A wacky race

PRICES can say a lot about the health of a market. Low prices tend to signal sharp competition. High prices can mean a cosy stitch-up, with fatcat incumbents who fear only antitrust watchdogs like the Competition Commission. But in Britain’s strange car-insurance market the conventions are flipped. Fierce rivalry has led to high prices and a shrinking product range. And insurers are keen for the commission, which will report on the car-insurance market next month, to tell them how the industry might work better.

Car insurance seems to defy economic logic. Since 2007 the price tag on a new car has risen only slowly and second-hand motors have become cheaper (see chart). So the cost of replacing stolen cars, which accounts for a quarter of insurers’ claims costs, has fallen. The total number of claims is down too, from 4.3m in 2007 to 3.3m in 2012, according to Datamonitor, a consultancy. That combination of cheaper cars and rarer crashes makes the persistent rise in insurance prices appear odd.

Stranger still, competition abounds. The largest ten insurers take less than two-thirds of the £15 billion ($24 billion) in annual premium revenues. Barriers to entry are low: new entrants and foreign firms have gained a foothold in recent years. Price-comparison websites make it easy to compare deals and switch insurers.

The problem is rocketing costs. Between 2007 and 2012 insurance companies’ average cost per claim rose from around £1,700 to just over £2,900. This more than offset the drop in the number of claims. Personal-injury claims, some of them dodgy, are one cause. The 480,000 whiplash injuries per year on their own make up a quarter of claim costs.

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But even genuine claims are too costly. The problem seems to be the way they are handled. After a crash the insurer of the “at fault” driver takes the hit. It becomes liable for car repair and a host of sundries like towing and hire cars. But once liability is agreed, firms take care of their own customers’ vehicles: the blameless motorist’s insurer bills the other firm for repairs. As a result, the firm responsible for paying the bill loses control of costs.

The commission’s economists found that when insurers control repair costs (for example, when a crash involves two drivers insured by the same company) bills tend to run to around £1,200. But when costs are to be passed on to competitors the tab jumps to £1,600. Overall, “overcosting” might add 30% to repair costs, the commission thinks. And the provision of hire cars while repairs are being done appears just as excessive. Almost four days’ extra car hire is provided when insurers lose control of these costs.

When a car is so badly damaged that it must be written off, a different variant of the same problem emerges. The at-fault insurer pays the non-fault firm an amount based on the difference between the scrap value of the wreck and its insured value. Here the commission’s evidence suggests non-fault insurers may be setting artificially low estimates of salvage, resulting in higher payouts. In short: competition leads not to better deals for consumers but to higher costs for rivals.

Choice suffers, too. Because even small bumps have become a big liability, “third party only” cover, traditionally used by thrifty young drivers with low-value cars, is no longer much cheaper than fully comprehensive insurance. It has been in decline since 2007.

It ought to be possible to scrape off the mud. Insurers do not benefit much from the current set-up. A few are leaving the market, driven out by a combination of high costs and low returns from investing policyholders’ premiums. Insurers recognise the problems that de-linking cost liability and control can bring, says James Dalton of the Association of British Insurers. Yet obvious solutions, such as jointly agreeing price caps to apply to car-hire companies or repair workshops, would look like collusion.

That explains why Britain’s insurers have welcomed the antitrust investigation. The unusual problems in this market mean familiar remedies, such as splitting up big firms, are no use. Instead the commission could clarify exactly what insurers can and cannot do to keep suppliers’ charges under control. Or it might order a shift to a “first option” model, in which liability and cost control stay together. If its remedy works, the market’s other attributes—plenty of choice, easy comparison and switching—could yet shift prices into reverse.