WHY MIGHT INSURANCE COMPANIES CHARGE HIGHER RATES TO urban residents? Why might city dwellers be less likely to receive loans than their suburban counterparts? Cities are often populated with a higher percentage of minorities, so one hypothesis is that bankers and insurers are engaging in discrimination. Another hypothesis, however, is that insurers and lenders make business decisions based on the drive for profits, rather than discrimination. If the latter hypothesis is correct, many of the government interventions may actually lead to the unintended consequence of precluding city dwellers and minorities from the market. Since the goal of policy is to give access to financial services to more individuals, not fewer, an economic analysis of the public policy prescriptions will be useful. We seek to determine whether government intervention in the insurance and loan markets is an effective way of assisting urban consumers.
First, let us ask why insurance companies might charge higher rates to urban consumers. Do they discriminate because they only want to do business with their suburban brethren? Do they do it so they can exploit minorities into paying higher premiums? Is there a collective agreement among non-minority-run businesses?
Let us assume, for the moment, that the answers to these questions are yes, that the individuals at banks and insurance companies are discriminatory. If all of these suppositions are true, what will the pricing structure of the discriminatory companies look like? Let us say that home insurance at market rates is $2,000, but urban minorities are overcharged. Just because of their demographics, they have to pay $3,000. By simply discriminating, these insurance companies have enabled themselves to make an extra $1,000 profit on every minority person they insure.
This would be awful, but is it really possible? In this case, insurance companies would try to insure as many minority customers as possible. The more minority customers they sign up, the higher their profits. No profit-driven company would pass up the opportunity to make so much extra money, so they want to attract even more minority customers. Indeed, why would the company bother with non-minority customers at all? With so many profitable minority customers to insure, non-minority customers would be shown the door.
But this institution cannot last for long. Other companies alert to profit opportunities would catch on and undercut their competitors by offering insurance for slightly less. This would attract further business from the minority community, so instead of making $1000 profit on a handful of downtrodden, it could make, say, $900 profit on hordes of people. The latter position would yield enormous profits. Would this be the final outcome? Would minority customers now be exploited, only this time to the tune of $2,900 at the hands of a new competitor?
The answer is no. Retaliation would ensue, and others would charge less, to increase profits in the same fashion. In this case, companies charging $2,900 would lose customers and have to lower their price as well. This process would continue until the price paid by the customer roughly equaled the marginal cost to the company, $2,000. With competition, no firm would be able to exploit minorities by charging them $3,000 for $2,000 insurance. In the long run, if the price of the insurance to a customer stays at $3,000, then that must be its market value.
So why do disparities between insurance rates persist in the absence of laws forcing them to conform? Simple: many insurable risks are higher in the inner city where the minority population is proportionately higher. Through no fault of their own, city dwellers are often faced with higher rates of crimes against their property.
If property is more often the target of burglary, the inner-city insurance customer would need to be reimbursed more often than his suburban counterpart, and this translates to higher premiums. It is totally unrelated to racial discrimination (Williams 1982). All of the additional costs to the insurance company require higher premiums if bankruptcy is not to ensue. The fact that city residents face a higher risk of infringements on their property is unfortunate, but insurance companies set their rates based on actuarial tables, not personal worldviews. If they did, it would create profit opportunities for companies that were more sensible.
Should the owner of a house in a flood plain assume that he should pay the same rate as someone out of harm’s way? Of course not. The property has higher risks, and will have higher premiums. There is no discrimination operating here. To the extent that irrational discrimination exists, it would get penalized by the market process.
Yet, some people argue that it is unfair that people should be penalized merely for living in a high-crime neighborhood. The theory is that they have a hard enough time as it is. Insurers should not add to the burden by tacking on penalties for poor living conditions that residents would change if they could. For this reason, many state governments, most famously Massachusetts, have set maximum price ceilings on insurance premiums.
The question becomes whether government intervention in the insurance market is the most effective way to benefit the downtrodden. Unfortunately, government intervention with insurance rates has the unintended consequence of preventing many people from finding insurance. Let us say a company is legally forbidden from charging anything above the going rate for insurance in the suburbs, $2,000. What customers will insurers tend to want to insure? With a price ceiling imposed, the insurance corporations will do everything they can to not insure any inner city residents. The inner city residents will be discriminated against in a real sense, but in this sense the problem is not inherent in the market, the problem stems from price controls. The companies are not being racist; they are simply responding to perverse incentives created by bad policies. The government has moved us from a situation where there had been no shortage of insurance for people in the inner city to one where it is virtually unavailable.
Another tactic is to impose anti-discrimination laws that impose penalties if government notices any systematic disparities in the pricing structure for insurance between racial groups. The company will still face the reality that risk pools are not equal for all people. The companies have to be more subtle about it, but they will do what they can to avoid high-risk areas. In this way, anti-discrimination law works like a price control. It distorts the availability of insurance, raises premiums for everyone, restricts innovation, and dampens competitive bidding among suppliers.
Nowhere is this more obvious than in auto insurance, where states like Massachusetts and New Jersey both mandate insurance and prohibit discrimination. The result has been a financial disaster for consumers. As Kurkjiin (1995a) reports, “Massachusetts is one of few states that prohibits [insurance companies from writing policies that insure homes at their fair market value, instead of their replacement cost], and the financial impact is particularly tough in poorer neighborhoods.” The unwillingness of the insurance industry to provide coverage to inner city residents has not stemmed from inherent racism. Rather, it stems from the fact that they are unable to charge prices that cover the costs involved—let alone prices that allow for profit.
Similar problems exist with bank lending to urban minority clients. Many people believe that banks make their decisions based on race rather than on profits, and that the government must step in. If all demographic groups had the same credentials and banks bypassed minority borrowers, there would be a clear case of unfair discrimination. Let us say that most banks are guilty of such prejudice and are unaware about the good risks that certain demographics represent.
If a group of minority borrowers could not receive loans because of unfair discrimination, they would do whatever possible to receive a loan. Such individuals would be so desperate that they would be willing to pay higher than the market interest rate. With a large group of otherwise qualified people willing to pay higher rates, any bank would be foolish not to lend to this group. The first bank to notice the situation could enhance profits by charging these qualified people higher rates. The bank could be run by one entrepreneur who cares more about profits than about discrimination.
The company that discovers this market opportunity would earn above-normal profits by catering to minority borrowers, and discriminating against non-minority borrowers. But this situation could not long endure. Just as in the insurance example above, the banks would compete until long-run profits were zero (Block 1992). Banks would keep undercutting each other’s prices in order to attract profitable customers. This process would continue until the point where these qualified minority borrowers would be paying the same rates as their non-minority counterparts. Eventually, all others catch on, and lending rates to the two groups will be the same, all else equal.
In the current world, all else is not equal, so lending rates may differ between demographic groups. Even though every individual has different credentials, government believes that there should be no disparities between groups such as race. Unfortunately, certain minority groups do, in fact, receive a disproportionately lower percentage of loans. But this reflects not personal preferences of bankers but differences in applicants’ income, credit ratings, default risk, and assets. Because each individual is different, we should not expect to see averages across groups to always be the same.
Interestingly, when looking at the data, adjusted for all of these factors, we find that some minority groups receive a higher proportion of loans than their credit would suggest. Jacoby (1995) reports that Federal Reserve economists tracked 220,000 federally insured loans and discovered “a higher likelihood of default on the part of black borrowers compared with white households.” This finding brings doubt to the hypothesis that current lenders discriminate against minorities. If banks were indeed rejecting qualified minorities, then the minorities who did receive loans must have been extra-qualified and would have lower default rates.
Lending to borrowers who are more likely to default is likely a consequence of non-discrimination law, which has used ends determined by politics and pressure groups. For example, regulators need only have a reason to believe that discrimination has taken place before fining banks, blocking mergers, or stopping other kinds of regulatory applications that banks may be working on. Moreover, regulators look for three types of supposed evil: “blatant discrimination,” “different-treatment discrimination,” or “adverse-impact discrimination.” The burden of proof is generally on the accused.
With advances in banking, neighborhood-based banking is in decline, but still there are claims that banks “red line” certain areas out of the lending market, a charge which banks have denied for decades. But there would be little negative effects of red lining, even if done conspicuously. If anything, it alerts competitors that a bank is writing off whole sections of the city where there might be profits to be had.
Again, even if bankers are inherently discriminatory, unless they are willing to forgo profits, their criterion for making loans will be expected monetary returns. If a lender finds few residents in a specific neighborhood qualified for loans, he will take his business elsewhere. Banks look at a potential borrower’s likelihood of paying back a loan and these factors of course differ from person to person. But it may be the case that neighborhoods consisting of rental housing have fewer good candidates for home mortgage loans.
To determine whether red-lining should be prohibited requires deciding whether loan decisions should be made by people putting their money on the line or by political agents. Should lending institutions be compelled to make loans against their better judgment? According to many, the answer is yes. For example, the number of hurdles that Fleet Financial Group had to pass when it purchased Shawmut National Corporation demonstrates this well. Unless the newly formed company promised to make large amounts of loans to the disadvantaged, Massachusetts regulators would not approve the merger. As Reidy (1995) detailed:
[The most recent commitments] bring to more than $600 million Fleet’s commitments in recent months to affordable housing, mortgages, and small business loans. The programs, analysts said, are part of Fleet’s efforts to mute opposition from community groups and state agencies as it seeks the approval of federal regulators to purchase Shawmut.
Eventually, the merger was approved, but the politicians imposed significant costs. This is just one of the many examples of how financial decisions have become more and more influenced by the political process.
The insurance market faces its share of government involvement as well. As principles of economics demonstrate, price restrictions prevent supply and demand from equilibrating, creating shortages or surpluses. Because of various price restrictions and regulations, insurers have simply chosen not to underwrite large classes of goods. To fill this void, government is put in the odd position of either mandating private provision or providing financial services itself.
Both controlling private firms and creating state-run enterprises can create perverse incentives. Invariably, this leads to more government involvement (Mises 1992). A state-sponsored insurance company crowds out private firms, because they now have a competitor that can charge less and take tremendous losses without going out of business. The Massachusetts state-sponsored Fair Plan provides insurance to people who cannot obtain the private variety. In Roxbury, northern Mattapan, and southwest Dorchester, where a higher percentage of minorities live, over three-quarters of the insured homes are covered by the Fair Plan. This compares to half a percent of all homes in Newton, a town with a lower percentage of minorities (Blanton 1995). But the costs of government policies are often ignored. Just because government provides a service does not mean it is free to society. When a state enterprise’s expenses exceed its revenue, taxpayers end up footing the bill.
Government regulation is usually promoted as a measure to benefit consumers, while in actuality it can have the opposite effect. It is quite possible that when increased regulation raises costs to producers, they will pass those on to consumers. What has been the result of the regulations and more involvement in Massachusetts? Have they really helped citizens against high insurance costs? The answer is pretty clear: “On average, Massachusetts drivers pay the third-highest auto insurance bills in the country. With rates set by law every year, there has been little opportunity for competition” (Kurkjiian 1995b). With all of its interference in the market, government does not seem to be an effective tool for increasing choices for consumers.
This leads to the question of what is government’s proper role in a market economy. Should government be providing banking and insurance to all comers? If the answer is yes, then what makes the insurance industry unique? Consider a contrived example to demonstrate the effects of government interference in these markets. In an effort to make refrigerators more affordable, the state could impose restrictions on that industry. Supposing Frigidaire would charge five hundred dollars for its product, should the government prohibit any price over one hundred dollars? Then, once companies stopped selling as many refrigerators as before, should the bureaucrats mandate that they sell more? Now, Frigidaire would be less likely to sell their refrigerators anywhere, but especially in inner cities. Would they be discriminating by not selling as much? Should the state step in and force them to sell more refrigerators to inner cities, or would Frigidaire not be able to satisfy the need? Should the government then provide affordable refrigerators to the people? This whole scenario is folly. Right now, there simply is no refrigerator “crisis.” The U.S. has no “refrigerator policy.”1
But how different is that imaginary case from what the government is doing to financial services? If the insurance and banking industries were able to operate freely,2 everybody who could afford and wanted services could get them.3 There would be no shortages and no need for state-provided services. With fewer restrictions, the quality of services would also increase.
Economic logic forces banks and insurers to be driven not by considerations of discrimination but by the promises of profits. Like the refrigerator industry, anyone who is willing to pay for a good would be able to obtain what they want. Should we allow companies to charge more and allow people to pay more if that is what both parties prefer? Higher insurance rates and higher loan-rejection rates all occur because of higher inner-city costs and higher default risks. As we have seen, discrimination does not cause the higher prices; it is, rather, higher costs that cause higher prices. In an unregulated market, would there be equal insurance rates and bank loans to all people? Any differences among groups, just as differences among individuals, would be reflected in market phenomena. Unfortunately, in the current market, government policies have made it more difficult for city residents to purchase the financial services they demand.
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Walter Block, Nicholas Snow, and Edward Stringham, Business and Society Review 113, no. 3 (2008): 403–19. In-text references can be found in the bibliography section of this book.
1 That, undoubtedly, is why there is no problem.
2 Nothing here should be taken to imply that the present authors believe these to be completely free. On the contrary, both depend on restrictions on entry and other illegitimate government interventions. For more on this, see Rothbard (1983, 1994).
3 It is even less clear why those who advocate policies to help the poor do not request that the poor be given cash transfers to purchase insurance. Perhaps there is an ulterior motive for supporting regulation (Stigler 1971).