Pay-As-You-Drive Insurance and True Cost Pricing

In an April 20^th article for the New York Times Magazine, Stephen Dubner and Steven Levitt, economists and authors of Freakonomics, argue that Americans drive too much and that Pay-As-You-Drive (PAYD) insurance can forestall some of the excess. A question they leave unanswered, however, is whether federal policy should play a role in incentivizing PAYD insurance and other forms of pricing externalities. Further, they don't elaborate on why PAYD insurance doesn't address the other externalities.

They note that driving has three main external costs, i.e. costs to other people that a driver doesn’t pay: congestion, carbon (and other pollutant) emissions, and traffic accidents. In essence, each time you drive you increase congestion for other people, emit pollutants that harm them (and the environment as a whole), and raise the risk of a causing an accident that hurts them – but you don’t pay anything to compensate them for these effects. Combined, these externalities cost society hundreds of billions of dollars a year. The basic issue then is how to structure the cost of driving so that drivers pay the true cost in terms of congestion, emissions, and accidents. If drivers know and have to pay the full cost of driving, they are likely to adjust their behavior according to how much they value the benefits of driving.

Their full article can be found here.

The most efficient way to price driving is by pricing at the margin, which means charging drivers the true cost of driving one more mile (a true cost factors in the value of externalities, as well as the cost of gas, insurance, etc). With traditional insurance you pay maybe $1000 at the beginning of the year regardless of how many miles you are going to drive, and so there is in fact a strange incentive for you to “get your money’s worth” by driving a lot. The more you drive, the less the insurance costs you on a per mile basis. This incentive is removed with PAYD insurance. By using in-car tracking devices your insurance rate is based on how much you drive, and potentially, on how you drive (i.e. the speed you travel and the severity of your braking). Several insurance companies globally already have PAYD pricing schemes, and Progressive is starting such a plan in the United States soon.

PAYD insurance is, however, directed at the externality of traffic accidents. It is less effective in mitigating congestion and emissions, which need their own pricing systems. Federal policy needs to incentivize all methods of pricing that reduce the Big 3 externalities. Congestion pricing, which charges drivers based on the time of day they drive (you get charged more during rush hour than at 3am), is one such method. PAYD insurance doesn’t diminish congestion by time of day and it doesn’t directly encourage drivers to reduce the emissions caused by their driving. While reducing overall driving will lower emissions (other things held constant), other methods more directly affect driver behavior in that regard, such as charging more at the dealership for inefficient cars, and pricing fuels based on their CO2 emissions.

A sound federal approach to dealing with externalities is one that encourages and incentivizes pricing innovation. The federal policy role for reducing externalities associated with driving is clear, but the federal role in PAYD is not. The widespread offering of PAYD insurance would be a welcome boon to many consumers and the country as a whole, but it only gets us part of the way towards reducing the other important externalities of congestion and pollution.

-Daniel Lewis