The Impact of Rate Regulation on Claims: Evidence from Massachussetts Automobile Insurance

Rate regulation has a long history in insurance markets. In many states an important goal of regulation is to reduce price variation across purchasers, and specifically to reduce price levels for high-risk purchasers. That feature of rate regulation leads to price cross-subsidies from low-risk purchasers to high-risk purchasers. Consumers who are charged higher prices in order to finance cross-subsidies to high-risks may be less likely to purchase insurance and to reduce participation in insured activities. These adverse selection effects will lead to a higher proportion of high-risk consumers and a higher proportion of insurance purchased by high-risks. In addition, because crosssubsidies reduce the links between insurance risk and insurance prices, all consumers face reduced incentives for loss prevention and safety investments due to moral hazard.

The article tests the hypothesis that insurance price subsidies lead to higher insurance cost growth. To squarely focus on the impact of regulatory price subsidies rather than that of price regulation more generally, the paper makes use of data from the Massachusetts private passenger automobile insurance market. Cross-subsidies were explicitly built into the rate structure through rules that limit rate differentials and differences in rate increases across driver rating categories. Two approaches were taken to study the potential loss cost reaction to the Massachusetts cross-subsidies that began in systematic form in 1977 and continued through 2007. The first approach compared Massachusetts to all other states on demographic, regulatory and liability coverage levels. Loss cost levels that were 44 to 50 percent above the expected level were found for Massachusetts during the 1978-1995 periods when premiums charged were those fixed by the state and included explicit cross subsidies from low risk drivers to high risk drivers. A second approach considered changing cost levels across Massachusetts by studying loss cost changes by town and relating those changes to subsidy providers and subsidy receivers. Subsidy data for 1999-2007, with underlying accident year data for 1993-2004, showed a significant and positive (relative) growth in loss costs for towns that were subsidy receivers in line with the theory of underlying incentives for adverse selection and moral hazard.

Keywords: Auto Insurance, Subsidies, Adverse Selection, Moral Hazard