Buying car insurance

Going online to buy car insurance is one of those bewildering experiences. You are faced with screen after screen of information-gathering questions used by insurance company algorithms to assess how much of a risk you are. Questions include your age, number of years driving, how you plan to use your vehicle, any previous insurance claims, etc. Then you get a price quote.

This process is called screening where insurance companies try to get as much information as they can about car drivers because of asymmetric information. This is an adverse selection situation where there is an imbalance in information between the buyer and seller in a market.

In car insurance, the buyer is often seen to have the information advantage because they know more about their risk as a driver than the insurance company. This means the insurance company might underestimate a driver’s risk and charge them a price that is too low. If the driver has an accident the cost of the pay-out to the driver is borne by their insurance provider who will recoup this by charging higher premiums to other drivers. The overall effect of adverse selection is for overall insurance prices to be higher for all drivers which can be viewed as a market failure.

The other implication of information asymmetry in the car insurance market is called moral hazard where insured drivers take excessive risks because they know their insurance will cover their reckless driving. Because these drivers have more accidents this adds to an insurance company’s costs, and this pushes up car insurance premiums for all other drivers.

Young drivers (17-20 years old) are a particularly difficult information asymmetry for insurance companies because they have no or very little driving history for the companies to make a judgement about a young driver’s risk. To cover their lack of knowledge about young drivers, insurance companies charge them very high premiums. The average annual insurance cost for a young driver in the UK is £1800 ($2,200). The average cost of car insurance in the UK is £420 ($504).

Car insurance is so expensive for 17 to 20-year-olds because they are at a much greater risk than older people. 23% of young drivers are involved in an accident in their first two years of driving.

Apart from screening during the car insurance application process, car insurance companies use other methods of reducing their asymmetric information problem. Telematics car insurance monitors the way someone drives through a small device fitted to their car. This allows the insurance company to obtain personalised information about the way someone drives to give the provider a more accurate assessment of a driver’s risk. Insurance companies also charge drivers an excess which is the amount a person has to pay from their own money for the cost of an accident. The average excess in the UK is £400 ($480). This reduces moral hazard behaviour by drivers because they will have to pay for the cost of their reckless driving.

Possible discussion questions for a class

1. What is asymmetric information?
2. What is adverse selection?
3. What is moral hazard?
4. How does asymmetric information lead to market failure in the car insurance market?