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data available on the Internet would alleviate some of these information problems.

Proponents of a more regulated environment note that while the information available to the public is better now than it ever has been, there remains significant information asymmetry in personal lines markets. One recent example of this is the significant number of homeowners who think flood is a covered peril in standard homeowners policies.13 Yet the mere fact that consumers may lack information is not proof of a market failure if the information is readily available but consumers choose not to obtain it. In these instances, additional educational efforts by regulators or consumer groups may be desirable in order to reach consumers more effectively.

In addition, the fact that insurance is a complicated product does not necessarily call for greater regulation, as numerous products from computers to automobiles are complicated in their design, manufacturing and engineering. With many products, consumer groups provide buyers guides and detailed reviews of the product. This occurs to some extent with insurance products, and some consumer groups have recently called for greater disclosure of data related to insurers’ conduct in the marketplace.

The Importance of Aggregate Consumer Demand in Insurance Markets

An essential element to consider when looking at competitiveness in markets is that of inter- vs. intra-industry competition. Intra-industry competition – market competition among insurers – has been the primary source of competition studies undertaken in the insurance academic literature. Little, if any, research has been done on inter-industry competition in insurance. Inter-industry competition involves the idea that consumers do not have substitute goods for insurance and can be “captured” by suppliers. For regulated industries, inter-industry competition can be of more significance than intra-industry competition. This distinction is critical to the insurance market. While consumers may have several choices from whom they can buy personal lines insurance, for all but a wealthy few, there are no alternatives to insurance.

Because of the mandatory or near-mandatory purchase and limited available substitutes, it is possible that aggregate demand for personal lines insurance does not exhibit the traditional downward-sloping linear demand curve that is assumed in economic models of competition. The result may be an inelastic demand curve, at least in the relevant market range. An inelastic demand curve is one in which the quantity demanded by buyers is relatively unresponsive to a price change. Consumers exhibit relatively inelastic demand curves when demand is great and no alternative sources of supply or substitutes are available.

It is more likely that personal lines aggregate demand is a kinked demand curve, where at a certain (high) price point, most consumers would choose not to purchase insurance coverage regardless of requirements to do so. At the other end of the curve, most consumers would purchase insurance because of the real or perceived economic benefits of doing so. Appendix A provides a description of the kinked demand curve concept as it applies to personal lines insurance. What is important to understand is that when the aggregate demand function is inelastic, market forces will put upward pressure on prices so that the firms’ total revenue is maximized and marginal revenue equals zero. The additional revenue that would be gained by adding new customers would not be sufficient to compensate for the decreased revenue from reducing prices to gain new customers. In fact, the inelastic demand concept is commonly found in regulated markets. It then becomes a matter of public policy as to whether a market equilibrium is socially acceptable. If at this point industry marginal profit (marginal revenue – marginal cost) equals zero, then price regulation to lower rates cannot create a net welfare gain.

Under the kinked demand concept, it would be expected that competitive markets would, on average, exhibit higher prices and higher profits than markets in regulated states. While research on such a concept in insurance is not available, there exists a body of research on price differentials and industry profits between regulated (stringent regulation such as prior approval) and competitive rate regulation (non-regulated) states. The results of these studies have been mixed, with some finding lower premium rates in regulated states14, others finding higher rates in regulated states15 and some finding no significant evidence

13 NAIC Press Release; What Isn’t Covered by your Homeowners Insurance? June 4, 2007.

14 Tennyson, Sharon. (1997) “The Impact of Rate Regulation on State Automobile Insurance Markets,” Journal of Insurance Regulation, Vol. 15, no. 4; Suponcic, S.J. and Tennyson, S. (1998) “Rate Regulation and the Industrial Organization of Automobile Insurance,” in David Bradford, ed., The Economics of Property-Casualty Insurance. Chicago: University of Chicago Press; Cummins, J.D., Phillips, R. and Tennyson, S. (2001) “Regulation, Political Influence and the Price of Automobile Insurance,” Journal of Insurance Regulation 20 (1): 9–50.

15 Choi, P. B., Weiss, M. A. (2005) “An Empirical Investigation of Market Structure, Efficiency, and Performance in Property-Liability Insurance,” Journal of Risk and Insurance 72 (4), 635–673.

© 2009 National Association of Insurance Commissioners 8

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