Tuesday, 4 October 2016

The Car Insurance Anomaly


An argument I see from time to time from libertarians is that "If it wasn't compulsory, car insurance would be much cheaper, and more competitively arranged, instead of being something the law compels you to purchase".

I think, on this occasion, people who make this claim are under a slight misapprehension. Whether something is a legal compulsion is not the determiner of how cheap it is - what determines prices is competition.

Even though car insurance is mandatory, there is plenty of competition among providers regarding prices. Therefore, as long as no politician looks to impose a price control on the industry, car insurance can operate contemporaneously under a system that legally mandates it, yet allows the competition to keep prices close to their market clearing rate.

Furthermore, something else of interest - from what I recall reading in Freakonomics, car insurance was one of those strange instances of a departure from the norm, whereby, actually, making it non-compulsory in one State (Philadelphia, as I recall) saw prices surge due to non-linear feedback effects.

This also isn't that surprising. To see why, let me explain about feedback effects. The general rule of feedback is that an event becomes part of a feedback loop where a cause and effect chain ends up with situations feeding back into the event. 

You have seen this happen in real situations – for example, when a guitar and speaker produce a sound loop between the audio input and the audio output we hear feedback effects. This is what happens in society too, and here are some examples. 

On the Internet an artist or a weblink can become hugely widespread by a sticking effect. A YouTube video with an unusually high number of hits may create an interest, meaning more hits 'because' of that interest, and this causes a sticking effect, where hits begets more hits, and so on.

For example, suppose 15,000 people happen to view a weblink (this may be a fairly random occurrence), the link may be passed on to an average of 7 people by each one of 80% of the people, meaning that by the second day it has been viewed by 75,000 people. Suddenly you have a lot of people wondering why this link has attracted so much attention - so people look to see what all the fuss is about. 

This then increases the weblink views, which then increase the interest further, which then knocks on to increase the viewing numbers further. In a very short space of time an arbitrary weblink can have huge popularity almost entirely on the basis that this sticking effect has occurred. Most of the views have been because others have been viewing it, and the greater the increase in views the greater the interest, and so on.

Here's another example.  As more people shop online, department stores lose custom. They compensate this loss by putting their prices up, meaning the remaining customers are hit with more expensive products, which means more will change to the cheaper option online, which means that to compensate the department stores hike their prices up even further, causing even more of their customers to choose the online option, and so on.

This same principle explains why, in all probability, if it wasn't compulsory, car insurance would not in actual fact be much cheaper, but probably more expensive. The logic is the same as above. If a US State introduces a policy of non-compulsory car insurance, there will be a reduction in drivers buying car insurance, with the knock on effect being that more drivers have to claim off their own insurance because the person who has hit them has no insurance. 

Because of this, insurance companies increase their premiums, which then prices out more drivers who chose to opt out of insurance buying. This increases the need for insurance companies to increase premiums further, which means more people do not insure their cars. One cause affects the other, and we see back and forth causal factors, leading to a situation like in Philadelphia where car insurance became discordantly high in comparison to the rest of the country.

The Philadelphia car insurance anomaly is a great example of this sticking effect - it has caused unnaturally high car insurance premiums in a place where there is no incommensurably high rate of accidents or car thefts. It is simply a mutually related causal activity where A increases B which then further increases A, and so on until it peaks and gives way to another factor.
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