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This blog is focused on providing information on Pay As You Drive car insurance in Australia. If you find any information, papers, news articles or websites that we should add, please let us know!

Sunday, November 23, 2008

A Multiple Prisoner's Dilemma

The concept of PAYD, or usage based pricing for car insurance has been around since 1920. The following is an excerpt from an email sent to me by Patrick Butler, Insurance Project Director at the National Organization for Women:

"The audited odometer mile exposure unit has been available for commercial fleets since at least the 1920s, was discussed by 1996 Nobel laureate economist William Vickrey in a 1968 paper, was the subject of a sex-discrimination lawsuit brought in 1986 by Pennsylvania National Organization for Women and documented in three Journal of Insurance Regulation (JIR) papers in 1988 and 1989, was described as the basis for an efficient pre-paid-miles personal car odometer system in a 1993 CAS Forum paper to support exposure unit legislation introduced in Pennsylvania 1990-1993, and so on.

All of these items are documented by papers and reprints available on the website www.centspermilenow.org."


So why is it taking so long for insurers to adopt Pay As You Drive. Progressive in the US had a pilot called Autograph in 1998. That is 10 years ago! Either the concept is flawed, or there must be another reason. 

In terms of the concept being flawed: The concept of PAYD will be flawed if there is no meaningful relationship between how far a person drives, or how they drive, or where they drive, and the amount of risk they bring to the risk pool. The possibility of there being no meaningful relationship is counter-intuitive, but nevertheless possible. Published results of Progressive's Autograph pilot in Texas indicates a clear relationship between distance driven and risk. Furthermore, traditional insurance pricing does its best to capture driving behaviour, by looking at factors like age, gender, vehicle modifications, etc as proxies for risk. So it is unlikely that PAYD is not taking off due the concept being flawed. There must be some other reason. I believe there are two major reasons, and a number of smaller ones. This post deals with the first reason (Prisoner's Dilemma). The second big reason I believe is systems, and will be discussed in a future post.

Multiple Prisoner's Dilemma:
The concept of Prisoner's Dilemma is a classic game theory problem. The basic prisoner's dilemma is explained quite well in Wikipedia. What does that have to do with PAYD? 

To answer this we need to look at the basic premise of the product: In traditional insurance, people who drive less, pay the same as people who drive more (all normal rating factors assumed to be the same). The reason for this is that traditional rating factors (age, gender, suburb, car make and model, claims experience, etc.) are crude proxies for the true underlying risk. Insurance companies have not used mileage actively as a rating factor, because of the difficulty of verifying mileage (mileage as a rating factor is mandated by law in California, but is not checked by insurance companies and a consumer can frankly declare whatever they want). So PAYD introduces accurate pricing for mileage, and by doing so low mileage drivers can receive a more accurate and fair premium.

If you are an existing insurance company with a large book of existing car policies, you most likely have a finely balanced book that is profitable, albeit with thin margins. Your pricing is working, and the cross-subsidies between high mileage and low mileage drivers are balanced. If you introduce PAYD you will charge low mileage drivers less (and a fairer price) and high mileage drivers more. High mileage drivers will most likely leave you and take insurance from someone else who still provides traditional insurance. As an insurance company you face the prospect of losing a large part of your book before you can replace it with low mileage drivers (where you are in fact competitive). That is a daunting prospect. You have a large infrastructure in place which you've built up painstakingly and which is well matched to your current size and volume. If you lose material volume your expense ratios will blow out, which will in turn very quickly eat through your thin margins, leaving you unprofitable. That is not an appetising scenario for any insurance executive.

So this is where the multiple prisoner's dilemma comes in. If nobody acts (i.e. nobody offers PAYD), then status quo remains, books remain finely balanced and life goes on. The first large player to offer it faces the uncertainties listed above, and may take some short term strain. After the short term strain however, the first mover(s) will start benefiting from attracting more and more low mileage drivers and having a competitive offer for arguably 50% of the market. 

What does that do to the other companies? As their low mileage drivers start abandoning them, their book becomes unbalanced. They have less low mileage drivers to cross-subsidise their high mileage drivers. Over time their margins will erode, and arguably in time they will be forced to switch to PAYD.

The Prisoner's Dilemma is not a trivial problem for existing insurers to overcome, and I think it will take many years for them to do so.

Friday, November 7, 2008

PAYD Webinar archive

On the 5th of November the National Underwriter hosted a webinar on Pay As You Drive, titled:

PAY ONLY AS YOU DRIVE INSURANCE COMING READY OR NOT

What Are the Business, Technology and Regulatory Realities You Need to Know?

It was attended by 280 people, mostly based in the US. Most of the major carriers were represented, as well as state regulators and consumer groups. The archive of the actual webinar can be found on http://www.summitwebseminars.com/exigen/Pages/default.aspx.