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The End Of All-you-can-drive Insurance

Suppose that, instead of paying for gas each time they filled up, drivers paid a fixed sum every six months to cover their fuel costs. This sum would vary based on the driver's age, type of vehicle, and location, but wouldn't change with the number of miles driven. It sounds absurd, of course, but it's exactly what happens in the auto-insurance market. Accident risk—like fuel use—increases in roughly linear fashion with each mile a person drives, but insurance costs the same (or almost the same, since some insurers offer small discounts to drivers with self-reported low mileage) whether you drive 500 miles each year or 50,000.

It's a huge market failure, one that leads people to drive much more than would be economically optimal. The way to fix it is to make drivers pay for insurance on a per-mile basis. According to Brookings researchers Jason Bordoff and Pascal Noel (who describe their work in a Resources for the Future web commentary), getting all drivers to switch to pay-as-you-drive insurance would cause an 8 percent reduction in the total number of miles driven in the United States, roughly the same reduction that would result from a $1-per-gallon increase in the gas tax. Better yet, because a few high-mileage drivers account for a disproportionate number of miles driven, some two-thirds of drivers would actually see their insurance rates go down.

Bordoff and Noel have some common-sense proposals for encouraging pay-as-you-go insurance—most notably a tax credit to cover the initial cost to insurance companies of installing remote mileage-monitoring devices in customer's cars or setting up a network of odometer-inspection stations. But what they don't point out (at least, not until you read pretty far into their longish discussion paper on the subject) is that once a critical mass of drivers switched to pay-as-you-go, it would create a cycle of snowballing economic incentives that would pretty quickly lead most people to switch, even if they had to cover the initial cost of installing a mileage monitor in their cars.

Why? The first people to switch to pay-as-you-drive insurance would be the ones who drove the least. Because this would effectively remove the lowest-risk drivers from the pool of people buying lump-sum insurance, the prices for lump-sum insurance policies would have to go up. This would cause slightly higher-mileage drivers to switch to pay-as-you-drive policies, which would cause the price of lump-sum policies to rise even further, and so on. In the end, only the highest-mileage drivers would stick with lump-sum policies, and they would pay a price that reflected the true cost of providing them with insurance.

This process, better known as adverse selection, is what causes individually-purchased health insurance to cost a lot more than a comparable employer-provided plan. But the auto insurance market is one place where it could have a positive effect—and an impressively large positive effect at that. After all, the Lieberman-Warner cap and trade bill would have raised gas prices by only 25 cents per gallon, causing a much smaller than 8 percent decrease in driving. This means that in the short run, at least, changing the way that auto insurance is priced could have a much bigger impact on people's driving habits than getting a climate bill passed.

--Rob Inglis