Sneaky Taxes: auto insurance and credit scoring provide a useful economics lesson that pits the majority against the minority.

The eminent political economist James Q. Wilson has a powerful lesson for insurers: The demand for government action in economic and political matters depends on the extent to which benefits and costs of a policy are either concentrated or widely dispersed. A policy that imposes a slight cost on the majority of citizens while delivering concentrated benefits to a small minority will rouse little opposition because the nuisance is too small to warrant strong opposition. Conversely, a policy that imposes highly concentrated costs on a minority while delivering very small benefits to a majority will fail because the minority has substantial incentives to resist it in the face of the near indifference of most citizens.

This insight--here called Wilson's Rule--is vitally important for insurance. A classic important example of Wilson's Rule is the fight over the use of credit scores, education, occupation and territory to set auto insurance premiums, which masks the fact that the beneficiaries of regulations against the use of these and other rating factors are a small group imposing a small tax on a far larger majority.

The market for auto insurance is ferociously competitive. Competition in the auto industry works exactly as basic economics says it should: Lots of companies fight over customers by charging prices low enough to attract business yet high enough to cover costs while earning a reasonable profit. Insurance scoring, territorial rating, or other rating factors are used to distinguish high-cost from low-cost clients in order to set prices that cover the full cost of providing protection.

Of course, high-cost drivers do not want to pay high auto insurance premiums, and smaller companies that have not been able or willing to adopt the information technologies used to rate auto risks want relief from competitive pressure. These groups will search for champions in politics--especially insurance commissioners and legislators--who denounce the use of rating factors as racially discriminatory or unfair to the poor and therefore unsuitable methods for pricing auto insurance risk.

For example, one frequently hears the refrain that the use of credit scores discriminates against low income African-American and Latino drivers in favor of higher income white drivers and should be banned for that reason. While it is true that credit scores for African Americans and Latinos tend to be lower than those for whites, it also is true that credit scores for low income workers of all races are lower than those for higher income workers of all colors. The real problem is that low-income drivers tend to live in urban areas with high loss costs and also, low-income drivers have low credit scores because they face lousy economic conditions that have nothing to do with auto insurance. In other words, credit scores, and therefore auto insurance rates, only reflect the unpleasant reality of life for lower income workers and drivers.

Banning the use of credit scores is a perfect illustration of Wilson's Rule in action. Who benefits from such a ban? A small clutch of high-cost drivers--since most insured drivers have moderately good to excellent credit scores--and, of course the politicos acting as tribunes of the oppressed. Who loses because of a ban on credit scoring in auto risk rating? The losers are the vast majority of drivers who will pay slightly higher rates--on the order to $10 to $20 a month in some states--a small irritant but not enough to warrant serious attention.

The best way to help low-income, high-cost drivers is to reduce the sources of loss costs: medical care, fraud, vehicle repair, auto theft and exploding jury awards. And basic economics strongly favors competitive market prices combined with direct subsidies to target populations instead of government intervention in the pricing process. But all of these efforts are expensive, difficult and, above all, visible enough to arouse the curiosity of the public.

Insurers always should keep Wilson's Rule in mind because it suggests the best way to fight to keep competitive markets is to make sure that the public sees the hidden transfers of income from the majority of policyholders to small groups able to capture the attention of politicians. In the end, Wilson's Rule shows why these small groups will try to use government power to impose small, sneaky taxes on majorities. Insurers should expose these undercover levies because transparent taxes are better than sneaky taxes, and because insurance companies are lousy tax collectors.

Contributor Marcellus Andrews is an economist with the Insurance Information Institute. He can be reached at [e-mail].