The Unpleasant Effects of Price Deregulation in the European Third-Party Motor Insurance Market: A Theoretical Framework

In some European countries, the liberalization of the motor insurance market in the 1990s led to substantial increases in fares and claims throughout the whole decade. In this paper we argue that these phenomena are due to the impact of liberalization on companies' optimal incentives to fight fraud. By developing a circular city competition model with a cost-reducing stage prior to the price game and a settlement stage following it, we show that price deregulation entails decreasing monitoring investments and increasing claims both in the short and long run. Even equilibrium premiums may steadily increase if the ``competition effect" connected to new entries is outweighed by a ``monitoring effect" that raises marginal costs.