Provider-induced Asymmetric Information in the Insurance Market

Larry Y. Tzeng*

Jennifer L. Wang**

Kili C. Wang***

Jen-Hung Wang***

Abstract

This paper examines the existence of provider-induced asymmetric information in the insurance market. The empirical data on comprehensive automobile insurance in Taiwan provide a unique opportunity to test our hypothesis. Consistent with this hypothesis, we find evidence that providers do induce asymmetric information problems. Our empirical results show that the conditional correlation between the coverage level and the occurrence of a claim is higher for insurance policies sold through dealer-owned agents than for those sold through other marketing channels.

Key words: asymmetric information, automobile insurance, dealer-owned agents, marketing channel.

* Professor, Finance Department, NationalTaiwanUniversity

**Associate Professor, Risk Management and Insurance Department,NationalChengchiUniversity

***Associate Professor, Risk Management and Insurance Department,ShihChienUniversity

**** Assistant Professor, Finance Department, ShihHsinUniversity

1. Introduction

Rothschild and Stiglitz (1976) pioneered the study of asymmetric information problems in the insurance market. In the three decades since, their work has inspired many researchers whocontinue to provide ingenious theoretical findings. The theoretical papers on asymmetric information that followed Rothschild and Stiglitz (1976) include Wilson (1977), Miyazaki (1977), Grossman (1979), Shavell (1979), Riley (1979), Radner (1981), Holmstrom (1982), Dionne (1983), Rubinstein and Yarri (1983), Crocker and Snow (1986), Cho and Kreps (1987), Cooper and Hayes (1987), Hellwig (1987, 1988), Arnott and Stiglitz (1988), Hosios and Peters (1989), Hoy (1989), Mookerjee and Png (1989), and Abreu, Pearce, and Stacchetti (1990). However, until recently, relatively few empirical studies have been devoted to this issue.

As discussed by Chiappori and Salanie (1997), data from insurance companies are well-suited for studies of asymmetric information, because they not only record both the coverage and the claim amounts but also provide information on many characteristics of individuals. Some recent papers have used empirical data in alternative insurance markets to investigate asymmetric information problems. In the life/health insurance market, Cawley and Philipson (1999), Cardon and Hendel (2001), and Finkelstein and Poterba (2000) have examinedthe US life insurance and health insurance markets and the UK annuity market, respectively. At the same time, in the property/liability insurance market, Puelz and Snow (1994), Chiappori and Salanie (2000), and Dionne, Gourieroux, and Vanasse (2001) have studied the automobile insurance market by using data from the US, Canada, and France. Althoughthesestudies have successfully constructed a bridge between the theoretical world and real practices to further understand asymmetricinformationproblems, their empirical results have not provided consistent findings for the existence of asymmetric information in the insurance market.

In addition, most of these empirical studies have focused on asymmetric information between the insurer and the insured. Only a few have investigated asymmetric information caused by providers. Polsky and Nicholson (2004) investigated the risk differences of enrollees and medical expenditures between HMOs and non-HMOs; Newhouse (1996) also investigated asymmetric information problems in these different organizations. Without a doubt, the provider’s asymmetric information problems—e.g., the existence ofmoral hazard in health insurance—have raised major concerns in real insurance practices. However, an empirical testing ofasymmetric information caused by providers might be difficult because it requires data from both the insurance companies and the providers.

In Taiwan, it has been widely believed that comprehensive automobile insurance coverage has long suffered from asymmetric information problems. According to Wang (2004), alternative products could be designed to cope with these problems in this market. Thus, the comprehensive automobile insurance coverage market meshes with our goal to determine whether asymmetric information problems exist in the market, since it is voluntary and offers different coverage choices. There are three different types of comprehensive coverage: A, B, and C in Taiwan. Type A covers all kinds of collision and non-collision losses, including those caused by missiles or falling objects, fire, explosion, windstorm, intentional body damage, malicious mischief, and any unidentified reasons other than the exclusions in the policy. Type B covers all the areas of type A but excludes the non-collision losses caused by intentional body damage, malicious mischief, and any unidentified reasons. Type C covers only damage in a collision involving two or more vehicles. Collision losses caused by hitting other objects—such as a telephone pole, a tree, or a building—and non-collision losses that used to be covered under types A and B are specifically excluded from type C. In this paper, we intend to use comprehensive automobile insurance data from the largest insurance company in Taiwan to examine whether this problem might be induced by the providers. The data from the automobile insurance market in Taiwan provide a unique opportunity to investigate provider-induced asymmetric information problems, since more than 40 percent of automobile insurance policies are sold through dealer-owned agents.

We first examine whether a positive relationshipexists between coverage and the occurrence of a claim. If there are asymmetric information problems, we should observe a positive correlation between them.[1] One important conclusion of Rothschild and Stiglitz (1976) is that a separating equilibrium could exist in the insurance market. In this case, insurance companies offer a varietyof products to attract different types of insured, since the companies may not have enough information to identify the insured’s risk types. Thus, in this equilibrium, high-risk individuals choose higher-coverage insurance and low-risk individuals choose lower-coverage insurance. On the other hand, it is also wellknown that high insurance coverage could induce the insured’s moral hazard problem in the insurance market. An individual with high insurance coverage might drive less carefully, since most of the loss would be compensated. However, why would asymmetric information be induced by dealer-owned agents?

Generally speaking, the policies sold through dealer-owned agents might include a larger percentage of high-coverage policies; and those who purchase insurance through dealer-owned agents might include a greater number of high-risk drivers. On the one hand, car dealerships may have an incentive to promote higher coverage to high-riskcustomers, since contracts with higher coverage are more expensive and the dealerships are rewarded with a commission that is a fixed percentage of the insurance premium.Meanwhile, high-risk customers[2] may bring them more revenues from repairing cars because of accidents in the future. On the other hand, the high-risk insured also have an incentive to purchase insurance through the dealer-owned agents. One reason for this is because dealer-owned agents have stronger bargaining power enabling the high-risk insured to obtain a “better” dealon their contracts. This is especially the case when they consider the ongoing purchase of contracts in subsequent years. In such cases, high-risk customers might be more likely to be involved in an accident, and thus they should be charged a higher premium as a penalty if an accident really does occur and a claim is made in the previous year. In practice, the subsequent contracts sold by dealer-owned agents seldom reflect the punishments recorded in accident records[3]. The other reason is that dealer-owned agents maypromise to provide “better” service for the insured when they have their cars repaired. Thus, dealer-owned agents may attract more high-risk insured to purchase high-coverage policies.

Moreover, high-coverage policies sold through the dealer-owned agents may result in more claims for insurance companies. Repair shops owned by car dealers may have an incentive to augment the work to increase their revenues, especially for those car owners who not only repair the cars at their repair shops, but who also purchase insurance from them. On the one hand, they are very clear about who has high coverage contracts and how those high coverage contracts can cover the loss from an accident, as compared with the case of an insured who is without any dealer-owned agent standing by him. On the other hand, only repair shops can really comprehend how damaged the car is from an accident, and how much work is needed to restore the car. Because repairing a car is such a professional task, if the insurance companies want to audit the claim, they should devote more efforts and funds to this channel than to other channels. When the cost of the audit is too high to cover the benefit derived from auditing the claim, the insurance companies will not bother to audit the claim[4]. This is one of the reasons why the insurance companies will devote less effort to auditing the claims resulting from the contracts sold by the dealer-owned agents. The other ironic reason is that insurance companies usually have to tolerate this type of corruption between the insured and the supplier simply to avoid losing business, since repair shops owned by car dealerships are the major distribution channels for automobile insurance in Taiwan.[5] In some cases, insurance companies may even pay claims under certain amounts without performing an inspection.Thus, dealer-owned agents could have both the motive and the ability to lie and induce the over-use of car-repair expenditures from insurance claims.According to Alger and Ma (2003), dishonest car dealers and repair shops owned by car dealerships (i.e., the providers) always lie when the insurance contracts are not collusion-proof.Since insurance companies may audit them less, they should be more likely to induce more augmented claims involving higher coverage than in the case of insurance sold through other channels.

Therefore, we hypothesize that automobile insurance policies sold through dealer-owned agents might suffer from more severe problems of asymmetric information. We expect the conditional dependence to begreater in the group of dealer-owned agents than when other channels are involved. We follow Chiappori and Salanie’s (2000) approach and perform a preliminary test of the conditional dependence between the choice of coverage and the occurrence of the claim. The empirical evidence from this methodologyshows that there seems to be a higher positive conditional correlation in insurance policies sold by the dealer-owned agents than in those sold through other marketing channels. However, we can only compare the values of the conditional correlation coefficients for each of those channels using this method, and we hardly perform a formal test[6] to prove whether the contracts from the dealer-owned agents suffer more severe asymmetric information problems than thosefrom other marketing channels.

To complete the test of our hypothesis, we also adopt a methodology similar to that of Dionne, Gourieroux and Vanasse (2001), i.e., a two-stage method to test the conditional dependence between the choice of coverage and the occurrence of the claim. The main benefit in this research from using this method is that we can test whether the asymmetric information problems are more severe when they go through dealer-owned agent channels than through other direct channels. Because the choice of coverage and the occurrence of claims may interact with each other, we engage in two different models in the two-stage methodology while we test for the conditional dependency. We estimate the probability of the occurrence of a claim in the first stage, and then perform a regression on the choice of coverage in the second stage in one of the models. Furthermore, we estimate the probability of the choice of coverage in the first stage, and then perform a regression on the occurrence of the claim in the second stage in the other model. In the former, we test our hypothesis through the cross term between the dealer-owned agent dummy and the occurrence of the claim dummy in the second stage. In the latter, we test our hypothesis through the cross term between the dealer-owned agent dummy and the choice of coverage dummy in the second stage. Again, all of the evidence from the two-stage method, regardless of which one is modeled, supports our hypothesis.

The remainder of this paper is organized as follows. Section 2 describes the data and the methodology used. In Section 3, the main empirical results are presented. Section 4 concludes the paper and provides recommendations for further research.

2. Data and Methodology

To empirically analyze the asymmetric information problems in Taiwan’s automobile insurance market, we collected individual-level data as well as provider-level data from a large automobile insurance company that controls over 30 percent of the market share of automobile insurance in Taiwan. The research data included 61,642 and 64,234 observations in 1999 and 2000, respectively.

Since type C coveragewas first introduced to Taiwanin 1999, we employed data only in the policy years 1999 and 2000 in order to control for the market’s learning effect. It is easierto detect the existence of asymmetric information in the early stages when insurance companies offer alternative products to sort the insured. One possible reason why Chiappori and Salanie (2000) did not find evidence to support the existence of asymmetric information in the French automobile insurance market is because that market was already well-developed. The asymmetric information problem might exist in the early stages of insurance, as described by Rothschild and Stiglitz (1976), but could be solved prior to the mature stage, since insurance companies have many years to learn from their underwriting results. Thus, Chiappori and Salanie’s empirical results (2000) and Rothschild and Stiglitz’s theoretical models (1976) could be reconciled if we can find evidence to support the existence of asymmetric information in the early stages of an emerging insurance market. We believe that the comprehensive automobile insurance market in Taiwan provides us with a natural experiment to investigate this proposition.

In order to conduct the empirical testing, we used two methods to examine whether providers induce asymmetric information problems. In this paper, the first method basically follows Chiappori and Salanie’s (2000) empirical model to test for the conditional dependence between the choice of coverage and the occurrence of a claim. We separate the data into two groups: insurance contracts sold by the dealer-owned agents and those sold through other marketing channels. For each group, we run a pair of probit models and then test the conditional dependence. The probit models are as follows:

, and (1)

,(2)

where is the variable for the insured’s information,

and are the regressor coefficient vectors, and

and are error terms.

Since both types A and B cover non-collision claims and type C covers only collision claims, we classify types A and B as high coverage and type C as low coverage. When an individual chooses comprehensive coverage automobile insurance of type A or B, then ; otherwise .

It should be noted that we do not use all claims when defining the variable . Instead, we only examine claims involvinga collision with at least two cars. It is important to recognize that we can observe all the claims but may not be able to observe all the car accidents. Since types A and B have broader coverage than type C, the insured with types A or B might report more claims than those with type C. Thus, accidents involving insured with types A or B may be more observable than those with type C. To avoid a potential bias caused by unobservable accidents in type C, we employ the same criteria to identify a claim for all policies, i.e., when an individual files a claim caused by a collision with at least two cars; otherwise.

We further define by using three monetary thresholds:a claim amount above NT$0, a claim amount of more than NT$10,000 and a claim amount greater than NT$20,000. It should be noted that the monetary threshold may influence the existence of asymmetric information, since insurance companies usually pay more attention to claims involving larger monetary amounts.

The estimators of and can be calculated as follows:

(3)

,(4)

where and are the density and cumulative distribution functions of ; and and represent coverage and accident, respectively.

To test the conditional dependence of and , we follow Chiappori and Salanie (2000) and use a statistic:[7]

(5)

is distributed asymptotically as . We test its significance under the null hypothesis of.