Connected car : Improving Risk Assessment Accuracy - The Motivation for Usage Based Insurance

With virtually every country requiring some form of insurance for automobile owners, drivers are constantly looking for ways to save money by lowering their monthly or annual premiums. When that search intersects with insurance companies’ desire to accurately assess individual customer’s risk to limit their liability exposure, the result is usage based insurance (UBI). With several different varieties of usage based insurance available, UBI appears to offer potential benefits to both consumers and firms. This paper examines the various types of usage based insurance available in the United States and Europe before considering the potential advantages and drawbacks of more large-scale adoption of this new insurance offering.

In contrast to the typical fixed rate insurance which determines a driver’s premium using fixed formulas based on categorization, usage based insurance uses a driver’s individual behavior to determine the cost of their insurance (NAIC 2014). Instead of using past indicators of risk, usage based insurance attempts to calculate a driver’s future risk based on their current driving habits (DeGraff 2013, 9). Because risk categories such as age, gender, and credit history are often imprecise and even inaccurate predictors of future risk, insurers are turning to usage based insurance in an effort to more accurately identify which drivers are safe and which are not (NAIC 2014). Doing so would allow insurers to charge customers premiums more closely aligned to their actual risk. Safer drivers would be rewarded with a lower rate while risky drivers would bear more of the cost for their liability (Insurance Journal December 8, 2011). Different variations of usage based insurance have emerged over the past several decades. Among the most common are distance based, pay as you drive (PAYD), and pay how you drive (PHYD). One of the primary difference between the different methods is that distance based insurance uses existing technology built into cars while both pay as you drive and pay how you drive rely on telematic devices to collect data (Rose 2013, 1).

The simplest form of usage based insurance is known as distance based insurance. While many insurers ask applicants to estimate their yearly mileage, evidence shows that such estimates typically under-report mileage totals – especially if doing so will lead to financial savings for consumers (Rose 2013, 1). In response, some insurers have begun using odometer readings to verify these mileage estimates and establish a more accurate record of yearly automobile usage (IINC April 25, 2011). This method of insurance has gained higher popularity in Australia and other countries as well as the United States (Litman 2012, 11; IINC April 25, 2011). An initial concern with this method was that consumers would simply lie about their odometer readings in order to obtain lower raters. In response, insurers implemented a process of odometer auditing (Litman 2012, 11). In these yearly audits, a certified mechanic or other entity inspects the odometer and makes an official record of the total mileage driven (Litman 2012, 10). Some critics have pointed out that drivers may tamper with their odometers to reduce the mileage recorded, however manufacturers are increasingly installing tamper resistant and tamper evident devices (Litman 2012, 12). If an audit discovers evidence of tampering, the insurer is then able to take adverse action against the customer (Litman 2012, 12).

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