Inflation and Auto Insurance

Center for Economic Development and Policy Research, CEPR

Dean Baker

When we hear about inflation most of us probably think of items like food, gas, and rent, but when it comes to the Consumer Price Index (CPI), the most frequently cited measure of inflation, auto insurance has played a very large role in recent years. The index for motor vehicle insurance rose 0.9 percent in July. It was responsible for 0.024 percentage points of the 0.4 percent inflation reported for February.

Over the last year the insurance index has risen 20.6 percent and is responsible for just over 0.5 percentage points of the 3.2 percent inflation rate in the overall CPI. It accounts for more than 0.6 percentage points of the 3.8 percent inflation shown in the core index over the last year. We would likely be thinking about inflation very differently if the auto insurance index showed a more moderate rate of inflation.

Part of the story with rising auto insurance prices reflects inflation in the relevant sectors of the economy. New and used car prices rose rapidly in the pandemic due to supply chain problems. We also saw a big increase in the price of car parts for the same reason. And, auto repair prices also rose rapidly, partly due to higher prices for parts, but also due to labor shortages pushing up pay in the industry.

This part of the insurance inflation story is diminishing as inflation in these components comes under control. New vehicle prices have risen just 0.4 percent over the last year and used vehicle prices are down 1.6 percent.

The index for parts and equipment fell 0.5 percent over the last year, after peaking with a year over year increase of more than 15 percent in 2022. The index for maintenance and repairs rose 6.7 percent over the last year, but that is down from a peak of 14.2 percent at the start of last year.

These inflation-driven aspects of auto insurance prices are coming under control, but that is only part of the story of the rise in the insurance index. The other part is simply that there is more damage to cars and passengers.

There are many factors here. We have seen a rise in accident rates since the pandemic. There also is more damage due to climate-related events like hurricanes and flooding. Insofar, these factors lead to higher insurance premiums. This will be picked up in the CPI insurance index, since it simply measures the premiums that drivers pay.

This is in contrast to the auto insurance component of the Personal Consumption Expenditure Deflator (PCE). That component uses a net measure of the cost of auto insurance, which subtracts out the amount paid to customers in claims.

The insurance component in the PCE has a much lower weight in the index, just 0.57 percent, compared to 2.83 percent in the CPI. It also shows a considerably lower rate of inflation, rising just 6.6 percent over the last year.

What Should Count as Inflation?

This differing treatment raises an interesting conceptual issue about how we think about the CPI, inflation, and the cost of living. The CPI measures the change in the price of a fixed basket of goods and services. The basket changes every year, but it doesn’t pick up the effect of people switching, say from beef to chicken, in response to a change in relative prices, if beef prices rise more than chicken prices.

This issue has often been raised as a reason the CPI is inadequate as a measure of the cost of living, meaning that it overstates the true increase in the cost of living. In reality, this sort of “substitution” actually doesn’t matter much. An index that allows for the effect of substitution, like the PCE, shows a 0.2-0.3 pp lower rate of inflation. That can add up over time, but it doesn’t really qualitatively change our view of inflation.

The more important issue is how we deal with societal changes, as is happening with auto insurance. Suppose auto insurance costs more because more bad things are happening, like accidents or floods destroying cars. The PCE measure of insurance would not show this as an increase in the cost of living. The logic is we are not actually paying a higher price for the same insurance, we are paying more because we are effectively getting more insurance.

This is in some sense true, but the only reason we need to buy more insurance is because drivers have become more reckless, or climate change is causing more damage. These changes increase our cost of living. This occurs in ways not picked up in measured inflation.

To take a similar story, suppose crime in a neighborhood has exploded. Now people routinely get burglar alarms, put in extra locks and bars on windows, and get vicious dogs to discourage intruders. These are all higher costs people will incur. None of them are included in the CPI or any other inflation measure.

Healthcare presents similar problems. Our inflation indexes measure the cost of specific treatments. But we don’t actually value the treatments — most of us would probably be happy never having to see the doctor – we value our health.

When a new disease appears, like Covid in 2020 or AIDS in the 1980s, costs of treatment for the new disease is not factored into the inflation indexes. In fact, when the cost of a treatment declines, as when a drug goes off patent and the availability of generics drive down the price, the new disease has the effect of lowering the measured rate of inflation.

To my view, the best way to measure the cost of healthcare in an inflation index is to measure what we pay and simply deduct it from our disposable income. We have separate measures to evaluate health. People’s health may improve because they eat better, exercise more, or have a healthier environment. These outcomes imply an improvement in living standards in most people’s book even if we are not getting more drugs, tests, or medical procedures.

We also have problems that items become necessities, but the associated spending is not picked up in the CPI or other inflation measures. The Internet is great but try getting by without it. It really is necessary now to be on-line to be able to get access to a wide swath of information, much of which used to be available through other channels. (Have you seen a phone book lately?).

However, the cost of monthly Internet access, or the device needed to get on the Internet (phone or computer), does not appear as increase in the cost of living in our inflation indexes. There are many other items that fall into the same category. A car could be a luxury for most people 70 years ago. Now that many cities are pretty much designed around cars, it would be very difficult to get around without one.

Anyhow, this is a long way of saying that the cost of living can be a difficult concept. The CPI’s treatment of car insurance provides an interesting window on the issue. This measure is one way in which the effects of global warming will show up in the measured rate of inflation. Unfortunately, it is not the only way in which it will affect the cost-of-living.