Totaled!

Short-sighted interference has wrecked the car-insurance market. A repair guide.

Conway Collis knew his audience when he announced that he was running for California insurance commissioner last March. "If I'm elected commissioner, I'm not going to be fair to the insurance industry," declared Collis, who was later praised by Ralph Nader and endorsed by Harvey Rosenfield, the man behind Proposition 103. "I'm not going to be reasonable. I'm not going to be even-handed. I'm going to break their backs. I'm going to be their worst nightmare come true."

Although he lost the contest for the Democratic nomination, Collis's remarks revealed as much about the public mood in California as they did about his own attitudes. In a state where virtually every driver has a car-related horror story to tell, the insurance industry is not very popular. Demagogues such as Collis paint insurers as both greedy and inefficient, crooks who provide poor service and charge outrageous prices for it. They find receptive listeners among urban drivers who pay upwards of $1,200 a year for insurance.

A combination of factors is pushing up the price of car insurance in California and elsewhere, including increases in traffic congestion, car thefts, litigiousness, damage awards, and legal, medical, and car-repair costs (all three of which are rising faster than the rate of inflation). But frustration over escalating premiums, particularly in highly urbanized states, has focused on insurers. It is feeding a drive for greater regulation of the car-insurance industry, epitomized by California's draconian Proposition 103.

This Naderite initiative, approved by the voters in November 1988 but still entangled in litigation, seeks to impose rate rollbacks of more than 20 percent; forbid insurers to set prices according to risk; require insurers to obtain state permission for rate changes; and force companies to continue serving current policyholders indefinitely. It would transform one of the freest auto-insurance markets in the nation into a command-and-control system in which political forces prevail over the choices of consumers.

Proposition 103 has already spawned rollback measures in other states. "What's going on is a movement from markets to a regulated system," says University of Chicago law professor Richard Epstein, who writes frequently on tort law and insurance and has represented Allstate Insurance Co. "The essence of all these bills is an effort to confiscate.…The difference between unregulated and regulated rates is the difference between feast and famine."

The urge to do something about car insurance is understandable. In 1988, the average premium in California was $673, the fourth highest in the nation (behind Massachusetts, New Jersey, and Nevada). During the last 20 years auto-insurance rates nationwide have climbed by an average of 7.7 percent a year, compared to an overall inflation rate of 6.3 percent a year.

A handful of jurisdictions have seen dramatic increases. Between 1982 and 1988, for example, average premiums jumped 135 percent in Arkansas, 130 percent in the District of Columbia, 119 percent in Massachusetts, and 111 percent in North Carolina. Premiums are especially steep in high-risk, high-density areas such as Philadelphia, Los Angeles, Boston, Detroit, and Miami. A colleague of mine moved to Los Angeles a year ago; his premium shot to $1,900, nearly four times what he had paid in North Carolina.

Not only is car insurance expensive, it's mandated by law in all but eight states. Having imposed this requirement, state governments must guarantee that insurance is available to every driver at an affordable price. This imperative has become the basic rationale for a variety of regulatory systems.

Two states, Massachusetts and Texas, actually set insurance rates. Twenty-two others (including California) require prior approval of rate changes in all or some cases. The rest allow insurers to set their own rates without approval, although most require that the state insurance office be notified of changes.

When regulated rates approximate competitive prices, the market works well: In most states, more than 98 percent of drivers obtain insurance in the voluntary market. But in several states, especially New Jersey, Massachusetts, and South Carolina, government-approved rates are inadequate. Regulation and pre-emption by the state drive out companies that specialize in covering motorists rejected by other insurers.

The assumption that the market cannot serve high-risk motorists becomes self-fulfilling, and many drivers end up in the residual (involuntary) market. These drivers are either assigned to insurers by the state or covered by a fund to which all insurance companies must contribute. Since their premiums are kept artificially low, they have to be subsidized by drivers in the voluntary market.

This system creates perverse incentives. When I told a Los Angeles insurance broker that I had never been involved in an accident and had received only one ticket during the last three years, he said that was too bad. If I had been in a crash or received more than one ticket, I would have qualified for the assigned-risk plan, and my annual premium would have been $650. As it was, I would have to pay twice that. In that case, I suggested, it would be in my interest to ram a parked car or run a red light in front of a police station. "That might not be such a bad idea," the broker said. He was joking. I think.

When the state does not allow insurers to raise rates enough to cover the cost of subsidizing the residual market, companies try to cut costs. They get pickier and pickier about whom they'll insure, ceding more and more drivers to the residual market. Ultimately, the residual market may include a majority of drivers, along with the very bad risks it was intended to serve. In New Jersey, the state's now-defunct Joint Underwriting Association insured 47 percent of drivers last year. In Massachusetts, insurers had ceded an astounding 65 percent of drivers to the Commonwealth Auto Reinsurers fund.

A 1986 General Accounting Office study found that the proportion of drivers served by the residual market was twice as high in prior-approval states as in competitive states. "The growth of the shared market is inexorably linked with regulatory control of insurance pricing," writes University of Massachusetts economist Simon Rottenberg in a 1989 paper.

Despite the problems associated with rate regulation, groups such as Rosenfield's Voter Revolt argue that the government must impose price rollbacks to compel insurers to cut the fat from their operations and stop gouging customers. Yet by every important measure, the auto-insurance market is quite competitive. Concentration is low, and so are barriers to entry. So it's hard to see how insurers could afford to be grossly inefficient or to charge excessive prices, as Voter Revolt alleges.

But such charges appeal to drivers who want to vent their anger at somebody. "The public is suspicious of the insurance industry," says Scott Herrington, a professor of insurance and finance at the University of South Carolina. "A lot of people don't care about competition. They just want their rates to go down."

That is what Proposition 103 promised. The initiative's solution to high premiums was to tell insurance companies to stop charging so much. Specifically, it ordered them to cut their rates to 20 percent below the levels of November 1987. The only exception was for insurers on the verge of insolvency. In May 1989, however, the California Supreme Court ruled that insurance companies are entitled to a "fair and reasonable return," in effect scuttling the rollback provision.

Now the only way to cut premiums for people in Los Angeles and San Francisco is to raise them for drivers elsewhere in the state. This is what Insurance Commissioner Roxani Gillespie, appointed by Gov. George Deukmejian, has begun to do.

The idea is familiar: Take a little from each member of a large group and give a lot to each member of a small one; if you're lucky, the first group won't notice, and the second group will appreciate the favor. "You're buying votes in urban areas," Herrington says. "If insurance companies are to survive, the only real political gain to be had is to intervene in the market so that high-risk groups pay less and low-risk groups pay more."

In addition to location, insurance regulators have questioned the use of several other pricing criteria. Massachusetts, for example, has prohibited insurance companies from considering sex, age, or marital status in setting rates. The state's insurance commissioner has declared that pricing categories must serve "established public purposes" and has expressed a preference for "classification which…takes a small increment from [each of] many to lighten the load of a designated few."

Such measures appeal to people's sense that insurance customers ought to be treated as individuals, not categorized by such seemingly arbitrary factors as sex, age, or zip code. The fact that people tend to apply such standards of justice to insurance premiums—as opposed to, say, the price of corn flakes or haircuts—is closely related to compulsory insurance laws. By requiring drivers to buy coverage, government takes the "voluntary" out of this market transaction. If they're going to make you buy it, you might argue, the price had better be fair. Even the insurance lobby, which certainly knows better, sometimes says that the object of rate setting is to make sure that policyholders pay their "fair share."

This approach, however, misconstrues the issue. Risk categories are not supposed to be fair; they're simply supposed to help estimate how likely it is that customers will file claims and how large those claims will be. If you live in a congested, high-crime area such as Los Angeles, you are more vulnerable to accidents, theft, and vandalism than if you live in Fresno. Men tend to get into more accidents than women, and your likelihood of being involved in a crash declines with age. Married men are safer bets than single men.

Such correlations have been established by studying the actual experiences of millions of drivers. The easier a factor is to measure and the stronger its relationship to claims, the more apt insurance companies are to consider it. Gender qualifies on both grounds. But insurers find that mileage is a poor substitute for gender both because it is difficult to verify and because it does not fully account for the differences between the accident experiences of men and women.

Now that the rollbacks promised by Proposition 103 have degenerated into fiddling with risk categories, Voter Revolt is pushing an initiative that would create a state auto-insurance monopoly. "If the auto insurers refuse to lower their rates and obey Proposition 103 within a year after the enforcement measure is passed, they will be relieved of the privilege of doing business in California," Rosenfield explains in a Los Angeles Times piece. "In their place would be a non-profit, publicly controlled auto insurance company."

To forestall price regulation and the inevitable spiral of state intervention—culminating, perhaps, in a government takeover of the industry—insurers have embraced no-fault insurance in one form or another. Insurers in California spent $70 million in 1988 to promote an unsuccessful no-fault alternative to Proposition 103. The Insurance Information Institute's literature notes the shortcomings of the liability system and touts the virtues of strong no-fault laws.

The case for no-fault is based on the view that the liability system is fundamentally flawed, that the compensation it provides has little to do with actual damages. The industry estimates that fraudulent claims represent 15 percent to 20 percent of all car-insurance payments. In California, Herrington says, about 75 percent of personal-injury claims involve sprains and strains, which are notoriously difficult to verify.

The incentives created by the liability system for fraudulent and exaggerated accident claims are familiar: Insurance provides deep pockets into which plaintiffs can reach with the help of attorneys, who are all too eager for their share of the money. Plaintiffs with minor injuries tend to be overcompensated, since insurers prefer to settle a small claim rather than endure the cost and inconvenience of a court battle. Those with more serious injuries, by contrast, tend to be undercompensated, since they need money soon and insurers are less inclined to settle a large claim out of court.

Consider a typical fender-bender. A friend of mine, who lives in Los Angeles and is not insured, was turning right out of a parking lot, moving at a few miles an hour, when his front bumper scraped the right rear bumper of another car. "We stopped, and we talked," he recalls. "She [the other driver] said she was OK."

That evening, my friend called the other driver and talked to her husband. "At first, he wasn't saying anything about injuries," my friend says. "In fact, he said everyone was OK." But the man said it would cost more than $500 to fix the bumper. That seemed excessive to my friend, who suggested they go to another garage for a second estimate. "At that point, he got irritated, and he said, 'I'll teach you a lesson.'"

A few weeks later, my friend heard from the other driver's attorney. The woman's insurance company later dispatched an adjustor to examine his car and judge the severity of the accident. "She said there was no way you could get even the slightest sore neck from it," he says. But the adjustor, who declined to put that assessment in writing, also told him that the other driver was seeking thousands of dollars in compensation under her uninsured-motorist coverage for neck and back injuries sustained in the accident.

If the company pays the claim, it may in turn sue my friend, who now wonders whether he should have simply paid the inflated repair bill. He observes: "We have developed a system in which extortion is easy, because they say no accident is so small that you couldn't get a neck or back injury from it."

The perceived inefficiency and inequity of the liability system gave rise to the movement toward no-fault insurance some 25 years ago. The idea was deceptively simple: In exchange for surrendering their ability to sue, policyholders would receive compensation from their own insurers for injuries caused by traffic accidents, regardless of who was at fault. By eliminating lawsuits and payments for noneconomic damages (mainly pain and suffering), no-fault insurance would reduce the cost of settling claims and lead to lower premiums.

In practice, however, no state has enacted a pure no-fault system, which would do away with auto-liability suits entirely. Most of the nominally no-fault systems allow suits in all but the smallest cases. Still, the idea of no-fault remains popular, and lately activists and legislators have incorporated it into a variety of plans that allow consumers to choose between liability and no-fault coverage.

A 1985 study by the U.S. Department of Transportation verified some of the claims made for no-fault. Looking at 12 years of records in 24 jurisdictions, the study found that the proportion of accident victims who received personal-injury compensation was nearly twice as high in states with no-fault laws as in states with traditional liability systems. On average, compensation was quicker and more generous in no-fault states.

These findings are to be expected. After all, no-fault means that you receive compensation from your own company, regardless of responsibility, just as you would under personal-injury or collision coverage in a standard liability system. But like other kinds of first-party coverage, no-fault policies do not compensate for noneconomic damages. And unless it is accompanied by significant restrictions on lawsuits, mandatory "no-fault" actually increases insurance costs.

States that substantially limit the ability to sue, however, have managed to control rate hikes. In both New York and Florida, for example, growth in premiums declined markedly after these states tightened restrictions on lawsuits. In 1988, Florida ranked 27th on the list of average premiums; New York, which you would expect to be at or near the top, ranked 10th.

Strong no-fault has several advantages for insurers as well. It cuts their legal costs and makes business more predictable by curtailing the uncertainty of court battles. Although it increases the likelihood of paying claims, it reduces the prospect of soak-the-insurer court judgments. Furthermore, no-fault plans divert the urge to beggar insurers through rate regulation.

But lawsuit restrictions, which are central to the no-fault concept, raise a troubling question. When is it legitimate to deprive an injured person of the ability to sue? Trial lawyers, who have their own reasons for vociferously opposing no-fault insurance, say never. Every individual, they argue, has a basic right to seek a civil-court remedy for injuries or damages caused by another's negligence.

As a general principle, this appears to be correct. A right not to be injured by someone else's negligence would have little meaning unless one could obtain compensation for violation of that right. Justice seems to require that the person who caused the injury make amends. But as a practical matter, the law places limits on who can sue, when, under what circumstances, and for how much. The most fundamental limit on suits is the legal definition of negligence.

No-fault advocates question the meaning of negligence in the typical traffic accident. Jeffrey O'Connell, the University of Virginia law professor who co-wrote the first model no-fault bill, puts it this way in his 1971 book The Injury Industry:

"How can one talk with moralistic fervor about the wrongdoer 'answering for his wrong' when one's wrong in a traffic accident, if wrong there be, usually consists of a momentary motoring slip of the type that all of us are guilty of again and again, and when the wrongdoer is not only allowed but required to pass the payment for his wrong along to an insurance pool?" O'Connell argues that a certain number of accidents are inevitable and that in most cases the person who is deemed to be responsible has not acted differently than the average driver.

How often do you forget to signal before turning, miss a car in your "blind spot" while changing lanes, or go through a traffic light just as it's turning red? Most of the time, such common errors do not result in accidents. But when combined with the mistakes of other drivers or some other factor—say, icy streets or a defective traffic light—such routine "negligence" becomes much more serious in retrospect.

In such cases, the liability system doesn't seem to deter bad driving. Since your insurance company pays the actual damages, your penalty probably amounts to a premium increase. "If you don't turn on your blinker, it's because, at some implicit level, you consider the risk of an accident to be negligible," says Orin S. Kramer, a New York public-policy consultant who specializes in financial services. "You're not going to calculate the effect on your insurance premium should you end up in an accident that could seriously injure or kill you."

In cases of truly reckless driving, on the other hand, the prospect of a lawsuit may add little to the deterrence provided by criminal penalties. Even in a world where motorists could not sue, speeders and drunk drivers would face fines and imprisonment. And insurers could still consider a policyholder's driving record in setting rates.

The arguments of no-fault advocates suggest that the legal standard for negligence in auto-liability cases needs to be fine-tuned. But they cannot justify doing away with the concept entirely, since at least some accidents are caused by the failure to exercise reasonable care. A civil remedy should be available for damages caused by careless driving, whether or not a criminal penalty also applies.

This does not mean, however, that drivers could not voluntarily accept limits on their ability to sue. Herrington argues that a fully informed, rational consumer would be willing to trade the right to noneconomic damages for lower rates and quick, sure compensation. Both O'Connell and Project New Start, a consumer group, are promoting the idea of allowing drivers to choose between no-fault and liability coverage. Pennsylvania, previously a no-fault state with a low threshold for lawsuits, recently adopted a choice system that includes stricter limits for no-fault drivers.

Under these plans, drivers who choose no-fault insurance pay less and receive first-party coverage; those who choose liability pay more but retain the ability to sue. No-fault drivers, however, still need liability coverage, since they can be sued if they collide with drivers who opt for standard liability coverage or if damages exceed the legal threshold.

So here's the problem: Since it includes liability coverage, the policy purchased by a no-fault driver would naturally cost more than liability alone. But no-fault is supposed to be cheaper than liability; this is its main attraction for consumers. Pennsylvania's legislature addressed this problem by simply decreeing that insurance companies must charge less for no-fault plus liability coverage than for liability alone.

New Jersey, which now allows a choice between cheaper coverage with a high threshold for suits and more-expensive coverage with a low threshold, took a more sophisticated approach. It set up a pool through which buyers who choose the low threshold subsidize those who agree to stricter limits. The system is designed to allocate the benefits of no-fault to those who are responsible for them.

This makes some economic sense: Drivers who give up the ability to sue reduce costs and help bring premiums down, a benefit that accrues to all drivers and insurance companies. It is in the interest of insurance companies as a group to offer a lower rate to drivers who agree not to sue except in serious cases. But acting independently, insurers would have little incentive to do so.

A voluntary arrangement similar to New Jersey's pool is conceivable, but high transaction costs would make it difficult to achieve and maintain without coercion. And there is justice in compelling drivers with standard liability coverage to subsidize those with no-fault policies. In essence, such a system imposes a special tax on those who are more likely to use the civil courts. The revenue from the tax helps relieve the burden on those who are less likely to do so. (This scheme could be extended to uninsured drivers as well. Those who chose not to sign a contract limiting their ability to sue would be taxed to fund rebates for those who did.) Such an arrangement is more equitable than one that taxes people to support the legal system regardless of their ability to sue.

Like the question of who pays for the courts, the problem of multiple compensation raises issues of fairness as well as efficiency. If the purpose of civil justice is to make plaintiffs whole, there is little sense in allowing victims who have already been compensated under insurance policies to recover damages in court for the same injuries. Subrogation, which instead gives the insurer the right to seek reimbursement, would prevent such redundancy. Since insurers are more apt to use arbitration and less inclined to pursue small cases, expanded subrogation would probably reduce the number of lawsuits as well.

In addition to these legal changes, states can free up the insurance market by eliminating restrictions that reduce competition and choice. For example, some states prohibit banks from selling insurance; getting rid of this restriction was one of Proposition 103's few sensible provisions. State laws also set minimum coverage standards, which effectively create price floors, and limit the use of group insurance and agent rebates, which can help bring premiums down.

Deregulation can increase the efficiency of the car-insurance market, and legal reforms—such as limiting pain-and-suffering awards or adopting a "loser-pays" system to cover legal fees—can increase the efficiency of the tort system. Such changes may reduce the price of car insurance, but they are not going to make it universally cheap.

Those who can barely afford car insurance can find ways of reducing their risk. (The ultimate answer may be living somewhere else.) But those who cannot afford to buy coverage (or who prefer not to) should not be compelled to do so.

Epstein argues that mandatory insurance laws are necessary because financial responsibility rules that come into play after an accident do not provide adequate deterrence. In his view, the requirement to carry liability coverage is just another prudent restriction on the use of public roads. "If you can't buy insurance, that's a good signal that you shouldn't be driving," he says.

But if liability insurance truly is a necessity, it's because the concept of negligence has been distorted beyond recognition. In requiring motorists to buy insurance, the government is saying that a careful driver cannot reasonably expect to avoid losing an auto-liability suit. The law presumes that every driver will be negligent.

Mandatory insurance laws, in any case, are readily evaded: In South Carolina, for example, an estimated 27 percent of drivers are uninsured; in Philadelphia, about 30 percent; in Los Angeles County, as many as 75 percent, according to the Los Angeles Business Journal. Imposing a penalty—for example, license suspension—on drivers who are judged responsible for accidents and cannot pay compensation should deter negligence. This approach focuses on behavior that violates the rights of others, not on the decision whether to buy insurance. Furthermore, it allows the working poor to continue driving so long as they exercise proper care.

"Choice" is the byword of the main alternative to Proposition 103–style reform. That choice should include the freedom to take your chances.

Jacob Sullum is assistant editor of REASON.