My first experience with adverse selection was soon after a friend moved into a new house. He received a call from a neighbor letting him know that Sears had mispriced their fertilizer from $20 a bag to $2 a bag. Every neighbor and friend got the call or passed the information along until Sears ran out of fertilizer that day. It is a small, but effective example that demonstrates how fast adverse selection can happen.
Over the years, working in insurance, I have seen this played out a numerous times. In one case a friend told me that he and everyone he knew was registering their cars in a different state to avoid Massachusetts rates and, he even explained how to do it. In another instance, a large insurer in health care mispriced their product and the agents directed their clients to buy the underpriced product to the point that the line was closed due to heavy losses. And in one particularly blatant case, a newspaper on the west coast in the early 1990s published a list of insurance carriers that were not testing for AIDs so that patients could obtain insurance without the carriers knowing they had a preexisting condition.
Costs From Risk Assessment Weaknesses Add Up Fast
The point of all these stories? If a carrier has a known weakness in their risk assessment, you can be sure that everyone else knows, and agents, clients, and advocates will take advantage – sometimes on a small scale and sometimes on a large scale. Regardless of the scale, the exposure can grow quickly and wipe out a company’s profits. Adverse selection is a positive feedback loop that can take low volume garaging fraud and quickly turn it into a large volume of garaging fraud.
Garaging Fraud Costs on the Rise
Garaging fraud is a known issue in auto insurance. It is estimated to be a $2 Billion to $7 Billion annual premium problem. The way carriers manage this problem varies. Some attempt to make a cure up front before they issue the policy, while others and some say most, attempt to address the issue in the rating plan. By addressing it in the rating plan, carriers can make the Rate, Quote, Bind, Issue process as fast and clean as possible, helping them to be competitive in price. If a carrier tests for garaging fraud and is the only one testing, they will not see any revenue from that applicant, as anyone caught would likely have their premium adjusted higher and be driven away by the rate hike. The philosophy is to get the premium on the books and address incorrect garaging information at the time of application as a renewal or claim issue.
Here is where adverse selection really gets going and the positive feedback loop takes off. By using the rating plan to cover losses from clients that misrepresented their garaging information, good clients are charged more than they should be charged. A good risk client finding this out, will shop and move their policy. At the same time the client that is under charged is bragging about the low premium that got from that carrier. So now the carrier is losing good risks that are covering for poor risks, and at the same time issuing more policies to poor risks. With losses mounting, prices go up causing more good risks to leave, and the spiral continues.
This is death spiral. Driving away the best risks with prices that are too high because they are covering for bad risks that are charged too low is a sure way to go out of business. There is a reason why the very large carriers are getting all the good risks in the market, they assess the risk correctly at the point of sale and charge accordingly. Good risks get good rates and bad risks get higher rates. This is how insurance should work.
Who relies on DRN to find the car?
- 85% of the Top 100 Auto Finance companies in the United States use DRN’s vehicle location data to recover more than $3 Billion in repossessed vehicles
- Insurance SIUs use DRN vehicle location data to identify garaging fraud
- Over 3,000 United States law enforcement agencies use DRN to find the criminals’ garaging address.
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