Insurance Redlining and Government Intervention
Forcing Firms to Sell at Regulated Prices Is Detrimental to Consumers
JUNE 01, 1997 by GARY WOLFRAM
Gary Wolfram is George Munson Professor of Political Economy at Hillsdale College in Michigan.
Redlining has been a topic of public policy debate and action for several years. Figuring most prominently in the provision of real estate and mortgage services, it has now spilled over into the provision of insurance. Unfortunately, policy recommendations have generally resulted in attempts to further regulate insurance. The solution to the problem of redlining lies not in further regulation, but in removal of governmental barriers to entry in insurance and other markets, enforcement of property rights in areas with high concentrations of poor people, and reduction or elimination of barriers to economic growth in these areas.
What Is Redlining?
Redlining is generally taken to mean the practice of refusing to provide a product or service within a given geographical region. The term comes from the image of an owner of a service firm drawing a red line around a portion of a map and deciding not to provide any service within that area. This could be a bank official declaring that the bank will not make any loans in the area, a retail drugstore chain declaring it will not put any stores in the area, or an insurance company deciding not to insure any risks in the area.
Two obvious policy questions are: does redlining occur, and if it does, why does it occur? To answer these questions we must first ask what we mean by redlining. Does redlining exist if ABC Insurance Company decides it will not sell homeowners’ insurance in four census tracts in the city of Baltimore, but three other insurance companies all offer such policies? Does redlining exist if ABC Insurance Company only offers certain types of policies in a section of the city, or charges a higher price for insurance in that area than it does elsewhere?
If redlining does exist, is it the result of a market process or simply prejudice? Business decision-makers ordinarily try to obtain business, so a deliberate decision to abstain from it is remarkable. We need to explore the decision-making process to see if it can be explained as something other than irrational discrimination.
Why Discriminatory Redlining Cannot Last in a Market System
The Austrian school of economic thought, as begun by Carl Menger, and developed by Eugen Bohm-Bawerk, Ludwig von Mises, and Friedrich Hayek, has presented in detail how the market system operates. According to Austrian analysis, no firm can long pursue economically inefficient actions without going out of business. Even ignoring opportunities to improve efficiency will result in other firms entering, attracting market share, and eventually eliminating those firms that fail to innovate. Because the market system offers sufficient rewards to those who see and pursue new markets, when profitable opportunities arise, firms will enter.
Suppose that my firm decides not to sell insurance in neighborhood A because the managers of my firm are prejudiced against Catholics, who make up a substantial portion of the population of this neighborhood. Suppose also that it is economically feasible to sell insurance in this neighborhood; that is, the potential customers are willing to pay an amount for insurance that covers the marginal cost of selling the insurance. The latter would include such things as the expected losses from those events that are insured against, administrative costs, retailing costs, rental costs for offices, labor costs, and so on. As long as the government has not set up barriers to entering the market for insurance in neighborhood A, other insurance companies that already exist, or new insurance companies—perhaps run by Catholics—will enter that market. The possibility of making profits will ensure that insurance will be provided as long as there are no government-imposed barriers to entering the market.
Nobel Laureate Gary Becker used a slightly different approach to analyze discrimination in his classic work The Economics of Discrimination. His point was that one can view a taste for discrimination as part of the production function of firms and the consumption function of purchasers. If we apply this to the insurance example, we see that my firm is giving up profits by not selling insurance to Catholics. My taste for discriminating against Catholics is costing me the amount of profit to be made from serving that market. What will happen is that those firms that have lower tastes for discriminating will enter the Catholic neighborhood and sell insurance, perhaps at a higher price than non-discriminatory firms. But then, the high profits being made in the Catholic neighborhood will attract firms that have even a lower taste for discrimination, say a Catholic-owned firm, and eventually the market will provide insurance at a rate which results in no discrimination in the insurance market. As long as there are no barriers to entry and the production function for insurance is such that a non-discriminatory firm can supply the market for the neighborhood, then there will be no difference in the provision of insurance in the Catholic neighborhood and non-Catholic neighborhoods that is based upon discrimination against Catholics.
The Cost of Providing Insurance in Urban Areas
The differences in premiums and quantity of insurance written between inner-city areas and the rest of a metropolitan region is likely to be due to differences in the cost of providing insurance. Consider, for example, a 1992 study of insurance availability and affordability in California. The authors present evidence of auto insurance claim frequency, claim severity, and average loss-per-insured vehicle for Los Angeles and three other large California cities and compare it to the statewide average. They also look at claim costs and premiums for 20 California counties and six Los Angeles County cities. The evidence is clear that losses are much higher in Los Angeles than the rest of the state, and there is a strong positive correlation between claim-costs and average premiums, indicating that the prices insurers charge in different areas are closely related to claim-costs.
A study of 18 large cities in 13 states conducted by the National Association of Independent Insurers found similar results: high-premium cities had a frequency of claims much higher than their statewide averages. It found that high-premium cities were generally the most congested as measured by population and vehicle densities, that a relatively high number of personal injury claims was a major factor in explaining the difference between high-premium and low-premium cost cities, and that most high-premium cities had significant losses attributed to uninsured motorists.
Cost considerations also explain premium differentials for homeowners’ insurance. Underwriting costs are higher in inner cities for several reasons. Buildings tend to be older in inner cities, with less adequate wiring. They are closer together and more susceptible to fires. Theft and arson rates are higher in these neighborhoods. They are more at risk for civil disorders, such as the Los Angeles riots, which resulted in more than $200 million in losses. The replacement costs of homes in inner cities may far exceed their market value. When this occurs, there is less incentive to take precautions against fire, since the insured would financially benefit from destruction of the property. Given these facts, it is not at all surprising that insurance companies charge more for insurance in inner-city areas, if they offer it at all.
Forcing Firms to Sell at Regulated Prices
The preferred solution to redlining of many who see themselves as champions of the poor is for the government to force insurance companies to sell in all areas of the state, including redlined areas, and to sell at regulated, non-discriminatory rates. Is this a good solution?
Ludwig von Mises wrote extensively about the effects of government interference in the market process. The thrust of his argument is that, since the market system is made up of many interrelated industries, interference in one industry will have multiple effects on other industries. These effects will permeate the economic system, causing unintended consequences which will have an overall result detrimental to all. Government intervention, in short, will prove to be counterproductive. While the interested reader can examine Mises’s writings, along with those of Hayek, we can briefly make the point using the insurance example.
Suppose that the government requires firms to sell insurance in given markets at prices below those which they are currently charging. If the market for insurance is open, so that firms can enter the redlined neighborhood, then we can presume that the prices for which companies are selling insurance in the neighborhood are sufficient to cover costs and a competitive return on investment, but no more; otherwise other firms would enter and bid away profits. When the government requires firms to sell at a lower price, they will do one of two things. They will either try to reduce the quality of the product charging the same premium for less coverage, or they will decide that doing business in that state is too costly and exit the market. Neither option is beneficial to consumers.
In an effort to solve the problem of declining quality of insurance, the government will probably be driven to regulate it, specifying what types of policies can or must be offered and at what price. More firms will then decide that it is too expensive to serve the state and will exit. The more the government tries to force insurers to behave in ways that are contrary to their interest, the more it creates a state-wide insurance crisis.
The mandate to sell insurance at unprofitable rates in redlined areas will have further repercussions. If insurance companies can increase prices elsewhere, residents of the state will find their rates rising. But since the precedent has been established that the government intervenes in insurance markets when prices are too high, there will be more demands for government regulation to drive rates back down. If politicians accede to these demands, we will again see declining insurance quality and/or the departure of firms from the market. The spiral of intervention continues.
The reduced availability of insurance will result in calls for the government to directly supply insurance, which it may eventually do. Of course, the government will be faced with the same dilemma that confronted private firms—that is, it will have to subsidize its losses through other means. In the end, the taxpayer will be paying for losses of the government insurance company, which will have its prices and policy set through the political process, rather than through the market process. All firms that use insurance will now become involved in the political process for setting rates and types of insurance, and the government will eventually bog down in an inefficient, high-cost insurance environment.
Attempts by the government to force firms to sell insurance at certain prices in given areas will result in inefficiencies and unintended consequences, the most likely of which will be an abandonment of the targeted areas altogether and loss of availability of insurance not only in the targeted areas but throughout the rest of the market. Government will be forced to have all firms, regardless of their specialty, participate in the losing market for insurance in the targeted neighborhoods. Yet, as Adam Smith pointed out in the first sentence of An Inquiry into the Nature and Causes of the Wealth of Nations, it is specialization that leads to economic growth. Some firms are better able to take on certain risks than others. Some may not be capable of correctly analyzing and underwriting risks in urban areas. Government mandates and controls inhibit specialization and lead to a less efficient use of resources than would be the case on the free market. The more the government interferes with specialization and trade, the poorer the society will be.
There is nothing in principle that distinguishes insurance from any other product. If we accept the right of the government to determine at what prices and in what amounts a product must be sold in a given neighborhood, then what is true for insurance must be true for new cars, used cars, groceries, hardware items, dry-cleaning services, and so on. This idea is entirely repugnant, as it sounds the death knell for private property and the market order. Can we require every car dealer to sell its cars for the same price in every neighborhood? Can we require every hardware store to operate at a certain number of locations in every neighborhood? Can we require every dry cleaner to service a certain number of customers in every neighborhood? As we extend the principle to other goods and services, the fallacy of the proposition that the government can and should intervene in the insurance market and force equal premiums and equal amounts of insurance in every neighborhood becomes obvious.
Solving the Real Problem
The real problem is that people in the areas where redlining is a concern have low incomes. Because they have low incomes, their housing is older and less safe, and they are concentrated in areas where crime rates are high. Attempting to lower insurance rates through coercion will only aggravate their problems. Insurance companies will be reluctant to enter the market and there will be a true shortage of insurance as the price is held below the market-clearing price. There will be less insurance provided and fewer jobs created by the insurance industry.
The ultimate solution to the problem is to increase the incomes of people who live in redlined areas. This can only be done by increasing the amount of capital that each person has to work with, including physical capital, such as machinery and equipment, and human capital, for example, training and formal education. Job opportunities and wages will increase for residents of low-income areas once greater capital investment raises their productivity. This will then allow them to increase the quality of their housing, reduce the threat of fire and theft, and generally improve their living conditions. When this happens, the probability of theft or fire decreases and they become more attractive customers for insurance companies. Insurance rates will decline due to the force of free-market competition, not because of coercive government intervention.
Reduced regulatory costs and lower taxes would improve the job opportunities of urban dwellers, giving them a chance to upgrade their housing stock and reduce insurance costs. This would also stabilize neighborhoods, thus providing more certainty to insurance companies and improving their ability to forecast losses, again resulting in lower insurance premiums.
Increased quality of education for inner-city dwellers is perhaps the primary way of improving the circumstances of residents there. There is a large and growing literature on how to improve schools. This is not the place to provide an answer to the problems of inner-city schools. However, improved educational opportunity for those living in so-called redlined areas would do more for the housing stock than a thousand statutes purporting to deal with insurance redlining.
Stronger enforcement of property rights in urban areas would also have a salutary effect on the cost of insurance. If the police could reduce the probability of theft and arson, then insurance rates to protect against loss by theft and arson would decline. If fire departments were able to respond more quickly and efficiently to fires, then homeowners’ and renters’ insurance rates would be reduced.
Since insurance is regulated by states under the McCarran-Ferguson Act, each state must look to its insurance code in order to examine barriers to entry that may preclude persons from forming insurance companies to compete in urban areas, or preclude existing companies from competing in urban areas. As an example, the formation of community-based financial cooperatives have made useful contributions to the credit problems of low-income areas in Britain. States might alter their insurance codes to provide incentives for the creation of community-based insurance companies that can service urban areas more efficiently than larger companies that may have to rely on less specific data to set rates.
It is unlikely that redlining, in the sense of insurance companies deliberately not selling to certain areas because of racial discrimination, or selling at rates that create high profits, exists. In the absence of government barriers to entry, insurance companies would enter markets where profits could be made, increasing the supply of services and driving down prices.
Poor people suffer from a number of maladies. They live in areas which have a high concentration of other poor persons, substandard housing, high incidence of fire, theft, and other crimes, unstable family conditions, and so on. Government intervention in the provision of any good or service, whether it be insurance, food, or medical care, in order to improve the living conditions of the poor will only result in creating problems that exceed those which they try to correct. Attempts to set the price of anything below the market-clearing price will create shortages and aggravate the problems of inner-city residents. This will then require the government to force the provision of the good or service to the area. This will in turn lead to further government regulation and use of the political process to allocate scarce resources. Since markets are the most efficient way of organizing society’s resources, everyone will be made worse off.
Instead of pointing to redlining and making it an excuse for interference with the insurance market, we should focus on the real problems, which are the low incomes of persons in the inner cities and the high cost of providing insurance. The reduction of crime, better fire protection, lower taxes, better schools, and reduced occupational licensing and zoning regulations, are the real solutions to the problems of inner-city life.
1. S. Harrington and G. Niehaus, Dealing with Insurance Availability and Affordability Problems in Inner Cities: An Analysis of the California Proposal, Journal of Insurance Regulation, Vol. 10, No. 4, 1992, 564-584.
6. Hayek points out how government action on an ad hoc basis will result in its being driven to further actions that were not contemplated nor desired. See The Constitution of Liberty (Chicago: University of Chicago Press, 1960), p. 111.
7. For those who feel this scenario is far-fetched, look at the various proposals for state insurance companies, FAIR plans, insurance codes, etc. We now are discussing a national disaster protection act which would create a national government insurance company. For more of this see, G. Wolfram, The Natural Disaster Protection Act: A Disaster Waiting to Happen, The Freeman, August 1994.