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Appendix A

Discussion of Aggregate Demand Function for Personal Lines Insurance

D1

S*

Q

P

PH

Q*

S1

P1

PL

Q1

0

E*

E1

Personal lines insurance can be characterized by a kinked market demand curve as a result of externalities created from compulsory purchase requirements (either by statute for auto liability or imposed by finance company requirements in home and auto physical damage) and the unavailability of substitute goods for nearly all consumers. The first portion of the market demand curve, D1, says that at some price (> PH), most consumers will decide to ‘go bare’ and not purchase insurance at higher prices. On the other end of the kinked demand curve, at some price (< PL), most consumers will decide to purchase insurance because they perceive the cost of insurance coverage to be negligible relative to their risk.  The demand curve between points PH and PL, the relevant portion of the demand curve for insurance markets, denotes a relatively inelastic market demand for insurance coverage reflecting the fact that consumer are required to purchase insurance whether they want to or not and, in most cases, do not have an alternative product or products to consider other than personal lines insurance.

With this kinked demand curve, the optimal supply curve for the insurance industry is characterized by S*, with an optimal amount of insurance Q* at a market price of PH. In this market (regardless of regulation) there is no incentive for the insurance industry to expand their market capacity (an outward shift of the industry supply curve to S1) beyond this level. Such an outward shift on the inelastic portion of the demand curve would yield a modest gain in new customers or increased insurance coverage (Q* to Q1), but at a large decrease in price (PH to P1). Such a small increase in new business in the market would not compensate for the relatively large decrease in price since total revenue is maximized (as measured by the area of 0,PH,E*,Q*). At point E*, marginal revenue for sellers equals 0. As a result of the inelasticity of demand, market forces will result in an inefficient allocation of resources as buyers, in the aggregate, are unable to exert sufficient market pressure on suppliers to lower prices and no market incentives exist for insurers to prove additional coverage.

© 2009 National Association of Insurance Commissioners 11

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