 1, car ownership and driving lead to better employment outcomes and higher wages (Raphael and Rice, 2002). The costs associated with automobile accidents are equally important to society. In 2009 there were 2,011 fatal collisions and 123,192 additional collisions causing personal injury across Canada. Over 2,200 individuals died and 11,450 suffered serious injuries in car collisions (Transport Canada, 2011). It is estimated that the cost of traffic accidents is about 1.9 percent of GDP in Canada (International Transport Forum, 2011). As the primary mechanism for funding these accident costs, the automobile insurance system is an important concern. In addition, the social importance of the automobile and the extent of automobile accident compensation in North American society generate public interest in automobile insurance. There are many different automobile insurance systems worldwide and 13 different (provincial) insurance systems across Canada alone. There are significant differences in the insurance product and regulatory regimes across the provinces. Market conduct regulation of insurance is a provincial (and territorial) responsibility. As such, each province has its own rules for underwriting and marketing insurance policies, and its own regulatory approach to product and price oversight. Generally, products and prices are monitored and controlled, rating and underwriting are regulated, and insurers face extensive filing requirements. Regulation of the automobile insurance system may be imposed to achieve a number of different objectives. In Canada an important objective of regulation is to achieve social goals due to the social risk created by driving. Drivers are exposed to risk of significant loss from automobile accidents, and in turn 1 See Regina v Tri M Systems (B.C.S.C.), note 24: 1

10 impose accident risk and accident costs on others. The purchase of automobile insurance helps to internalize the costs of accidents through payment of policy premiums that reflect the expected costs of driving. When a driver chooses to drive uninsured, accident costs are shifted to other drivers or to society as a whole. The cost to an individual from driving uninsured is small, as the majority of personal injury costs are shifted to society through taxes and/or levies on insurance policies. The potential for drivers to shift accident costs to others is one reason for government regulation of automobile insurance. The existence of publicly funded, universal medical care in Canada makes it easy for drivers to shift this cost to others, creating an additional reason to make the purchase of auto insurance compulsory. The cost of providing medical care to those injured in automobile accidents is substantial. A potential for overutilization of medical care exists if insurance benefits are generous and there is a separation between the provision of care and the financing of care. Thus, there may be a role for governments to optimize the use of the medical system. The division of public and private responsibilities for the provision of auto insurance may be chosen from a wide spectrum of arrangements and is a critical design element of the automobile insurance system. Since the early 1990s Ontario has made a number of significant changes to the automobile insurance product in an effort to control costs and improve compensation. Changes began with the introduction of no fault insurance in 1990 and include the more recent reductions to statutory accident benefits. Despite a series of regulatory interventions over time, the automobile insurance system in Ontario has consistently been problematic for the government and for the industry. This report aims to contribute to the process of creating a more sustainable insurance system for the province. Rather than focusing solely on concerns in Ontario, this report uses insights from theoretical and comparative analysis of auto insurance systems to identify principles for designing a sustainable 2

11 automobile insurance system. The analysis reviews insurance theory and evidence on the experiences of other jurisdictions to identify practices that work well for the insurance industry, consumers, and society. Section 2 of the report provides the conceptual framework for automobile insurance and identifies the objectives of a well functioning automobile insurance system. These are comprised of availability, affordability, service quality, cost efficiency, sustainability, fairness, informed consumers, and adequate competition. In Section 3 the key policy levers that are available when designing an insurance system are described. These are compulsory versus optional insurance; public versus private provision; tort versus no fault compensation; and pricing schemes. We summarize the evidence from academic research regarding the strengths, weaknesses, and overall effectiveness of each design feature as employed in existing insurance systems. Because an auto insurance system combines choices regarding each of the individual system elements, there exists a wide range of automobile insurance systems. The systems employed in Canada are documented in Section 4. We compare the performance of the auto insurance systems in each of the provinces in Canada, defining metrics to measure the objectives outlined in Section 2. Section 5 reviews the history of auto insurance reform in Ontario and examines the statistical evidence on the historical performance of Ontario s system using the lens of this analysis. We consider the performance of Ontario in relation to other provinces, and we also compare the performance of different geographical regions of Ontario. In Section 6 we briefly discuss auto insurance systems and auto insurance reforms in jurisdictions outside of Ontario. Case studies provided in the Appendix support the discussion in Section 6. We conclude with policy considerations for a well functioning insurance market and specific considerations for the Ontario insurance market in Section 7. 3

12 2 Background on Automobile Insurance 2.1 Economics of Automobile Insurance Insurance is a mechanism by which one can protect against the risk of a future contingent loss. The buyer pays a fixed sum of money, the premium, to an insurer in exchange for the insurer s promise to compensate the insured for a potential financial loss. Because individuals are typically risk averse, they prefer to purchase insurance instead of facing the risk of the loss. The insurer pools together the premiums of many individuals to pay for the future losses that will be incurred. At its most basic level, each insurance buyer is charged a premium that reflects the expected costs that he or she imposes on the insurance system, and the premiums paid by all buyers are pooled to pay the losses of those who experience a loss. Automobile insurance provides compensation to parties who suffer injuries or incur damages due to automobile accidents and losses. Given the variety of losses which may be incurred, automobile insurance is actually a package of insurance coverages that provides protection for both damage to property and injuries to persons. Because there is the potential for causing losses or damages to others as well as to one s self, the package includes both liability ( third party ) insurance and first party insurance. First party insurance covers costs of one's own automobile related property or injury losses. Liability insurance covers damages to other persons or their property that arise in an automobile accident with the insured, and for which the insured is held responsible. The function of liability insurance differs in some respects from that of first party insurance. In addition to protecting the insured driver from the unexpected costs associated with automobile accidents that are his fault, liability insurance provides protection to other drivers by assuring that funds will be available for their compensation in such a circumstance. 4

13 Insurance has many economic benefits. Insurance reduces uncertainty for risk averse drivers by providing protection against losses from automobile accidents. Insurance also increases the productivity of financial resources by removing the need for individual drivers to hold large contingency funds (Curak et. al, 2000). Thus, insurance provides great benefits to individuals and to society. However, the cost of insurance and the potential solvency of the insurance provider is impacted by moral hazard in both risktaking and claiming behaviours, and by adverse selection. Moral hazard arises from the fact that in the presence of insurance, individuals have incentives to take less care than they would otherwise. In auto insurance, for example, individuals may drive with less care or be less careful when choosing a location to park a vehicle, because they know they are insured. Moral hazard exists if this change in behaviour increases the likelihood or size of a loss, and if insurers cannot directly observe the actions of the insured or if it is prohibitively costly to do so. Because insurance protects drivers from immediately bearing the full costs of accidents that they cause, the effects of insurance on incentives for safe driving must be carefully considered. Most insurance contracts are contracts of indemnity their purpose is to put the insured into the same financial condition as before the loss. However, the nature of the insurance product creates incentives to report fictitious losses or exaggerated losses, since receiving insurance payments for a loss that was not experienced leads to financial gain for the claimant. This negative consequence of insurance is intrinsic to all insurance systems, and the design of the insurance contract, insurance contract law, claims handling practices and even the selection of insurance customers must take this into account (Baker 1994). Fraudulent claiming is often an opportunistic response to the insurance contract. That is, individuals may decide whether to file an insurance claim, and the amount for which to file, based on the expected gains from filing relative to the costs of filing. Preventing and detecting this kind of claims 5

14 abuse is an important facet of insurance management in both private and public insurance systems. Fraudulent claiming may also result from organized criminal activity, however. Moral hazard can be reduced if insured individuals are required to pay part of any loss themselves, either by having to incur a deductible or by having to pay all costs beyond a certain threshold amount. Insurance companies also use experience rating (basing future premiums on the past losses of the insured, or in the case of auto insurance, past losses and driving record) to mitigate both moral hazard and excessive claiming practices. Moreover, insurance theory indicates that if fault is accurately determined, charging each driver a premium equal to the driver s expected losses is the best way to preserve safe driving incentives (Shavell, 1986). Adverse selection also reduces the ability to spread risks through insurance. Adverse selection exists when insureds have private information about their risk levels that insurers cannot observe, or when insurers are prohibited from using such information to distinguish between risk types. If insurance is offered at one standard premium to a heterogeneous group of individuals, it will be overpriced for those who are low risk and underpriced for those who are high risk. This will result in low risk individuals buying less insurance or even no insurance if possible, while high risk individuals will be more likely to buy insurance and will want to purchase more of it. The resulting insurance pool will be dominated by highrisk individuals. In practice insurance providers use both risk classification and experience rating to distinguish between risk types, and governments may require individuals to purchase insurance to overcome the tendency for low risk individuals to opt out. In summary, automobile insurance is a useful tool for risk averse individuals to transfer their risk of loss associated with driving, as well as to assure that those injured by at fault drivers are compensated for their losses. Adverse selection and moral hazard create barriers to offering insurance because they reduce the ability to pool risk, increase the costs of claims, and raise the costs of managing the insurance 6

15 pool. The design of an automobile insurance system has important implications for the extent of moral hazard and adverse selection problems and, more generally, will affect the extent to which incentive misalignments reduce the benefits and raise the costs of insurance. Such problems are a part of the trade offs which must be considered in designing the automobile insurance system. 2.2 Objectives of an Automobile Insurance System The discussion of automobile insurance highlights the benefits and costs of insurance, and raises a number of important issues that must be considered when designing an automobile insurance system. The following set of specific objectives summarizes key attributes that are relevant to these issues and that account for the interests of various stakeholders (policyholders, insurers, regulators, taxpayers). These objectives are widely held to be hallmarks of a well functioning insurance system, and may be used to determine the health of an insurance system: 2 Availability: Consumers have timely access to a variety of auto insurance products that meet their needs. When automobile insurance is compulsory, insurance availability may determine access to driving. Affordability: Consumers can acquire auto insurance at appropriate prices. Income differences across consumers may affect perceptions of affordability. Service Quality: Consumers are satisfied with their products and services. Cost Efficiency: Products and services are provided at least possible cost. 2 See, for example, the objectives developed by the automobile insurance working group in the Province of Alberta in 2007; Cummins and Tennyson (2002); Tennyson (2012). 7

16 Sustainability: Products, service quality, costs, and prices are at levels which are viable over the longterm. Fairness: Consumers benefit from fair treatment in the insurance system, both in the pricing of the insurance product and in the claims settlement process. Informed Consumers: Consumers understand the automobile insurance product and make informed decisions about purchasing and claiming. If insurance is produced and sold by firms in the private market, the additional objective of competition must be met in order to assure that the operation of the market leads to a well functioning insurance system: Competition: A number of insurers actively compete to serve consumers automobile insurance needs. 8

17 3 Design Considerations of an Automobile Insurance System The ability to achieve the objectives listed above is a function of a number of different parameters that define an automobile insurance system. This section describes the primary characteristics of the auto insurance system that will impact the achievement of outcomes. Four design considerations are of particular importance: Compulsory versus optional insurance Private insurance versus government provider The role of liability in determining compensation The pricing mechanism It is important to recognize that specific design parameters are better at achieving certain objectives and are less effective in achieving others. In the concluding section of this report we will discuss the trade offs that policy makers face in designing an effective automobile insurance system. For example, although consumers are inherently interested in affordable insurance, insurers must be able to cover their costs and earn a fair rate of return. Those who are injured desire a system with generous benefits, but this creates affordability issues. Without explicitly recognizing these trade offs automobile insurance reforms often address one problem but create another. Further, auto insurance does not operate in a vacuum: it interfaces with the private and public health systems, road safety and driver licensing mechanisms, and the legal system. The availability of public transportation, household wealth levels, societal acceptance of fraud, and the importance society puts on holding at fault drivers accountable also impact the auto insurance system. Any attempts at reform should recognize this interrelationship. 9

18 3.1 Mandatory Insurance Coverage The economic rationale for compulsory auto insurance arises from the same rationale that gives rise to government intervention in insurance markets: part or most of the costs of accidents fall on other parties. Due to potentially inadequate resources, in the absence of liability insurance an at fault driver may not be held financially responsible for damage caused to others. In the presence of both universal health insurance and private medical benefits, injuries to one s self or to others will be paid by taxpayers and/or the insurance company. Some costs may also fall upon employers for employees who have disability and health benefits from work. Because (uninsured) drivers do not bear the full cost of their driving, they will drive if the marginal individual benefit to them of driving is greater than the marginal individual cost. Compulsory insurance, if priced appropriately, is a mechanism that forces people to internalize the full cost of their driving and thereby give up driving (and reduce associated costs) if the marginal benefit is not greater than the marginal cost. A second argument for compulsory insurance relates to improving safety incentives. Liability insurance that is priced in relation to driving risk can encourage greater safety because drivers know that by driving more safely their premiums will go down, or by having an accident their premiums will go up. The main argument against compulsory insurance is the regressive impact on the distribution of income. Compulsory insurance laws are more likely to affect low income individuals since they are the ones most likely to go without coverage. Without insurance, their costs would have fallen on (primarily) the publicly funded health insurance system. This income shift from low income drivers to high income drivers is a common criticism of compulsory insurance laws. Mechanisms for reducing the regressive impacts include rate regulation or some degree of social pricing that subsidizes the cost of coverage. 10

19 A second consideration with compulsory insurance is the ability to enforce compliance. Greater numbers of uninsured drivers increase the cost of insurance for insured drivers, potentially increasing the problem of affordability; this in turn may result in more uninsured drivers (Smith and Wright, 1992). Evidence on the extent of this problem is mixed, since some estimates show no relationship between uninsured driving rates and the cost of automobile insurance (Ma and Schmit, 2000; Jaffee and Russell, 1998). However, Smith and Wright (1992) find a positive relationship between uninsured driving and average premiums using data from 27 large U.S. cities. Using state level data from the U.S., Tennyson and Weiss (2011) also find a positive relationship, with estimates suggesting that a 10 percent increase in uninsured driving leads to a 2 percent increase in automobile insurance premiums. These authors also find some evidence of a feedback effect whereby higher premiums lead to higher rates of uninsured driving. In practice, mandatory insurance coverage typically includes liability coverage, personal injury protection or first party accident benefits (more common in Canada than the United States), and uninsured motorist coverage. 3 Legal requirements generally specify an amount of insurance which must be purchased, with coverage amounts above this limit available but optional. The argument for mandating third party liability coverage is the potential for parties injured by negligent drivers to be uncompensated and forced to bear (at least a portion of) their own injury costs. In the presence of universal healthcare, accident costs that are covered would be shifted on to taxpayers, but would still be borne by others than the negligent party. In other words, negligent drivers can shift the cost of accidents to others. 3 A few jurisdictions require coverage for first party property damage to one s own automobile. 11

20 Although mandatory liability insurance helps to ensure that injured parties are compensated by negligent drivers, the time and expense associated with settling claims and the uncertainty associated with the value of the settlement is a disadvantage to relying on this means alone for compensation, especially for injured persons. This is an argument for some level of mandatory first party accident benefits that are paid without reference to fault (no fault insurance systems). In Canada, first party accident benefits are compulsory in every province except Newfoundland and Labrador (and in Newfoundland and Labrador over 70 percent of insureds purchase first party accident benefits). Such benefits are designed to achieve quicker and more accurate compensation, lower settlement costs (by eliminating many liability claims), and potentially quicker recovery of health (evidence shows that access to appropriate treatment soon after injury leads to better results). In an attempt to reduce liability insurance transactions costs, some jurisdictions mandate compulsory first party property damage coverage for not at fault damage. As noted by Kelly, Isotupa and Kleffner (2009), key benefits of first party as opposed to third party recovery for vehicular property damage are the elimination of the adversarial relationship that often results from two insurers having to negotiate the fair amount to be paid for a claim involving their own insureds, the elimination of the majority of subrogation costs for property damage claims, and a better matching of premiums to the actual potential loss. Despite the fact that some level of auto insurance is mandatory throughout most of North America, a substantial percentage of motorists drive uninsured. In the United States, the Insurance Research Council (IRC) estimated the percentage of uninsured motorists in 2009 to be 13.8 percent overall, and found that the uninsured motorist problem varied greatly from state to state, from 4.5 percent in Massachusetts to 28 percent in Mississippi (Insurance Information Institute, 2012). Estimates for Canada are less widely available, but using methods similar to the IRC suggests uninsured driving rates 12

21 of 5 percent to 15 percent across the provinces. Because of this, all jurisdictions in Canada and most in the United States mandate that drivers buy uninsured motorist coverage to protect against injury caused by uninsured at fault motorists Residual Markets The problem of uninsured drivers raises another important issue related to compulsory insurance: If auto insurance is mandatory for driving, but private insurers are not bound to offer insurance to every driver, then what is to become of those drivers who cannot obtain insurance in the market? Most jurisdictions, and all jurisdictions which mandate insurance purchase, provide some alternative market or mechanism through which such drivers generally high risk drivers may obtain insurance. This is often termed the involuntary or residual market. Residual markets, which usually provide insurance at subsidized prices, deal with the problem of drivers who are unable to find an insurer willing to provide them with insurance. Associated losses from the residual market pool are usually funded by loss sharing among private insurers or through general tax revenues. The need for residual markets in automobile insurance is generally low, except when restrictions on market pricing lead to shortages of insurance supply in the market. In a market in which regulation restricts pricing, insurers will tend to reject drivers for which there are large differences between expected loss costs and the allowable premium charges. These rejected risks must then receive insurance through the residual market. In this way, regulatory restrictions on pricing raise the percentage of drivers insured through the residual market (Ippolito, 1979; Grabowski, Viscusi, and Evans, 1989; Harrington, 2002). The size of the residual market is generally considered to be an important measure of how well private auto insurance markets are functioning: Healthy auto insurance markets, where coverage is widely available and affordable, are characterized by keen competition among companies, widespread 13

22 choice for consumers, and small (i.e. less than 2% of written vehicles) residual markets (Facility Association, 2003; p. 1). In the public insurance markets in Canada, government run insurers provide coverage to all drivers, regardless of their risk. In the private market provinces of Alberta, Ontario, New Brunswick, Nova Scotia, Prince Edward Island, Newfoundland and Labrador, and the three territories, insurers have created an unincorporated non profit organization, the Facility Association, which serves as a mechanism to provide insurance to those who cannot obtain insurance through the voluntary market. The operations of the Facility Association differ between each jurisdiction. The Facility Association operates a residual market (FARM) in each private market province, and it administers risk sharing pools in Ontario, Alberta, New Brunswick, and Nova Scotia. An approach which may be used as a support to the residual market is to mandate that insurers must accept all applicants. This take all comers requirement has been used in several U.S. states, and has been in force in the province of Ontario since 1993 and in Alberta since Under this requirement, insurers are legally obligated to offer coverage to those requesting it regardless of age, gender, marital status or any other characteristic. Alberta s take all comers rule is fairly stringent in that the rules for the risk to be written within the FARM (Facility Association Residual Market) are mandated by the province and are not based on each insurer s underwriting requirements. Under Ontario s take all comers regulations, insurers must cover all potential insureds who meet their underwriting requirements, but firms are allowed to use rating variables such as territory, vehicle types, driving records and driver classes, accident history, and past convictions to define those risks that they will underwrite. If residual market subsidies are financed through higher premiums for drivers in the voluntary market, this results in shifting of costs from high risk to low risk drivers. Regulations that subsidize highrisk drivers will dampen safety incentives for high risk drivers. If residual market deficits are passed on to 14

23 drivers in the voluntary market through higher premiums, the link between insurance premiums and driving behaviour is further weakened. 4 This will distort driver safety incentives in ways that may lead to reduced precautions for all drivers and thus higher claim frequency and higher loss costs (Harrington and Doerpinghaus, 1993; Weiss, Tennyson and Regan, 2010). 3.2 Public versus Private Insurance As indicated above, the mandatory nature of automobile insurance stems from the reliance on automobiles, the social importance of automobile compensation, and the risks that driving imposes on others. Thus, an important question is what level of government involvement is desirable in the mandatory automobile insurance market. The government may act as the supplier of insurance, through public insurance or a public private partnership; or when insurance is privately supplied the role of government may include defining the mandatory product (such as mandatory limits and benefits provided), and regulating rates, underwriting practices, and claims resolution. Arguments in favour of public insurance include potential economies of scale and lower transaction costs. This leads proponents of government run automobile insurance to argue that a government run monopoly will lead to lower prices and increased insurance benefits, relative to premiums paid. Fronsko (2011) notes that the goal of private insurers is maximization of firm value whereas public insurers likely have objectives that are aligned with legislative objectives. Typical objectives for a government auto insurer, for example, include road safety programs and road redesign aimed at reducing car crashes, and affordability and accessibility of auto insurance sometimes at the expense of actuarially 4 Harrington (1990) shows that there are subsidies from the voluntary to the residual market in a number of states, while Jaffee and Russell (1998) show that residual market prices in California during the 1980s were lower than those in the voluntary market for a large number of insured drivers, indicating cross subsidization. 15

24 fair premium setting. Another key objective is long term viability, although this is a difficult concept to measure if there is no transparent accounting separation between the government insurer and the government itself. Useful examples of monopoly public insurers are the provincial workers compensation (WC) boards in Canada and the four U.S. states that have monopolistic state WC funds. There are also 21 U.S. states that have quasi public workers compensation funds where private insurers compete with the state provider. A 2009 report found that in the U.S. the 25 public and quasi public plans perform better financially than the private market in a number of performance categories, and at least as well when it comes to the bottom line. The state funds were also shown to be more effective at preventing losses and improving safety. Further, although the public programs tend to have higher losses than the WC insurance industry as a whole, they offset those losses with lower expenses, higher investment returns, bigger dividends to employers, and better injury prevention efforts (Jablonowski, 2009). According to Jablonowski (2009) the key to state fund success stems from a dedicated approach to loss prevention and control. 5 Given that they typically work with other state agencies and share responsibility for health and safety, they are able to incorporate state of the art loss prevention initiatives with financial rewards tied to the insured s loss performance. Although public WC funds have higher loss ratios, they also have lower expenses. This is due in part to the fact that they do not pay taxes or licensing fees, but also results from efficiencies achieved through use of technology and coordination of loss prevention, safety and health efforts with other state agencies. 5 In Canada the potential benefits of a public auto insurer and the levers that the government is able to pull in order to reduce automobile accident costs is illustrated by Quebec s coroner calling on Transport Canada to require manufacturers to equip vehicles with a system for detecting drowsiness and loss of driver alertness. The coroner has also recommended that Quebec s auto insurer, the Société de l assurance automobile du Québec (SAAQ), undertake a public education campaign about driving while tired. The coroner recommends that the campaign should caution drivers on the use of cruise control, noting that this might be lulling drivers into a false sense of security. 16

25 In the context of automobile insurance, the monopoly insurer in Saskatchewan, Saskatchewan Government Insurance (SGI), provides another example of how costs can be controlled. SGI has been able to control costs both by being strict on what they will pay but also being very proactive on treatment and getting people better. The Early Intervention program requires an injured person to be committed to a specially designed treatment program in order to achieve the best recovery. Because it is a Crown insurer initiative, SGI is able to ensure consistent messaging and reap the benefits from a single, focused approach. Given that disability income benefits are generous (90 percent of net income), an important goal is to ensure that people are back to work as soon as possible. The incentives of the insurer and the injured party are aligned because the injured party only continues to receive benefits if she or he is fully committed to the treatment plan. Another potential advantage of a public insurer is the ability to negotiate regulated prices (or set maximum prices) for treatment from healthcare practitioners. The provincial WC boards in Canada are able to effectively control costs associated with treatment by using a set fee schedule. The absence of such a schedule in private insurance contributes significantly to higher costs. For example, in Michigan higher costs as compared with other states are attributed in large part to charges for medical services. The Insurance Institute of Michigan (2010) reports that reimbursement costs for no fault claims are roughly three times the reimbursement costs for workers compensation and four times the reimbursement costs for Medicare for the same procedure. Similarly, in Canada private automobile insurers in some instances pay two to three times the amounts that a provincial WC Board pays for the same treatment. Differences in prices charged to private auto insurers as compared with public insurers may be due to cost shifting as well as to differences in cost control mechanisms. Cost shifting occurs when healthcare service providers increase charges to private payers as a means of recouping revenue when 17

26 public reimbursements are reduced. A report by the Insurance Research Council (IRC, 2010) documents healthcare cost shifting from U.S. hospitals to auto injury claims, as a result of low reimbursement rates from government health insurance programs (Medicare and Medicaid) and the costs of treating uninsured patients. The Insurance Research Council estimates that U.S. auto insurers pay additional hospital charges of more than $1.2 billion per year as a result of this practice. There are very few academic studies on the specific costs and benefits of private versus public auto insurance, perhaps because of the lack of transparency of government entities. Kennedy and Mehr (1977) compare the performance of the public insurer in Manitoba with Alberta s private insurance marketplace. They find that private insurers clearly outperform the public insurer in terms of product and service, but that the government insurer can offer insurance at a much lower cost. This price advantage however is artificial: they note that premiums charged in Manitoba were inadequate and that deficits were offset by tax dollars. Quebec s public auto insurance fund has also run a persistent deficit. Data from the Société de l assurance automobile du Québec (SAAQ) show that that annual revenues were less than expenditures in every year between 1982 and By 2004 SAAQ reported a $450 million premium shortfall and a $617 million shortfall in assets, attributed to rising compensation costs and the failure to index insurance rates to inflation (SAAQ, 2006). Despite legislative changes and changes to the rate structure which were designed to remedy this shortfall, SAAQ reported an overall deficit of $1.6 billion in 2010 (SAAQ, 2011). Although the recent deficit may be attributed to the 2008 financial crisis, the deficits demonstrate the ability of government insurers to maintain operations despite persistent shortfalls; and provide further evidence that premiums charged by government run insurance programs may not reflect underlying claims costs. 18

27 Opponents to public auto insurance raise the following issues that arise when there is a monopoly provider: potentially poor customer service, lack of competition, and lack of consumer choice. Government monopolies also have little incentive to operate efficiently, and may lead to lower rates of innovation. These static and dynamic inefficiencies arise due to the lack of a profit incentive and protection from competition. A related argument is that lack of transparency and centralized decisionmaking will lead to politicized decisions that redistribute benefits for political reasons (e.g., Besley, Gouveia and Dreze, 1994). 6 Such concerns have recently been raised regarding the Insurance Corporation of British Columbia (ICBC), British Columbia s public automobile insurer. In the 2012 rate review (BC Utilities Commission, 2012), several observers charged that ICBC s management compensation and the number of highly compensated employees are excessive, and that information disclosure regarding ICBC s operating expenses is inadequate Public Intervention in Private Insurance Markets Due to the differences in public and private objectives in public insurance affordability and accessibility are typically given higher priority than service quality, consumer choice and fairness private auto insurance markets are often regulated to achieve social objectives. In order to achieve the objectives established, the extent of government regulation must be determined. The regulator attempts to balance the need for a financially stable and competitive auto insurance sector with the need to ensure that consumers pay affordable premiums, receive fair benefits, high service quality and timely compensation. The economics of policy analysis deem government intervention to be desirable only when (i) actual or potential failures of market competition exist; (ii) these failures could or do lead to meaningful 6 A large literature in economics examines inefficiencies in government run enterprises, and the results of these studies form part of the basis for the privatization movement in developed and developing economies in the latter part of the 20 th century (e.g., Stiglitz, 1998; Schleifer, 1998). 19

28 economic inefficiencies; and (iii) government intervention can ameliorate the inefficiency. Failures of competition are most likely to arise when one or a few market players control a large share of the market, externalities arise from market contracting, free rider concerns exist, or there is imperfect information. Failures of market competition are often evidenced by markets with only a few large sellers, high seller profits, lack of price variation, or consumer lock in. In privately run automobile insurance systems sellers of diverse size and characteristics 7 operate in most markets; automobile insurance profits tend to be modest in comparison to other industries; and price competition is readily apparent. Thus, there is no clear economic rationale for regulating prices in automobile insurance markets as long as the general legal system prevents collusion among firms in the economy. Skipper (1998) notes that imperfect information may be the most significant impediment to efficient contracting in insurance markets. However, Baltensperger et al. (2008) argue that because insurers recognize these information asymmetries as a cost of doing business, they have developed mechanisms to control adverse selection and moral hazard using both contract design and pricing mechanisms. Therefore regulation of this aspect of the industry is not essential. Nonetheless, information asymmetries suggest the need for other forms of insurance regulation. Insurance is the sale of an intangible promise: to pay financial compensation for losses experienced as a result of some future event occurring. The quality of that promise will necessarily be affected by insurer decisions that occur after the contract is signed, including investment decisions, capital holdings, and decisions regarding claims payments. These can t be perfectly observed and credibly committed to at the 7 In 2009, there were 124 private insurers selling auto insurance in Canada. Ninety five companies belonged to a larger group, 25 insurers were incorporated outside of Canada, and 30 were mutual insurers. The largest private insurance company sold $1.75 billion in auto insurance in 2009, whereas the average premium revenue per company was $130 million (Source: Author calculation from A.M. Best data). 20