01 June 2007

Auto Insurance Premiums

Peter Brink, writing in TheStreet.com yesterday, said that auto insurance premiums are falling. Why would that happen? Aren't auto insurance companies greedy bastards? as much so as any other capitalists?

Brink attributes the decline to the fact that vehicles are safer now than they were 10 years ago. http://www.thestreet.com/funds/ratings/10359691.html?puc=googlefi But, we might ask him: so what? If a business can keep selling its product for the same amount of money even though its costs are dropping, why wouldn't/shouldn't it? It's called profit maximization, isn't it?

Yes. For the sake of clarity, we ought to think this through a bit further. Suppose two brothers, Frick and Frack, have founded two insurance companies. Each has specialized in the field he thinks likely to be most lucrative. Frick sells auto insurance. Frack sells flood insurance. Suppose, now that both lines of business prove to be equally profitable. There is no incentive for either to change his business model, because each is doing as well as the other. What might change this nice equilibrium?

A sharp drop in auto claims, due to increasingly safe models of car over ten years, might change it. Frick continues to charge premiums at the price the market will bear. Since he pays out less money, his profit of course increases. This means he's doing better than Frack now. Some of the Fracks in the world will become dissatisfied with this situation, and will move into auto insurance themselves. The increasing competition (in the absence of prohibitive barriers to entry) will lead to lower rates after all.

That's how its been written up in books at least since Alfred Marshall's day. And that is what seems to be underway.


Aleda said...

Great work.

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