The Cost of Legal Restrictions on Experience Rating
46 Pages Posted: 16 Nov 2012 Last revised: 26 Jul 2018
Date Written: July 18, 2018
We investigate the cost of legal restrictions on experience rating in auto and home insurance. The cost is an opportunity cost as experience rating can mitigate the problems associated with unobserved heterogeneity in claim risk, including mispriced coverage and resulting demand distortions. We assess this cost through a counterfactual analysis in which we explore how risk predictions, premiums, and demand in home insurance and two lines of auto insurance would respond to unrestricted multiline experience rating. Using claims data from a large sample of households, we first estimate the variance-covariance matrix of unobserved heterogeneity in claim risk. We then show that conditioning on claims experience leads to material refinements of predicted claim rates. Lastly, we assess how the households' demand for coverage would respond to multiline experience rating under two models of risky choice. We find that the demand response is large but depends on the structure of risk preferences.
Keywords: claim rates, experience rating, insurance law, risk type, unobserved heterogeneity
JEL Classification: C58, D12, D82, G22, K23
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