Insurance Redlining; G. Wolfram

Unfortunately, policy recommendations have generally resulted in attempts to further reg ulate 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 concen trations 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 willnot 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 Gary Wolfram is George Munson Professor of Po litical Economy at Hillsdale College in Michigan. occur? To answer these questions we must first ask what we mean by redlining. Does redlining exist if ABC Insurance Company decides it willnot 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 simplyprejudice? Business decision-makers ordinarily try to obtain busi ness, 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, Ludwigvon Mises, and Friedrich Hayek, has presented in detail how the market system operates. According to Austrian analysis, no firm can long pursue economically inefficientactions without going out of business. Even ignoring opportunities to improve efficiencywill result in other firms 365 366 THE FREEMAN • JUNE 1997 entering, attracting market share, and even tually eliminating those firms that fail to innovate. Because the market system offers sufficientrewards 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. Sup pose 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 neigh borhood 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 willbe 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 classicwork The Economics ofDiscrim ination. His point was that one can viewa taste for discrimination as part of the production function of firms and. the consumption func tion 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 Cath olic 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 discrimina tion, say a Catholic-owned firm, and eventu allythe market willprovide 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 nondiscrimina tory firm can supply the market for the neighborhood, then there will be no differ ence in the provision of insurance in the Catholic neighborhood and non-Catholic neighborhoods that is based upon discrimi nation 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 provid ing insurance. Consider, for example, a 1992 study of insurance availability and affordabil ity in California.1 The authors present evi dence 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 state wide average. They also look at claim costs and premiums for 20 California counties and sixLos 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.,,2 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.3 It found that high-premium cities were gen erally the most congested as measured by population and vehicle densities, that a rela tively 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. Un derwriting costs are higher in inner cities for several reasons. Buildings tend to be older in INSURANCE "REDLINING" AND GOVERNMENT INTERVENTION 367 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 manywho 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.4 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 whichwillhave 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,5 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" neigh borhood, then we can presume that the prices for which companies are selling insurance in the neighborhood are sufficientto 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 costlyand exit the market. Neither option is beneficial to consumers.

In an effort to solve the problem of declin ing 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 firmswillthen 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 statewide insurance "crisis." The mandate to sell insurance at unprofit able rates in "redlined" areas willhave 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 gov ernment intervenes in insurance markets when prices are "too high," there willbe more demands for government regulation to drive rates back down. If politicians accede to these demands, we will again see declining insur ance quality and/or the departure of firms from the market. The spiral of intervention continues.6 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 insur ance, and the government will eventually bog down in an inefficient, high-cost insurance environment.7 Attempts by the government to force firms to sell insurance at certain prices in given 368 THE FREEMAN • JUNE 1997 areas will result in inefficiencies and unin tended consequences, the most likelyof which willbe an abandonment of the targeted areas altogether and loss of availabilityof 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 special ization 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 con trols inhibit specialization and lead to a less efficient use of resources than would be the case on the free market. The more the gov ernment interferes with specialization and trade, the poorer the society will be. There is nothing in principle that distin guishes 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 neighbor hood, 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 everyneighborhood? Can we require every hardware store to operate at a certain num ber of locations in every neighborhood?

Can we require every dry cleaner to service a certain number of customers in everyneigh borhood? As we extend the principle to other goods and services, the fallacy of the pro position that the government can and should intervene in the insurance market and force equal premiums and equal amounts of in surance in every neighborhood becomes ob vious. 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 in dustry.

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,8 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 in vestment 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 proba bility of theft or fire decreases and they become more attractive customers for in surance companies. Insurance rates will decline due to the force of free-market competition, not because of coercive gov ernment 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 neighbor hoods, 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 growingliterature on how to improve schools. This is not the place to provide an answer to the problems of inner-city schools. However, improved edu cational opportunity for those living in so called redlined areas would do more for the INSURANCE "REDLINING" AND GOVERNMENT~ INTERVENTION 369 housing stock than a thousand statutes pur porting 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 effi ciently to fires, then homeowners' and renters' insurance rates would be reduced.

Since insurance is regulated by states under the McCarran-Ferguson Act,9 each state must look to its insurance code in order to examine barriers to entry that may preclude persons from forming insurance companies to com pete 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.10 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. Conclusion It is unlikely that redlining, in the sense of insurance companies deliberately not selling to certain areas because of racial discrimina tion, 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, increas ing the supply of services and driving down prices.

Poor people suffer from a number of mal adies. They live in areas which have a high concentration of other poor persons, substan dard housing, high incidence of fire, theft, and other crimes, unstable family conditions, and so on. Government intervention in the pro vision 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 ag gravate the problems of inner-city residents. This willthen require the government to force the provision of the good or service to the area. This will in turn lead to further govern ment regulation and use of the political process to allocate scarce resources. Since markets are the most efficient way of orga nizing society's resources, everyone will be made worse off.ll Instead of pointing to "redlining" and mak ing 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. D 1. S. Harrington and G. Niehaus, "Dealing with Insurance Availability and AfIordability Problems in Inner Cities: An Analysis of the California Proposal," Journal of Insurance Regu lation, Vol. 10, No.4, 1992,564-584.

2. Ibid., p. 569. 3. Factors Affecting Urban Auto Insurance Costs, December 1988. 4. See, for example, Economic Policy: Thoughts for Today and Tomorrow (South Bend, Ind.: Gateway, 1979), chp. 3. 5. See, for example, Individualism and Economic Order (Chicago: University of Chicago Press, 1948). 6. Hayek points out how government action on an ad hoc basiswillresult in its being driven to further actions that were not contemplated nor desired. See The Constitution of Liberty (Chi cago: 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 insur ance company. For more of this see, G. Wolfram, "The Natural Disaster Protection Act: A Disaster Waiting to Happen," The Freeman, August 1994.

8. See Ludwigvon Mises,Planning for Freedom, 4th edition (South Holland, Ill.: Libertarian Press, 1980), p. 4. 9. 59 State. 33, 15 U.S.c. Sec. 1011 et seq. 10. See A. McArthur, A. McGregor, and R. Stewart, "Credit Unionsand Low-incomeCommunities,"Urban Studies, Vol. 30, No.2, 1993, pp. 399-416. 11. For a detailed discussion of the problems created by government intervention in insurance markets, see Harrington and Niehaus, op. cit.