Which factors may insurance companies use in setting rates? This is a subjective issue that only can be answered through the political process. Whatever the outcome, incentives — or the lack of them — always have consequences.
That’s one lesson from the ongoing brouhaha about whether State Farm and other insurers may consider the age of electrical wiring when setting homeowners’ rates.
Insurance is about quantifying and managing risk. Insurance firms know they can manage their risks best when they can weigh all the different variables that influence possible outcomes for a specific property or life.
Society accepts some such differentiation. Men and women have different life expectancies and pay different prices for life insurance. Smokers pay more than non-smokers. Many firms simply refuse to insure people with histories of heart trouble or cancer.
In property insurance, young sports car drivers with numerous violations pay more than retired sedan owners with 40-year clean records. Young men pay more than young women. We get a discount on home insurance because a fire station is only four blocks away. Asphalt shingles merit a cheaper rate than cedar shakes. People with no swimming pool pay less than people who have one.
Such distinctions are legal and non-controversial. We do not allow insurers, however, to charge African-Americans and Native Americans higher life insurance rates than Caucasians even though there are marked differences in life expectancies between the groups. We similarly ban overtly differential rates for Christians, Jews and Muslims, though we do allow membership-owned mutual insurance companies to sell only to Lutherans, reserve officers or college teachers, for example.
At some point, some distinctions will appear arbitrary. The same is true in property and casualty insurance. Many states have prohibited the use of credit scores in assigning auto insurance rates despite a strong statistical correlation between good credit and good driving. They do not ban, however, “good student discounts” for young drivers based on a similar statistical link.
In addition to varying rates by the type of siding and roofing, the distance from fire hydrants or stations, the type of foundation and structural material, home insurers also may charge more in counties with higher tornado loss experience. In Minnesota, however, they may not charge differential rates based on the age of the house.
Past abuses are the reason for this restriction. Many insurers once simply refused to insure houses in entire neighborhoods. The ostensible reason was higher losses in such areas. Those refused insurance tended to be poor and minorities. Such arbitrary “redlining” of entire areas was banned to eliminate de facto discrimination on the basis of race and income.
Many states, including Minnesota, also banned differential rates based on age of the structure because in many cities, poor and minority communities tended to live in older dwellings. Age-based rates could bring about the same discrimination as “redlining.”
Yet home insurers see an important cause-and-effect relationship between age of the electrical wiring and fire losses. I find the argument convincing. A few weeks ago, old wiring caused a fire in the farmhouse in which my mother grew up. In our own century-old house, the insulation on original wiring crumbles on being bent or struck. We have spent considerable amounts of money replacing such wires in the course of various remodeling projects.
Many homeowners — particularly low-income ones — do not similarly spend large amounts as long as their electricity works. Most old houses have old wiring. If we ban rate discrimination based on age of structure, is discrimination based on a highly correlated variable — age of wiring — legal? Should it be?
Economists will note that surcharges for old wiring would establish a financial incentive for homeowners to replace the wiring. If such wiring actually increases the risk of loss, this incentive would make society better.
Some would add that ages of houses are readily verifiable from public records. Newer wiring is harder to verify and may require expensive physical inspections. Allowing insurers to use age of a structure as proxy for age of wiring would save money on inspections.
But the burden of higher rates would fall disproportionately on poor minority households, advocates for these groups argue. Economists would agree, but many would argue that such groups are better helped with overt income transfers such as the Earned Income Tax Credit rather than regulator-mandated cross-subsidies in home insurance.
Skeptics like me wonder if the whole kerfuffle could have been avoided with better marketing.
State Farm proposed a 6 percent surcharge on homes with older electrical systems. What if State Farm had instead raised all rates by 6 percent and simultaneously instituted a “modern wiring discount” for newer houses? Would the governor and attorney general have paid the same heed?
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.