David R. Henderson  

Liberty Mutual: Pay More Now Instead of Later

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For the last few months, at least, my wife and I have been annoyed by the silliness of Liberty Mutual's ads for auto insurance. Thank goodness for the mute button, or, if we're watching something we have DVRed, the fast forward. The latter, by the way, has to be one of those little drops in the "prosperity pool" that Don Boudreaux writes about so eloquently and, for me, a pretty big drop.

Now to the content.

The gist of almost all the ads is that Liberty Mutual's auto insurance competitors are big meanies because they raise their rates when the person insured has an accident. Their complaint would be justified if there was no positive correlation between having an accident now and having one in the future. But, due to imperfect information about other factors that are relevant for setting auto insurance premiums, increasing premiums based on the insured person having an accident makes a lot of sense. The more accidents you have, the higher the probability that you will have one in the future.

And talking about probabilities, the probability that Liberty Mutual's actuaries do not know this is approximately zero.

Which means what? It means that Liberty Mutual, to make money or break even with its policy of not raising rates for clients who have accidents, must charge more now. Thus the title of this post.

I ran this reasoning by frequent commenter Greg Sollenberger, an insurance actuary, who says it makes sense.

Here's one further thought I've had since running it by Greg. So he's not necessarily vouching for this one. Who will find such ads appealing? I suggest it will be people in two categories: (1) those who don't think through the point I made above, and (2) those who do and who think of themselves as people who are likelier than the average person to have an accident. To the extent the latter are heavily represented (assuming Liberty Mutual takes this into account, as it is highly likely to do), the initial premiums will be even higher than I suggested above.


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COMMENTS (14 to date)
Stefan writes:

There is a 3rd reason: you're buying insurance both against the cost of the first accident and against the cost incurred by how much that rating reveals information about your accident proneness.

Think of the analogy to health insurance: you have a accident. Health insurance could pay for the immediate medical cost of that accident, and then raise your premium to cover subsequent costs (say rehab, or the expected cost of you being accident prone).

John Cochrane thinks private medical insurance should cover these subsequent expected premium increases with a onetime payment (as the outcome of the optimal enforceable contract).

http://faculty.chicagobooth.edu/john.cochrane/research/papers/Cochrane%20time%20consistent%20health%20insurance%20JPE.pdf

[html fixed--Econlib Ed.]

ThaomasH writes:

Since pretty much everyone here in Lake Wobegon thinks we are better than the average driver, I doubt there is much room for an adverse selection Death Spiral here. As a matter of fact when I did comparison shopping a few years ago Liberty was the lowest cost quote. Since then I've had a couple of accidents [which of course were NOT MY FAULT :)] so I guess I optimized well.

Jim writes:

Of course there will be some anti-selection. Not necessarily a Death Spiral but definitely some anti-selection.

RPLong writes:

Is it possible that Liberty Mutual's actuaries are capitalizing on the spread between the X% of people who have one accident and the Y% of people who have more than one accident? If X% is much, much greater than Y%, then isn't there some profit to be made by taking on that risk? This wouldn't be true for all X% > Y%, but certainly there is a range of X and Y for which this is true.

Phil writes:

The other Liberty Mutual ad that infuriates me is the one about the insurance company replacing "3/4 of the car." They imply that people do not understand the immediate ~20% depreciation that occurs on a new car coupled with the fact that they are insured for the value of the loss, not the cost to replace.

GregS writes:

Good, concise post. If I had written it, I might have spent a paragraph or two dispelling the commonly held notion that the insurer is trying to make back the money they spent on you. I hear this a lot, but the numbers make this story implausible. A single large claim costs many years’ worth of insurance premiums (it had darn well better, or else it’s not really insurance!), so the “making back their money” story doesn’t make much sense. Also, considering that the insurers usually only surcharge for the past 3 – 5 years’ worth of accidents, there’s no way they’re making back their money on a multi-thousand dollar claim. (Maybe they’ll recoup the cost of a few low-dollar comprehensive claims on those customers who use their insurance as an ATM.)

Slightly riffing on ThaomasH: Even accidents that *aren't* your fault are predictive of future accidents. Careful drivers are more defensive and so have fewer of these. (Of course, all this is in an "on average" sense.) As a courtesy these usually aren't surcharged, though. Insurers like to be accurately priced and segmented, but there is always a non-trivial consideration of the customer taking offense. I think that's what Liberty Mutual is trying to do here. Time will tell if they're taking it too far.

David R. Henderson writes:

@Greg S,
Thanks.
@Stefan,
There is a 3rd reason: you're buying insurance both against the cost of the first accident and against the cost incurred by how much that rating reveals information about your accident proneness.
Good point. Thanks.

Andrew_FL writes:

So? They're a private company making a misleading sales pitch that intelligent consumers can figure out-of which this post is proof.

What's the issue?

Michael Savage writes:

Assuming that the insurer is rational but its customers aren't, one hypothesis is that they're selecting customers who aren't price sensitive. If they are willing to pay more now, they might be more willing to accept annual price increases too. I wonder how much information they can get from shared databases (is there a FICO equivalent for insurance?). Maybe they price risky drivers very high, but expect also to get a sample of low-risk drivers too. They will be really valuable customers: low risk and price insensitive.

Glen Smith writes:

Seems that most insurance ads are based around the very arguments that people give when they argue for government to provision it.

Lauren writes:

No-fault insurance may be a major difference in terms of your reaction and mine about the Liberty Mutual ads, David.

In no-fault states--such as where I live out here on the East Coast--extra-high premiums are charged to folks who don't have accidents. Unused proceeds are distributed to folks who do have accidents. In no-fault states, auto insurers are not allowed to charge less to drivers who have fewer accidents than to drivers who have more accidents.

There's no way to get out of no-fault insurance out here in New York, New Jersey, and a bunch of other states. You live here, you pay through the nose.

Consequently, cheap add-ons and benefits rewarding good drivers have become increasingly desirable in these states. So, for example, if you as a good driver can insure yourself against having your auto rates go up by $400-$500 a year because of an accident you didn't cause but that is too costly for the on-the-spot police to decide who is at fault, paying an extra $12 a year is an excellent deal!

Notice, too, that Liberty Mutual displays the Statue of Liberty in the background of their ads. That's probably not some ploy to appeal to national pride (though frankly, I enjoy that they do that; and there are plenty of companies that shy away from displaying pride in being American these days).

But it's more likely because Liberty Mutual is absolutely and unquestionably making it clear to those of us who live here in New York State and the State of New Jersey--those of us who drive daily past that exact spot or know it well--that they, Liberty Mutual, are now offering this add on for accident forgiveness.

And it's no small potatoes that a small company is offering that add on of accident forgiveness. Till recently, it's only the big boy insurers--national insurers such as Nationwide and Allstate, etc.--who have offered the option to add this feature on to an auto policy. It's competition and new entry in action.

In my particular case, for my particular insurance policy and insurer, I've made some calls and have now figured out that an extra $12/year I originally agreed to add on, many years ago, for accident forgiveness--a great deal that I snapped at!--eventually got folded in with another low-cost feature I have--a feature that has reduced my deductible to near zero, along with some other small features that are each by themselves very small potatoes. I can no longer select just one or the other feature from a checklist. Nevertheless, it is still absolutely an option for me to choose to not select that bundled option as a whole. All told, it might save someone a total of $30-$50 a year to select the cheaper-grade insurance rather than the bundled option.

By the by: I actually love those Liberty Mutual commercials. Compared to most TV commercials, I find them enjoyably entertaining and clearly addressed to the humorous aspects and to information and explanation rather than fluff. Many young folks may not know what accident forgiveness insurance is about. I guess I prefer those commercials to a bunch of burping frogs or local lunatic car dealership owners yelling how their offers are crazy or huge. Liberty Mutual commercials get my vote.

John Fembup writes:

Dave, the Liberty Mutual ads are effective for the reasons you cite. But my favorite is Progressive. Why?

Gee, Progressive is such a nice auto insurance company! They will tell me if another insurer offers a lower premium! What a great service!

Progressive, of course, actually does this - and advertises it widely. I think their strategy is brilliant, both from a marketing standpoint, and from an underwriting standpoint.

The marketing brilliance comes from creating the impression that Progressive will help you find the lowest premium - even if it's not Progressive.

The underwriting brilliance is a bit more complicated (and not advertised) - but perhaps it's even more brilliant.

First, understand that every insurer underwrites risk in slightly different ways; to oversimplify, the basic risk components are generally the same among insurers, but the exact weights each company assigns to them differ slightly. These weights reflect what each company considers its ideal risk, gradually grading down thru what it considers more costly risks. Since each company assigns its own weights, different companies can have different premiums for the same driver.

Second, any insurance company can calculate the premiums of its competitors using the information publicly on file at the insurance department.

Third, when Progressive tells you its rates are lowest, it's really saying that you are among what it considers to be its best risks - i.e., less-costly risks. That's why it can offer you its lowest premium. But if another company's premium is higher than Progressive's, that's saying you are not among the risks Progressive thinks are least costly. In that case, Progressive is pleased pink to send you off to its competitors. Weirdly, even if you don't fit so well in Progressive's risk profile, you may actually fit nicely in other insurers' risk profiles.

Why do I think the underwriting part of Progressive's strategy is even more brilliant than the marketing part? Because while the marketing part boosts sales - the underwriting part boosts net revenue per sale.

Liberty Mutual's ads are effective. But Progressive's are my favorite.

David R. Henderson writes:

@Lauren,
Good points. Of course, I had assumed that the additional charge was much more than $1 per month.
@John Fembup,
Interesting point about Progressive’s apparent “Miracle on 34th Street” strategy. Thanks.

Swami writes:

I am a regular reader, and coincidentally, was also the driving force behind the creation and popularization of these features (which were first popularized at another company in the early 2000's.) I did the market research, and am intimately familiar with both the consumer psychology and actuarial logic to these features.

It is as follows:
A major frustration of consumers is the lack of reciprocity in insurance. Good drivers pay for absolutely nothing (their words not mine), and then when they finally have an accident they get penalized and pissed off. Thus we designed several features to address this.

Accident forgiveness, where you are not penalized with higher rates
Deductible rewards, which reward you with a lower deductible, for every year of safe driving,
Safe driving cash back bonuses, where we send the good driver a check refund of a portion of their premium for being a great driver (not coincidentally along with their renewal bill)

Now, you might think that these just lead to higher average premiums neutralizing the benefits, and you would be half right. But, the quest for reciprocity is really, really strong with people. Also, this allows companies to differentiate themselves from the incessant save $ mantra which previously dominated marketing of this product, and was "owned" by Geico.

Second, the net effect of the three features combined is to move funds from those who do drive well and avoid frivolous claims, and move it to those who do not. This changes behavior and thus makes the system more just and equitable.

Third, the features were sold (by us) in a package and the features self fund each other. You can't earn both accident forgiveness and a deductible reward in the same period. It is one or the other.

Most importantly, by a long shot, is that the name of the game in insurance is all about RENEWALs. Renewal customers have substantially lower expenses and loss ratios than new customers. All three of these features were designed to reward customer retention, especially deductible rewards (try getting a competitive quote for a zero deductible). These features effectively reward and lock in customers, and the higher renewal rates pretty much pay for the features over time. Effectively improving the pool of customers you are joining and in theory lowering long term premiums.

These products and features thus lead to differentiation, improved customer satisfaction, higher close ratio on quotes, outrageously higher renewal rates and substantial profit and at least potentially lower long term rates. This is especially true if the rewards packages are not the only product you sell (the company also offers stripped back conventional products).

I will add that I have absolutely no familiarity with Liberty Mutual's situation. Just with a much larger company which was the leader in these features starting around a decade ago,

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