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A bottom-up approach to Pay-As-You-Drive car insurance ∗

Pay-As-You-Drive (PAYD) is a concept in private automobile insurance under which premiums are quoted per mile. It is currently being tested by insurers world wide. With its increase in marginal driving costs Pay-As-You-Drive may present a politically feasible way to reduce driving (around 9%, according to recent studies) all the while saving most people money and increase fairness. The literature so far has analyzed PAYD with a representative agent approach, but concedes that both drivers’ heterogeneity and changes to caretaking incentives could significantly affect their predictions. To examine these potential side-effects I propose a bottom-up approach to compare individual driving behavior under various types of insurance pricing. One of the key findings is that when switching from standard to per-mile premiums drivers will for the most part reduce their driving but also exert less effort. Moreover there are considerable heterogeneity effects among drivers. In particular I find that infrequent drivers may actually increase their driving, which provides current non-drivers with more incentives to start driving than previously thought. In addition, I show that individual incentives to reduce driving decline when everybody else drives less. For these reasons aggregate mileage reduction and social benefits of PAYD may actually be less than the current estimates. Lastly I find that monitoring driving behavior will provide drivers with economic incentives to drive more carefully only if, in the absence of monitoring, they would not see their premiums increase too much after being involved in an accident.