A Multiple Prisoner's Dilemma

The concept of PAYD, or usage based pricing for car insurance has been around since 1920. The following is an excerpt from an email sent to me by Patrick Butler, Insurance Project Director at the National Organization for Women:

"The audited odometer mile exposure unit has been available for commercial fleets since at least the 1920s, was discussed by 1996 Nobel laureate economist William Vickrey in a 1968 paper, was the subject of a sex-discrimination lawsuit brought in 1986 by Pennsylvania National Organization for Women and documented in three Journal of Insurance Regulation (JIR) papers in 1988 and 1989, was described as the basis for an efficient pre-paid-miles personal car odometer system in a 1993 CAS Forum paper to support exposure unit legislation introduced in Pennsylvania 1990-1993, and so on.

All of these items are documented by papers and reprints available on the website www.centspermilenow.org."

So why is it taking so long for insurers to adopt Pay As You Drive. Progressive in the US had a pilot called Autograph in 1998. That is 10 years ago! Either the concept is flawed, or there must be another reason. 

In terms of the concept being flawed: The concept of PAYD will be flawed if there is no meaningful relationship between how far a person drives, or how they drive, or where they drive, and the amount of risk they bring to the risk pool. The possibility of there being no meaningful relationship is counter-intuitive, but nevertheless possible. Published results of Progressive's Autograph pilot in Texas indicates a clear relationship between distance driven and risk. Furthermore, traditional insurance pricing does its best to capture driving behaviour, by looking at factors like age, gender, vehicle modifications, etc as proxies for risk. So it is unlikely that PAYD is not taking off due the concept being flawed. There must be some other reason. I believe there are two major reasons, and a number of smaller ones. This post deals with the first reason (Prisoner's Dilemma). The second big reason I believe is systems, and will be discussed in a future post.

Multiple Prisoner's Dilemma:

The concept of Prisoner's Dilemma is a classic game theory problem. The basic prisoner's dilemma is explained quite well in Wikipedia. What does that have to do with PAYD? 

To answer this we need to look at the basic premise of the product: In traditional insurance, people who drive less, pay the same as people who drive more (all normal rating factors assumed to be the same). The reason for this is that traditional rating factors (age, gender, suburb, car make and model, claims experience, etc.) are crude proxies for the true underlying risk. Insurance companies have not used mileage actively as a rating factor, because of the difficulty of verifying mileage (mileage as a rating factor is mandated by law in California, but is not checked by insurance companies and a consumer can frankly declare whatever they want). So PAYD introduces accurate pricing for mileage, and by doing so low mileage drivers can receive a more accurate and fair premium.

If you are an existing insurance company with a large book of existing car policies, you most likely have a finely balanced book that is profitable, albeit with thin margins. Your pricing is working, and the cross-subsidies between high mileage and low mileage drivers are balanced. If you introduce PAYD you will charge low mileage drivers less (and a fairer price) and high mileage drivers more. High mileage drivers will most likely leave you and take insurance from someone else who still provides traditional insurance. As an insurance company you face the prospect of losing a large part of your book before you can replace it with low mileage drivers (where you are in fact competitive). That is a daunting prospect. You have a large infrastructure in place which you've built up painstakingly and which is well matched to your current size and volume. If you lose material volume your expense ratios will blow out, which will in turn very quickly eat through your thin margins, leaving you unprofitable. That is not an appetising scenario for any insurance executive.

So this is where the multiple prisoner's dilemma comes in. If nobody acts (i.e. nobody offers PAYD), then status quo remains, books remain finely balanced and life goes on. The first large player to offer it faces the uncertainties listed above, and may take some short term strain. After the short term strain however, the first mover(s) will start benefiting from attracting more and more low mileage drivers and having a competitive offer for arguably 50% of the market. 

What does that do to the other companies? As their low mileage drivers start abandoning them, their book becomes unbalanced. They have less low mileage drivers to cross-subsidise their high mileage drivers. Over time their margins will erode, and arguably in time they will be forced to switch to PAYD.

The Prisoner's Dilemma is not a trivial problem for existing insurers to overcome, and I think it will take many years for them to do so.

PAYD Webinar archive

On the 5^th of November the National Underwriter hosted a webinar on Pay As You Drive, titled:

PAY ONLY AS YOU DRIVE INSURANCE COMING READY OR NOT

What Are the Business, Technology and Regulatory Realities You Need to Know?

It was attended by 280 people, mostly based in the US. Most of the major carriers were represented, as well as state regulators and consumer groups. The archive of the actual webinar can be found on http://www.summitwebseminars.com/exigen/Pages/default.aspx.

 

Some coverage for Pay As You Drive in The Australian

The article below appeared in the Australian today.

Source: http://www.theaustralian.news.com.au/business/story/0,28124,24546649-5001942,00.html

A car insurance product

What's new | October 29, 2008

What is it? A car insurance product which the promoters say could significantly reduce a person's premiums.

Pay As You Drive from Real Insurance allows qualified motorists to pay only for the kilometres they plan to travel.

What are its features? Pay As You Drive allows motorists to cover their vehicles based on how far they drive. Motorists can buy kilometres and are covered until they complete that distance. Anyone driving less than the average for people with the same insurance profile should pay less than they would for traditional comprehensive car insurance. Those who qualify get comprehensive car insurance with a minimum annual premium and purchase insurance for the kilometres they expect to cover in that vehicle. Unused kilometres never expire -- they can be transferred year to year or be refunded and customers who are about to run out of kilometres can apply to purchase additional kilometres. Pay As You Drive reminds customers when they may need to top up their kilometre balance with a sticker for their windscreens and SMS messages to their phones. People who have not made a claim against any of their Pay As You Drive policies for three years in a row receive 10 per cent of the total premiums paid in that time. Similar insurance products overseas require policy holders to have their vehicles equipped with monitoring devices. Pay As You Drive in Australia relies on the customer reporting the odometer reading of the vehicle insured.

What are the advantages? Pay As You Drive is suited to people who drive to and from the train station or work close to home and perhaps use their cars on weekends. It also suits those who have a second or third car.

What are its disadvantages? Pay As You Drive is not for everyone. It works for people who drive less than average. Motorists who drive a lot are actually being subsidised by traditional car insurance, so Pay As You Drive won't work for them. Pay As You Drive is available only to drivers over the age of 25.

What does it cost? Pay As You Drive claims cost savings of "up to 60 per cent on car insurance per annum". A 29-year-old Parramatta man who owns a Mitsubishi hatchback would typically pay $981 a year for insurance, but if he only drives 5000 kilometres, he would pay $316 per year with Pay As You Drive.

For more details, visit  www.payasyoudrive.com.au

Webinar on Pay As You Drive Insurance on 5 November 2008 2pm ET

The National Underwriter, in conjunction with Real Insurance, Exigen Insurance Solutions and Tower Group is putting on a webinar on PAYD. The details are below:

• Date: November 5, 2008
  
•  Time: 2:00 p.m. ET
  

http://www.summitwebseminars.com/exigen/Pages/default.aspx

Pay Only As You Drive Insurance Coming Ready or Not

What Are the Business, Technology and Regulatory Realities You Need to Know?

 
 

Are you ready for the coming auto insurance revolution?

Low mileage driver interest in pay-only-as-you-drive insurance (PAYD) is growing fast, for many reasons. It will save most drivers money on their premiums. And it is environmentally responsible - a green product that creates incentives for driving less, resulting in less pollution, oil dependence and infrastructure cost. So why are some U.S. insurers moving fast while others are slow to act?

Get answers to the important questions:

• What is the market?
  
• Is consumer privacy an issue?
  
• What are the business barriers?
  
• What are regulators doing?
  
• What are the technology options and barriers?
  
  

Plan your company's next steps toward a fast emerging new auto insurance product. 

Moving to mileage-based coverage as a term of insurance has rating and pricing implications and it challenges conventional policy administration, claims, billing and other systems. Find out how Real Insurance, a division of Hollard Australia, implemented the first PAYD product not requiring a monitoring device within customers' vehicles - a solution that avoids consumer privacy issues. Hear all sides of the issue and make your plan of action.

Featured speakers:

• Roger Grobler, CEO, Real Insurance, a division of Hollard
  
• Karen Pauli, Research Director, Insurance,
  TowerGroup
  
• Fazi Zand, VP, Marketing & Business Development, Exigen Insurance Solutions
  

 
 

Pay As You Drive wins best general insurance product in Australia “

Real Insurance won the best general insurance product at the ABF awards for Pay As You Drive. We're very pleased about this, particularly because the product was only recently launched. It is quite an honour to win the award against all other general insurance products in a very competitive market, and I think it recognises the fact that the product is truly innovative and a great deal for consumers.

Channel 9's Extra program has also filmed a segment on Real's PAYD over the last few days. Extra is Channel 9's Queensland based lifestyle program. The segment is expected to go to air over the next few weeks.

An excerpt from the press release following the award below:

------

Pay As You Drive from Real Insurance, the first insurance product of its kind in Australia whereby qualified motorists pay only for the kilometres they travel, has won The Best General Insurance Product category at the Australian Banking and Finance Magazine Telstra Insurance awards.

Says Real Insurance CEO Roger Grobler: "Pay As You Drive gives people a fair go on their car insurance. We wanted to offer Australians a product which reflects large scale changes in their motoring habits and one which would accommodate these changing needs.

"We recognised that current car insurance is unfair to people who use their cars sparingly. The result is that Pay As You Drive offers people who drive less than the average for their age, gender and area to pay only for the kilometres they drive."

Grobler says that the way the current car insurance system is structured means that low-mileage drivers are simply subsidizing insurance costs for high-mileage drivers.

"We wanted to change that so if for example you drive to and from the train station, or work close to home, or you use your car a bit on the weekend, or you have a second or third car, it is likely that Pay As You Drive will save, in some cases quite dramatically, on your car insurance premiums," says Grobler.

The awards were mediated by a panel of leading insurance industry experts including former Suncorp Insurance boss, Diana Eilert, senior Moody's analyst, Wing Chew and top UBS analyst, Ralph Butterworth.

--------

Smoke, Mirrors and Insurance Discounts

Insurance discounts, and in particular the 65% No Claims Discount, are used extensively by insurance companies to sell insurance. A lot of it is smoke and mirrors, because the "normal" price is not defined.

Here is a bit of a closer look:
If a seller of a product or service promises a discount of say 65%, what does that mean? Logically it means that there is a normal price, and that the receiver of the promise can pay 65% less than the normal price. So if the normal price is $100, the receiver only needs to pay $35. That is quite reasonable. It is also a good deal if the $100 was a reasonable price to start with. What if the original price (the $100) is not known? In other words, the seller promises that he is giving you a 65% discount, but there is no "normal" price? That is hardly a discount but rather a misleading sales promise right?

In the retail space (like clothes) the much used "Sale Now On" sales technique is regulated by requiring shops to have the merchandise in their stores for at least a number of weeks at the normal price, before they are legally allowed to claim a sales discount. So the merchandise had to be on the rack at $100, and for sale to the customers of the store for a period of time, before the store can discount the price to $35 and claim the 65% discount. That avoids the practice of getting merchandise in that should sell for $35, and then sell it for $35 and claiming a 65% discount.

Not so in insurance.

One of the most common practices in insurance is the "No Claims Discount", or "No Claims Bonus", where an insurance company would give you typically up to a 65% "discount" for not having had any claims for a period of time. Consumers take it quite seriously and also take pride in their NCD "status".

What happens in reality? Is there a "normal" price? Is there a $100 that was discounted to $35? Not really. Insurance has no "RRP", or Recommended Retail Price, as each insurance company takes into account a myriad of factors in calculating an individual's specific premium.

To prove the point:

1. Take your insurance premium you are actually paying (let's say it is $700 a year). Your insurance company claims that they are giving you a 65% NCB. To do the maths, it works like this:
   "Normal" premium x ( 1 minus 65% discount ) = Premium you're actually paying
   so
   "Normal" premium x ( 1 minus 65% discount ) = $700
   to make the equation work:
   "Normal" premium needs to equal $2,000!
   Hard to believe.
   
2. 90% of people are on a maximum NCD. That makes it difficult to believe that the maximum NCD is not the market price. With all the steps between a rating scale of typically 1 through to 6, it is hard to believe that the fraction of people (2%?) on a rating 6 is the "normal" price.
   

The advert below (large Australian insurer) has been used extensively in print, on TV and is still used online. Add up the discounts. It comes to 105%! So they're going to pay you 5% of the "normal" price if you're really good? I don't think so.

Clearly the promises are all smoke and mirrors. If you read the fine print, it says that the 20% loyalty discount is available after 15 years. And also: "For customers with a No Claim Discount or Bonus, these are applied after the Multi-Policy Discount and Years of Insurance Discount." Not sure what that means? Clearly the marketing people at this company are not very good with maths. Or maybe they are, and the rest of us isn't?

Getting Privacy Right in Pay-As-You-Drive

Pay-As-You-Drive is a concept whose time has come. It is an amazingly obvious concept, with wide benefits for consumers, the economy and the environment. The question is, why has it not taken off? It has been contemplated (I am told) since the early 1990s), and versions of it has been in test since 2000. It is only now that it being sold as a commercial product (as opposed to a pilot or test). Why has it not taken off yet?

Probably 3 reasons:

1. The technology has been too expensive to date for telemetry. Norwich Union as an example had to build the black box from scratch at huge expense. Technology is now very cheap and becoming cheaper.
   
2. Privacy concerns. People don't like being tracked. Not yet anyway. I don't entirely buy this reason – I think it is a storm in a teacup. Think about your mobile phone. You don't think your carrier knows where you (your phone) are always?
   
3. Too complicated. The first set of products was very complicated. The Norwich Union one charged differently for time of day, type of road and combinations thereof. Just too hard to understand. That plus the fact that premiums were charged in arrears, so if you go on a long holiday by road, you get a big bill from your insurer.
   
4. A Prisoner's Dilemma. But more about this in another post.
   

This post is about privacy. It is ironic that the only academic paper (that I can find anyway) on privacy and telematics was published in Australia in 2006. It proposes a solution where the onboard black box calculates the premiums in the confines of the car, and sends anonymous aggregate driving behavior data back to the insurer for modeling purposes, whilst preserving driver privacy. So let us get back to why privacy is a concern in the first place.

Why would people be concerned about privacy, with relation to -

1. How they drive,
   
2. When they drive, and
   
3. Where they drive?
   

The only reasons I can think of are because of wrong doings. Either you're driving too fast, breaking the law in some other way, or maybe you're adulterous. Presumably existing privacy laws will protect you from your spouse catching you with your pants down, which leaves only breaking the law. From a society perspective, we have strict road laws, with large amounts of money being spent on a police force and infrastructure such as speed cameras. Safe driving is everyone's interest.

So the privacy concern for insurance would be that the government confiscates a copy of the black box data and charges drivers for misdemeanors based on the data. Is that a bad thing? I don't think so. It is a lot better than the current system, and will result in much safer roads. So should legislation ban GPS based devices? Probably not. Ultimately consumers will vote with their wallets, and if they think they're at risk because they drive like hoons they will opt out. From an insurance company perspective, that is a good thing.

The flip side is however also an interesting conundrum. What if the insurance company knows that a driver speeds often? What if it is clear from the data that a driver is putting others' lives at risk? Does the insurance company become complicit in the crime? Does the insurance company have a moral or even legal obligation to report the driver?

Ultimately I believe that all insurance will be telemetry based (Real Insurance does not rely on telemetry, but rather on a trust-based system), and all cars will be tracked by the government for all kinds of reasons (including taxes, law enforcement and traffic control). In the mean time, while the technology matures and while privacy issues are still open, we need some runs on the board with Pay As You Drive. The article below is one of quite a large number in the US about the technology and privacy. The original source is the Insurance and Technology Blog.

Getting Privacy Right in Pay-Per-Drive

By Anthony O'Donnell
Sep 19, 2008 at 08:44 AM ET

Our recent report on Real Insurance's mileage-only pay-per-drive policy raised, once again, the question of what it will take to get drivers to use such programs. Industry observers have predicted the resurgence of telematics (the monitoring of driver behavior via telemetry) but privacy concerns continue to shape insurers' pay-per-drive strategy, as the Real Insurance example demonstrates. The Australian insurer bypasses the "Big Brother" fears associated with telematics-based pay-per-drive programs by dispensing with telemetry all together and relying instead on customer-reported mileage alone.

Progressive´s convenient MyRate device represents an improvement on more costly "black box" technology that has hampered adoption.

Progressive has struck a different balance, dispensing with location information, but keeping the telemetry. The Mayfield Village, Ohio-based insurer has also addressed cost concerns that dogged Norwich Union's use of Progressive's patented methodology and technology: getting the "black box" that registered the telemetry proved prohibitively expensive.

Through its MyRate program, Progressive supplies a small, portable device that can easily be plugged into the on-board diagnostic (OBD) port of many car models built after 1996. The device delivers a much richer portrait of driver behavior than Real Insurance's mileage-only plan by recording mileage, braking and acceleration, and time of day. The device periodically transmits that information wirelessly back to Progressive.

With MyRate, Progressive has struck a compromise: the insurer loses valuable location information that it could use for underwriting purposes, but the carrier thus reassures customers uneasy with the idea of their insurer (or anyone else privy to the recorded information) tracking their every move.

Will that be enough for Progressive's Pay As You Drive to take off this time? Though the carrier has not reported any business metrics, Progressive claims that customer adoption has been promising. MyRate is now available in seven states and one out of three eligible drivers (e.g., those whose car has an OBD port) have accepted Progressive's offer to use MyRate, the carrier says.