The theory of insurance and motor insurance for women

01 August 2010 Robert W Vivian, University of the Witwatersrand

The new breed of insurance companies which focus on providing car insurance for women is a prime example of resonance between insurance theory and what happens in practice.

Remember the catch phrase “I love it when a plan comes together” coined by the character John "Hannibal" Smith in the famous A-Team TV series in the 1980’s? When theory and practice resonate, this catch phrase applies perfectly: the plan comes together.

When I lecture this part of insurance theory and I explain that the market for motor insurance for women is an example of the theory working in practice, the lights come on and the students understand the theory.

Theory of insurance

To understand the significance of the market now providing motor insurance for women, first we must understand something about insurance theory.

Many hold the view that insurance is about cross-subsidisation. Some say insurance subsidises the losses of the few with the contributions from the many. Others argue that medical insurance is about the young subsiding the old, the healthy the sick, and so on. Of course, insurance does not do that – so legislation must be passed to force cross-subsidisation. The proposed new National Health Insurance scheme is not insurance scheme but a tax scheme. A tax is levied on some for the benefit for others.

Adam Smith, a famous economist, explained over 200 years ago that anyone who pays a premium - which is sufficient to cover that person’s cost of claims, the cost of administering the insurance scheme, and a return on investment to the investors – should pay the lowest amount that person can expect to pay. To pay an additional amount to cover someone else’s claims is not what insurance is about.

Pooling risks

Some may argue that putting two different risks together, such as young and old, or sick and healthy, does not matter, since the premium will be somewhere between the two. In 1976, two hundred years after Adam Smith, two other writers - Michael Rothschild and Joseph Stiglitz, who was subsequently awarded the Nobel Prize - published a theory dealing with the consequences of pooling different risks. It proposed that it may not be possible to pool unlike risks, and that putting different risks together may well result in there being no market at all.

The red-line areas in the US are an example of this. Insurers were supposed to charge the same premiums, irrespective of the risk. However, some areas in American cities are much riskier than others. Insurers worked out that if they charged the same premium in those areas, they would run at a loss. So they decided not to offer insurance in those areas, at all. They outlined those areas with a red pen - becoming the famous red-line areas where insurance could not be purchased. So, even those who wanted insurance and were prepared to pay for it, could not get insurance.

Another consequence of pooling unlike risks would be a declining number of insureds of the lower premium class. The law of supply and demand dictates that if the price increases, the quantity decreases. So there will be a number of persons who can afford insurance at the right price, but cannot purchase insurance at the higher price. This market is economically inefficient. At the same time, there will be more higher priced persons purchasing insurance because of the subsidy by the lower risk insureds. Almost always, in this case, it will be the poor subsiding the rich. Assume for example that Mercedes Benz and Toyotas are pooled. The Toyota owner will be subsiding the Mercedes Benz owner!

The free market

If left to the free market, these problems will not arise. In a free market there are always people looking for ways to offer competitive products. So, if risks are incorrectly pooled, a new supplier will appear who will correctly price the product, providing the market with the correct product at the correct price. Those who are overpaying will have an alternative correctly priced product and will leave the joint pool to join the correctly priced pool and pay Adam Smith’s lowest reasonable premium. As fewer people are left in the joint pool, the price of the pool increases until it is correctly priced. This is the theory.

The theory in practice

In practice, female drivers are believed to have fewer claims, or lower value claims, than male drivers and thus their premiums should be lower than that of men. In a joint pool, women will be subsiding men.

According to the theory, if this is true and the difference between the risks is significant, a new insurer should appear, offering the correct insurance at the correct price for women. This is exactly what happened - motor insurance for women was launched in the market and thus the theory and the practice resonate.

Is it discrimination?

Of course, lawyers do not necessarily understand economics and there have been a number of constitutional challenges arguing that men are being discriminated against. Fortunately, these cases did not take place in South Africa. The outcomes of these cases have also been inconsistent.

In a Canadian case, Zurich Insurance Company v Ontario (Human Rights Commission) 1992 93 DLR 4th 346 SC, a single 20-year-old male complained that he was discriminated against because he had to pay insurance rates which exceeded the rates paid by women. He alleged he was discriminated against on the basis of age, gender and marital status. The court, by a majority of five judges to two, did not agree and ruled in favour or the insurance company.

On the other hand, in an earlier case - that of Hartford Accident & Indemnity Company v Insurance Commissioner of the Commonwealth of Pensylvannia 482 A 2d 542 Pa 1984 - a 26-year-old unmarried male with an unblemished driving record successfully protested against gender-based insurance rating and the Insurance Commissioner held that gender based rating was invalid. The Hartford Insurance Company applied to overturn the commissioner’s decision but was unsuccessful in Pennsylvania National Organisation for Women (NOW) v Commissioner of Pennsylvania Insurance Department 551 A2d 1162 Pa Cmwlth 1988.

I should point out that part of the argument in these cases was not about the economic principle, but rather whether or not the statistical evidence did indeed support the contention that women are lower risks than men when it comes to driving.

The converse holds true for pensions

The opposite argument can be made when it comes to pensions. Statistically, women live longer than men. This means, therefore, that they should pay higher contributions when it comes to funding retirement. But that is a topic for another discussion.

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