Insurance Markets and Regulation
By Lawrence S. Powell
The Independent Institute Copyright © 2013 The Independent Institute
All rights reserved.
Lawrence S. Powell
DOES YOUR INSURANCE cost too much? To many, this seems like a simple question with an obvious answer. A common response might be, "Of course it costs too much." In addition, very few people are capable of calculating the value of insurance. Politicians' awareness of these two widespread truths has led insurance regulation down a troubling path. The political arena pits policymakers against insurance companies in an "us" versus "them" scenario founded mostly in fiction. As a result, we find broad public support for bizarre applications of legislation and regulation to insurance that do not serve consumers' interests.
For their part, policymakers face moving and sometimes conflicting objectives of serving and satisfying constituents, most of whom know little about the forces at work within an insurance market. Insurance is too important to society and to commerce to be left as a political pawn. The obvious positive action is to inform politicians and their constituents about the mixed bag of modern insurance regulation. Thus, the primary purpose of this publication is to provide clear information and supporting evidence about choices in insurance regulation in a format that is accessible and meaningful to policymakers and consumers.
To this end, the collection of essays in Risky Business pursues two related objectives. In the first six chapters, we explain the case for market-based regulatory reform. In chapters seven through ten, we consider potential changes to the current system of insurance regulation in the United States.
As a preview of our conclusions, we find that heavy-handed regulation of pricing and underwriting is a poor strategy for serving consumers. When regulation forces prices below the competitive market level, private insurers must either implement unfair cross subsidies or withdraw from the market. In the former case, good drivers, to give just one example, are penalized to benefit bad drivers. In the latter case, reductions in the supply of insurance lead to sharp increases in price.
The economic and political considerations that often drive public policy decisions concerning insurance would improve if consumers and policymakers sought and applied available information. Policymakers have enacted many laws that do not benefit their constituents. One explanation for subpar regulation is that policymakers might not understand the economics of insurance markets and regulation. Another possible explanation is that policymakers are well informed, but they take advantage of the ignorance of their constituents; using insurance regulation to gain favor with certain influential groups. Florida Governor Charlie Crist's political attack against homeowners insurance companies is clearly an example of the latter behavior. In both cases, educating the appropriate party would improve regulatory outcomes.
Finally, we show that the current regulatory system includes unnecessary costs and that it could be improved by increasing uniformity across states and by including select elements of alternative systems. We find the current system of fifty-six separate jurisdictions in the United States adds billions of dollars in duplicative regulation costs. By creating a more uniform system, lower costs will be passed on to consumers. Furthermore, by modeling some regulatory changes after the new system being implemented in Europe, such as a principles-based regulatory approach, we can improve the current system.
The Case for Market-Based Regulatory Reform
Optimal insurance regulation seeks a delicate balance between enhancing industry competition and maintaining appropriate oversight. Competition among firms is the cornerstone of effective consumer protection. When suppliers compete for consumers' business, the prevailing price shifts from the highest price consumers will pay to lowest price at which providers will participate in the market. Some level of regulation is also desirable to monitor insurer solvency and some types of antimarket behavior.
All too often, crises draw extreme reactions from policymakers. Such reactions almost uniformly involve increasing regulatory stringency, stifling competition, and exacerbating problems they intended to solve.
In Chapter 3, Martin Grace examines the difference in timing considerations between insurance companies and politicians. Politicians are concerned with winning the next election — a relatively near-term event. Insurers are concerned about paying for large catastrophic losses that might happen once in a decade, or even once in a century. Therefore, if a politician can engineer a reduction in rates, even if it leads to a smaller asset pool on which to draw in an emergency, that's a friendly gamble. Insurance companies must profit in years without catastrophic losses in order to fund large losses when they do happen. Elected officials, however, can gain political support by reducing insurance profits in the good years, even at the price of making bad years worse.
As supporting evidence, Grace describes a host of colossal regulatory failures including Florida's market for windstorm coverage; automobile insurance markets in Massachusetts, New Jersey, and South Carolina; and the workers compensation insurance market in Maine. For example, following large losses from hurricane Andrew, regulators in Florida restricted premium increases. As a result, many companies chose not to sell insurance in Florida and the state-owned Citizens Insurance Company found itself underwriting more than 50 percent of houses in the state.
In each case, policymakers responded to increasing prices with suppressive rate regulation. As a result, market problems were exacerbated, prices rose, and the security of these insurance markets was threatened.
Chapter 4 examines a related problem of restricting information used in underwriting and pricing insurance. Insurance regulation can be used to favor groups with strong political influence. Any time regulators restrict the use of accurate rating variables, it creates an explicit subsidy. In automobile insurance, for example, the subsidy takes money from the average good driver for the expressed purpose of paying part of the cost of the average bad driver's insurance premium. One likely example of this behavior is the explicit subsidy Massachusetts regulators afford to Boston residents. Drivers outside of Boston pay substantially more for automobile insurance relative to expected loss than do Boston drivers.
In Chapter 4, I tackle the subject of credit-based insurance scores (CBIS) in pricing and underwriting automobile insurance. CBIS has been one of the most controversial rating variables for the last two decades. I describe how CBIS is used and review the existing research demonstrating it is among the most accurate rating variables. The innovation of this research is to measure the effects of CBIS on insurance markets. Using a novel measure of CBIS activity, I show that increases in scoring coincided with decreases in the number of drivers who were considered too risky to buy insurance from private companies and decreases in the cost and price of automobile insurance. In other words, Chapter 4 demonstrates the benefits to consumers from using the most accurate rating information.
In Chapter 5, Professors Patricia Born and Barbara Klimaszewski-Blettner provide empirical evidence of the benefits to consumers from limiting rate regulation. They compare responses in insurer performance measures between personal lines and commercial lines of insurance following unexpected catastrophic losses. This comparison is meaningful because personal lines of insurance (e.g., homeowners and automobile) face many more regulatory restrictions than do commercial lines. An insurer must hold capital in excess of expected losses to ensure claim payment when losses are greater than anticipated. The more capital an insurance company has, the more insurance it can safely sell. After a catastrophic loss, insurers must raise new capital to replenish underwriting capacity, or they must decrease the amount of insurance they sell.
The authors find commercial insurance markets much more resilient to catastrophic losses than are personal lines markets. Because regulation restricts insurers' ability to charge adequate prices, personal lines markets often face severe shortages of capacity, leading to drastic price increases following unexpected catastrophic losses. In comparison, politicians interfere less with commercial lines, and disruption in those markets is less pronounced.
In Chapter 6, Eli Lehrer provides a political-economic analysis of the National Flood Insurance Program (NFIP). While many scholars and practitioners have historically assumed that NFIP was created to address a market failure, Lehrer shows that NFIP did not emerge because of market failure alone. Lehrer argues convincingly that private markets would have developed flood insurance products but for the government's strong signal that it would offer this coverage at a subsidized rate.
The overarching theme of Chapters 3 through 6 is that consumers pay the price of heavy-handed insurance regulation. While policymakers are sometimes urged by their constituents to interfere in insurance markets, the informed response is to let markets protect consumers.
Assessing Potential Alternatives to Current Regulation
Insurance regulation in the United States is at a crossroads. Various stakeholders in the regulatory system have been clamoring for change relentlessly. Chapters 7 through 10 discuss the current regulatory system and compare it to alternative systems. We also measure the cost of the current system and potential costs and benefits to expect if policymakers implement substantial changes.
U.S. insurance companies are currently regulated at the state level, subjecting multistate insurers to different regulatory requirements from each state in which they are licensed. Should the United States abandon the fifty-state regulatory approach and move to a unified federal regulatory system? Or should insurance be regulated by a competitive federalist system in which insurers may choose one state to regulate them throughout all fifty states, as occurs in corporate law today? Results and conclusions from this project inform policymakers on this important issue and serve as a roadmap to regulatory reform.
Motivated by an array of interests ranging from an economic downturn to the aftermath of gulf coast hurricanes to modernization of global financial services markets, critics of the state-level regulatory system include an uncommon alliance of political actors and financial industry interests, substantially blurring party lines on the ultimate outcome of this national debate. The common thread in their goals is to effect some form of federal insurance regulation; however, there are wide differences in their motives. Politicians and self-titled "consumer advocates" from states with substantial hurricane exposure wish to repeal the McCarran-Ferguson Act of 1945 to subject insurers to federal antitrust laws so that federal officials can regulate insurance prices. Financial services firms, including most life insurers and some larger property and liability insurers, reinsurers, and intermediaries, desire the option of a federal charter or some other vehicle to facilitate streamlining of the current fragmented system for efficiency gains. For example, multistate carriers currently are required to seek approval of new products in each state where they will be sold. Many believe this redundancy of approval creates deadweight costs that must be passed on to consumers. Some also suggest this system hampers U.S. firms' ability to compete in the global market.
Opposition to this move toward federal regulation comes primarily from smaller property and liability insurance carriers and intermediaries. These groups are concerned about potential litigation and information costs expected to follow any change in the McCarran-Ferguson Act of 1945, the current law of the land, which gives states the responsibility of regulating the business of insurance and provides a limited antitrust exemption that allows insurers — especially smaller insurers — to participate and compete in domestic insurance markets. Because McCarran has been in effect for more than six decades, many of the potential uncertainties regarding antitrust issues have been litigated and resolved under the current regime.
Last, but certainly not least, state-level policymakers are concerned about their ability to maintain claims on insurance-premium tax revenues. In most states, insurance-premium taxes are among the largest sources of revenue. These revenues are not earmarked specifically to support costs of insurance regulation. They are often directed to the general state budget, creating a pseudo-hidden tax on all consumers of insurance. Premium tax rates are applied to total written premiums and range from 0.25 percent in Illinois up to 6.5 percent for some lines of insurance in Arkansas and Hawaii. This concern is voiced often by state-level political interest groups, including the National Conference of Insurance Legislators (NCOIL).
As insurance interests tire of waiting for meaningful reform at the state level, many of the current proposals to effect change have begun to involve some form of federal insurance charter, or a competitive regulatory environment that would create choices for insurers facing relatively onerous, innovation-stifling state regulation. However, these proposals carry the potential for both cost and benefit. Chapter 7 through 10 seek to describe these alternatives and estimate the costs and benefits of changes to the insurance regulation system.
In Chapter 7, Martin Grace and Robert Klein provide a thorough description of the history and current structure of the U.S. insurance regulatory system. Building from this foundation, they go on to describe several alternative systems being considered by Congress. The authors compare and contrast the status quo with a federal regulatory system, an optional federal charter, and a system of competitive federalism. While each system has certain benefits, Grace and Klein predict that both practical considerations and politics will encumber efforts to rationalize insurance regulation. Hence, a major revamping of the current system is unlikely to occur in the near future. What we are likely to see are smaller incremental changes at both the state and federal level that have been the industry's historical legacy. These changes will not achieve the objectives of reformists, but they may help set the stage for more substantive reforms under more favorable political conditions.
In Chapter 8, Martin Eling, Robert Klein, and Joan Schmit compare insurance regulation in the United States to that in the European Union (EU). The authors describe solvency regulation in the U.S. system as a static accounting system. In comparison, the EU system is dynamic and holistic. They also note the strong case for avoiding price regulation in any new regulatory structure. They encourage U.S. regulators to keep in mind a variety of ideas that emerge from the EU's Solvency II process when revising the U.S. system. Among the most important of these is the notion of a principles-based approach.
The last two chapters in this book attempt to measure the costs of the current system compared to alternative systems. In Chapter 9, David Eckles and I measure the cost of multiple regulatory systems compared to one uniform system. We estimate the effects on efficiency and expenses of increasing the number of states in which an insurer operates. We find the cost of multistate regulation to be significant and positive. By creating a uniform regulatory system, regulatory cost would decrease by approximately $1.6 billion per year.
In Chapter 10, Ty Leverty compares the operating expenses of risk retention groups (RRGs) to those of similar insurers operating under a traditional charter. Because an RRG is only regulated by its home state, the difference serves as an estimate of potential cost savings from implementing a competitive federalism system. Using an efficiency methodology, Leverty demonstrates that a system of competitive federalism could save as much as $1.2 billion annually compared to the status quo. (Continues...)
Excerpted from Risky Business by Lawrence S. Powell. Copyright © 2013 The Independent Institute. Excerpted by permission of The Independent Institute.
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