Do Insurance Companies Possess an Informational Monopoly? Empirical Evidence From Auto Insurance

• Date: 01 December 2013
• Author: Paul Kofman,Gregory P. Nini
• DOI: http://doi.org/10.1111/j.1539-6975.2012.01487.x
• Published date: 01 December 2013

© The Journal of Risk and Insurance, 2013, Vol. 80, No. 4, 1001–1026

DOI: 10.1111/j.1539-6975.2012.01487.x

1001

DOINSURANCE COMPANIES POSSESS AN

INFORMATIONAL MONOPOLY?EMPIRICAL EVIDENCE

FROM AUTO INSURANCE

Paul Kofman

Gregory P. Nini

ABSTRACT

This article investigates the impact of policyholder tenure on contractual

relationships in nonlife insurance markets. For a sample of auto insurance

policies, we find that average risk decreases with policyholder tenure, but

the effect is entirely due to the impact of observable information. We re-

ject the hypothesis that the incumbent insurer is privately learning faster

about quality of their policyholders. Wehighlight the importance of a public

signal regarding policyholders’ claims experiences and suggest alternative

explanations for the unconditional relationships in the data.

INTRODUCTION

In the United States, approximately one-quarter of auto insurance premiums are used

to pay expenses related to actuarial and underwriting activities (Insurance Informa-

tion Institute, 2010), which help insurance companies set prices and manage risk.

These activities help reduce natural information asymmetries between customers

and the owners and managers of an insurance company.Indeed, the theoretical justi-

fication for the existence of many financial intermediaries relies on the intermediary

capturing the scale economies inherent in the production of information. Through-

out the course of repeated underwriting and occasional claims settlement, insurance

companies produce valuable information concerning the risk profiles of their poli-

cyholders. Natural follow-on questions concern the availability and consequences of

this information once it has been generated by a particular intermediary. Does this

information become the proprietary property of the incumbent insurer? And could it

create a subsequent information monopoly that destroys policyholder welfare?

Paul Kofman is with the Faculty of Economics and Commerce, Department of Finance, The

University of Melbourne. Kofman can be contacted via e-mail: pkofman@unimelb.edu.au.

Gregory P. Nini is with The Wharton School, University of Pennsylvania. Nini can be contacted

via e-mail: greg30@wharton.upenn.edu. The authors thank Thomas Cipra and participants

at the Financial Intermediation Research Society Conference on Banking, Corporate Finance,

and Intermediation, and seminar participants at Victoria University Wellington, Maastricht

University,and Tilburg University for comments on earlier versions of this article.

1002 THE JOURNAL OF RISK AND INSURANCE

This article addresses these questions empirically by testing two hypotheses gener-

ated from models of asymmetric learning and policyholder lock-in. These models

assume repeated contractual interactions and a complete lack of commitment by both

the insurer and the policyholder, as is common in most nonlife insurance markets,

including auto insurance.1First, if an insurance company gains an information ad-

vantage relative to its rivals, the incumbent insurer should strategically retain a larger

fraction of lower risk policyholders, because these policyholders are unable to reveal

their higher quality to outside competitors. As a result, the average risk of a group

of policyholders will decrease as the policies age. Second, insurers will earn higher

average profits on policyholders with longer tenure, because insurers use discounts

to attract new customers and gradually increase prices as the information monopoly

grows over time.

Using a large set of policy level data from a single Australian automobile insurer,

the results strongly suggest that policyholder tenure is related to average risk. How-

ever, the relationship is driven by the effect of policyholder characteristics (e.g., the

insured’s age and claims history) that are easily observable by competing insurers,

and the conditional relationship between risk and policyholder tenure is considerably

weaker. We conclude that there is no evidence supporting the hypothesis that hidden

(unobservable) information is a source of policyholder lock-in.

We draw this conclusion based on estimated claim risk and severity models that

explicitly account for unobserved heterogeneity.By exploiting the occurrence of mul-

tiple claims for some policyholders during the sample period, we permit the risk

distributions to vary at the policyholder level according to characteristics unob-

servable to us as econometricians and to competing insurers. We find that claim

severity distributions do not have residual heterogeneity, meaning that we cannot

reject the null hypothesis that all policyholders have the same mean claim severity,

conditional on observable characteristics. For claim frequency distributions, we do

find evidence of residual heterogeneity; we confidently reject the null of zero vari-

ance in the mixing distribution that determines the Poisson parameter that governs

claim frequency. Importantly, however, we do not find any evidence that the level

of heterogeneity varies with policyholder tenure, which we interpret as corroborat-

ing evidence that insurers are not strategically retaining a select group of low-risk

policyholders.

We do observe a strong negative relationship between loss ratios—the ratio of

claim costs to premium, a traditional measure of nonlife insurance company

profitability—and policyholder tenure. However, we show that premiums charged

1These models are distinct from those used to describe life insurance markets, where contracts

are long term and the insurer can commit to future prices. Hendel and Lizzeri (2003) examine

such a market and show that premiums in the optimal contract are “front-loaded,” meaning

that premiums (relative to risk) tend to decrease over time to prevent policyholders receiving

good news from switching to another insurer. As will be described in more detail below,

with a lack of commitment by the insurer, Kunreutherand Pauly (1985) show that premiums

are back-loaded, meaning that premiums increase over time as incumbent insurers gain

an information monopoly. The models with a lack of commitment are relevant for nonlife

insurance markets.