Attempts to Socialize Insurance Costs in Voluntary Insurance Markets - Bartlett

Question 1

What are the arguments for socialized insurance?

Answer 1

1. Fairness - sharing insurance costs is fairer than basing insurance costs on an individual’s risk characteristics
2. Affordability - premiums should be affordable for everyone when the government compels individuals to buy insurance
3. Availability - ins. should be available to all, but some may not purchase ins if premiums are based on risk based pricing

Question 2

What conditions make socialized insurance most feasible?

Answer 2

1. participants are legally compelled to participate AND the ins is administered by a single entity with no competitors
2. a private insurer is insulated from competition or its profits and equity are subject to expropriation by the government
3. when participants believe that the overall benefits of group participation exceed the costs of socialization

Question 3

What structural factors facilitate cross subsidization?

Answer 3

1. market entry and exit barriers
2. market power
3. special cost advantages
4. the value of firm reputation
5. switching costs for consumers
6. constraints on consumer information

Question 4

Why may insurers find it difficult to exit a market?

Answer 4

1. states impose prior notice requirements for policy terminations and may enact severe restrictions on policy terminations, underwriting selection and exit
2. insurers may lose economies of scope in cross marketing multiple insurance products when withdrawing from a particular line
3. insurers lose their start up operating costs if they decide to withdraw from a state
4. regulators may require an insurer to withdraw from all lines, and not just the market where price constraints are imposed

Question 5

How may regulators constrain risk based pricing?

Answer 5

1. limiting the diff in insurer rates among different risk classes
2. suppressing an insurer’s overall rate level
3. prohibiting the use of certain risk classification criteria for pricing purposes
4. banning or limiting the use of certain risk factors for the purpose of underwriting selection

Question 6

How may insurers respond to regulator constraints on insurers’ rate structures?

Answer 6

1. selective underwriting - may market to either low or high risk insureds and may adjust their underwriting standards and overall rate levels
2. decreasing the quality of service they provide to high-risk insureds to lessen the impact of price constraints
3. passing on the cost of cross subsidization to insureds such that the cost is small relative to the premiums they charge

Question 7

What factors aside from the imposition of cross subsidies prevent insurers from exploiting consumers to earn excess profits?

Answer 7

1. regulatory monitoring of insurers’ overall rate levels and profits prevent insurers from earning xs profits for extended periods
2. low risk insureds may move their business for even a small difference in price, which in turn induces insurers to maintain competitive rates for all risk classes

Question 8

How are residual market mechanisms used to implement cross subsidies?

Answer 8

• the prices of RMMs are typically constrained by regulation
• as a result, some insureds could obtain ins in the voluntary market, but choose the RMM because it offers a lower price
• as a result, RMMs often run operation deficits that are funded through pro-rata assessments on insurers’ voluntary premiums
• these increased costs are passed on to the insureds in the voluntary market, which are typically the lower-risk insureds

Question 9

What problems are caused by funding residual markets through assessments on voluntary (low-risk) policies?

Answer 9

• discourages insurers from writing voluntary business
• discourages low risk insureds from purchasing insurance
• encourages moral hazard and cost inflation by failing to charge high risk insureds an actuarially fair rate

Question 10

In what kinds of organizations may equalized costs be feasible?

Answer 10

• organizations that provide unique benefits that deter low risk members from leaving
• organizations that enjoy special advantages or charters that insulate them from competition which offers similar insurance protection at risk based prices

Question 11

Why may information concerning an individual’s risk not be used by insurers

Answer 11

• If info is costly to acquire, insurers may limit risk classification factors to variables that are readily measurable and verifiable
• Certain risk differences are not significant enough to justify different risk classifications

Question 12

What is assessment life insurance?

What problem arose as a result?

Answer 12

• popular in the late 19th and early 20th century
• provided death benefits by assessing the remaining members after a covered individual died
• gave rise to adverse selection as younger members realized they were subsidizing the benefits of older members
• assessment life insurance organizations then adopted a pricing structure based on the member’s age
• still, such plans became less popular with the rise of more risk based alternatives (industrial ins, group life insurance etc)

Question 13

What was the original goal of Blue Cross insurers?

Answer 13

Blue Cross
• attempted to socialize healthy insurance via “community rating”
• community rating pricing ignores age, sex, occupation, income, or past claims experience; each subscriber pays same amt
• insulation from competition in their early years enables them to use community rating

Question 14

What are the characteristics of Blue Cross prepaid hospital expense plans?

Answer 14

1. Sponsorship by hospital or group of hospitals within a community
2. Not-for-profit status with certain tax exemptions
3. Limited choice of benefit options to plan subscribers
4. Direct writer method of distribution
5. Low administrative expenses due to size, distribution method and limited plan choice
6. Community rating pricing techniques

Question 15

What advantages do traditional insurance companies have over Blue Cross plans?

Answer 15

• provided greater flexibility in benefit design & greater reliance on commissioned agents and brokers to distribute products
• offered indemnity plans reimbursing hospitalization expenses incurred rather than hospital provided services
• used experience rating and risk classification factors to determine premiums
• were regional and even national in scope for larger carriers, and this gave them additional pricing flexibility, that the Blues, as community based plans, could not easily justify

Question 16

What advantages do Blue Cross plans have over traditional insurance companies?

Answer 16

• High cost distribution methods for traditional insurers
• Lack of tax exemptions for traditional insurance companies
• Discounts on hospital services that were given to the Blue Cross plans by their sponsoring hospitals

(traditional insurance companies have overcome these disadvantages through experience rating)

Question 17

Why did Blues ultimately adopt experience rating plans?

Answer 17

• commercial carriers attracted an increasing share of groups with more favorable experience
• employers chose plans which were in their best financial interest
• groups with more favorable experience migrated away from the Blue Cross plans

Question 18

Without community rating, what options do those buying insurance have?

Answer 18

• not purchase insurance at all
• take advantage of ERISA, which preempts state regulation of self-insured group plans
• allow employees to opt out of community rated plans via a medical savings account
→ this option is geared towards participants who expect a lower than average incidence of medical claims, and would lead to further adverse selection problems.

Question 19

How might state government attempt to socialize P-L insurance costs?

Answer 19

• restrictions on class rate relativities, including territorial or geographic rate differentials (personal auto and HO’s)
• constraints on insurers’ territorial definitions or the variables insurers may consider in establishing rating classifications
• banning or limiting the use of certain underwriting criteria

Question 20

What is the Michigan Essential Insurance Act (EIA)?

Answer 20

Michigan’s EIA was the state’s attempt at socializing P&L insurance costs by constraining territorial rating in personal auto and homeowners insurance in the 80s and early 90s.
The goals were:
• to limit rate increases
• to increase the availability and affordability of coverage

Question 21

What constraints did Michigan’s Essential Insurance Act put on territorial rates?

Answer 21

These constraints were intended to cap rates in urban areas relative to rates in other areas:

1. required insurer to not have more than 20 differential territorial base rates in state
2. required insurer’s lowest territory base rate to not be less than 45% of its highest base rate
3. for adjacent territories, the rate in the lower rated community could not be less than 90% of the higher rate
4. “take-all-comers” provision required insurers to accept all “eligible” applicants for insurance
5. prohibition of using gender or marital status as rating factors
6. move from prior approval to file and use system

Question 22

What is the definition of an eligible applicant under Michigan’s EIA (“take-allcomers”
provision)?

Answer 22

1. drivers having less than 6 points for driving violations

2. drivers who had not been convicted of severe driving violations (DUI etc.), fraud or other serious offenses

Question 23

Why did Michigan move from prior approval to file-and use?

Answer 23

Michigan moved from prior approval to a file-and use system in the EIA because they wanted to relinquish control of insurers’ price levels but maintain constraints on territorial rating

Question 24

What was the rationale for implementing the constraints in EIA?

Answer 24

2 Insurers Accused of Unfair Discrimination Against Detroit

#1 Auto Ins is an "Essential" Ins Coverage & Mandated by Law
• b/c the purchase of auto insurance is mandatory, the state had a responsibility to ensure coverage was available & affordable
• also, Michigan's strict no-fault law limited one's ability to sue

• economic decline, high traffic density & auto crimes in Detroit
• insurers’ pricing and marketing practices reflected this
• b/c Detroit has a large concentration of minority & low income residents, insurers were accused of unfair discrimination
• this generated political support for the EIA

Question 25

Why do urban areas have higher auto losses than rural areas (purpose of territorial
rates)?

Answer 25

• accidents more frequent since traffic density is greater and driving conditions are more hazardous
• severity of BI and PD claims may be greater
• cost of medical and auto repair services are higher
• tendency to litigate is higher
• incidence of vandalism and auto theft is higher

Question 26

What would be the expected result of the EIA constraints?

Answer 26

• Urban insurers would tie their rate level more closely to their Detroit experience than non-urban insurers.
• So their rate for Detroit would be close to the actual loss costs.
• But because the lowest territorial base rate could not be less than 45% of the highest territorial base rate, the rate for rural Michigan would be much higher than the actuarially sound rate.
• Non-urban insurers would tie their rate level more closely to the experience in these low-risk areas.
• So their rate for non-urban areas would be close to the actual loss costs, but the rate for Detroit would be much lower than the actuarially sound rate.
• As a result, few drivers in rural areas would buy insurance from the urban insurers and the non-urban insurers would choose to write very little business in Detroit.
• Hence, the amount of cross subsidies actually achieved among a given company’s insureds and among all insureds in Michigan, will be diminished by geographical market
segmentation.

Question 27

How successful was the EIA in achieving its objectives?

Answer 27

• The EIA failed to limit rate increases or make coverage affordable in all areas.
→ The average premium paid in Detroit remained significantly higher than the average premium paid in non-urban areas, and continued to escalate over time.
• The EIA failed to make coverage available in all areas.
→ Coverage availability worsened in Detroit, as an increasing number of drivers became insured through the state’s residual market mechanism (esp. young males).
• However, the EIA did achieve some level of subsidization for Detroit insureds.
→ The ratio of RWM to Detroit prem was higher than the ratio of RWM loss costs to Detroit loss costs. Therefore, the LR for RWM was far lower than that for Detroit which suggests some level of subsidization (esp PIP and comprehensive).
→ When the EIA constraints were relaxed, Detroit rates increased while non-urban rates remained stable.

Question 28

What was the impact of P.A. 10?

Answer 28

• Discontent w/ the effects of EIA led to the enactment of P.A.10
• suspended the rating constraints and substituted an alternative approach to limiting rate increases in Detroit (lim to 4% + CPI)
• sunset after 5 years
• required the insurance commissioner to issue a report in 1989

Question 29

What did the commissioner’s report conclude?

Answer 29

• concluded Detroit rates had risen in relation to outstate rates
• neither the availability or affordability of insurance had improved
• blamed insurers’ marketing for a perceived inadequate number of agents and distribution outlets in Detroit
• concerned with the fairness of insurers’ rating territories
• recommended that territories not be smaller than a county
• recommended that all insurers be required to implement a statewide marketing plan
• did not recommend a return to the EIA restrictions

Question 30

What are the counterarguments to the commissioner’s report?

Answer 30

• the commissioner’s report failed to make a convincing case that territorial pricing was unfairly discriminatory
• did not adequately explain how insurers could sustain excessive prices in urban areas in the face of competitive market conditions
• allowing territories to be no smaller than a county ignores the geographic variation within these areas
• one of the factors that discouraged oustate insurers from writing in Detroit under PA10 was uncertainty about whether the EIA restrictions would return with the sunset of PA10
• the fact that insurers increased Detroit rates under PA10 is evidence that Detroit rates were inadequate