Insurance Rate Regulation in the 20th Century - Harrington

Question 1

Describe the issues and results of the following legal cases:

Paul v. Virginia
U.S. v. South-Eastern
Underwriters Association

Answer 1

1868: Paul v. Virginia - Supreme Court deemed insurance not subject to laws affecting interstate commerce. This gave rise to:
1. collective ratemaking being exempt from federal antitrust law
2. states having power to regulate insurance.
1944: U.S. v. SEUA - The Supreme Court ruled that:
1. insurance was interstate commerce when transacted across state lines
2. Congress could regulate insurance
3. the Sherman Antitrust Act applied to insurance

Question 2

Describe the McCarran-Ferguson Act and the states’ response.

Answer 2

The act did the following:
1. endorsed state regulation
2. exempted insurers from federal antitrust laws to the extent state laws regulated insurance and did not involve boycott, coercion or
intimidation
States responded by:
1. making P&L insurance rates subject to prior approval
2. requiring or strongly encouraging all insurers to use bureau rates

Question 3

Why did uniform bureau rating subside?

Answer 3

In the late 1950s, uniform bureau rates gradually subsided due to the following:
• pressure for increased rate competition
• legal decisions
Also, direct writers obtained approval to charge lower rates given their lower op expenses and targeting of lower risk insureds

Question 4

What influenced the change from prior approval to competitive rating in the 60’s?

Answer 4

In the mid 1960s, a large number of states replaced their prior approval laws with competitive rating laws.

Reason for Move from Prior Approval to Competitive Rating

1. Movement away from bureau pricing
2. Increased administrative costs associated with multiple rate filings by insurers
3. Recognition that solvency regulation obviated rate regulation’s role in preventing insolvencies
4. Hope that price competition would stymie insurance affordability problems

Question 5

How did rate regulation change in the 70s and 80s?

Answer 5

The 1970s and 1980s reflected divergent trends.
- Some states largely deregulated PL ins rates (except WC)
- Other states increased the intensity and scope of regulation
→ shifted their focus from the promotion of rate adequacy to ensure solvency to more restrictive and comprehensive controls with the goal of limiting rate increases
→ an emphasis on insurance affordability caused states to begin to consider investment income formally in the rate review process

Question 6

How did states respond to rapid growth of claims costs in 80s?

Answer 6

Rapid growth in claim costs in the mid 70s and 80s prompted the following:

1. Passage of Proposition 103 in CA
2. Widespread regulatory suppression of WC rates
3. Devt of residual market mechanisms which capped rates

Question 7

How did rate regulation change in the 1990s?

Answer 7

• large CAT losses led to increased regulation in the HO market
→ constraints on non-renewals and insurer withdrawals
• movement toward deregulation in other PL lines
→ in part because insurers began to see federal regulation as reducing the direct and indirect costs of state regulation through less intrusive and more uniform regulation
• loss trends for auto ins improved substantially
→ reduced public pressure for auto rate regulation
• state reform legislation led to favorable cost trends in WC too
→ vol and RM rate regulation changed to allow higher rates and provide greater incentives for loss control
→ resulted in a substantial reduction in the size of the RM

Question 8

What trends prompted movement towards deregulation in 90’s?

Answer 8

Trends that Prompted Deregulation in the ’90s

1. Insolvencies of large carriers - regulators felt they should spend more time on solvency instead of rate regulation
2. High rates - it was believed that less regulation meant less expenses and thus, lower rates
3. More sophisticated buyers of commercial lines insurance
   - were savvy enough to find the best rates

Question 9

Describe the rate regulation climate in each of the following time periods:

1900-1943
1944-1970
1971-present

Answer 9

1900-1943
• Insurance was exempt under federal antitrust laws and ratemaking in concert was common.
• Rating bureaus had a lot of power and participation was often compulsory.
• Regulation of rates on a state level was not prevalent.

1944-1970
• After the passage of the McCarran-Ferguson Act, states quickly established rate regulations in order to avoid federal intervention.
• Most states implemented prior approval laws.
• There was a great adherence to bureau rates and deviations were discouraged.

1971-present
• Rating bureaus developed into advisory organizations and published advisory loss costs in lieu of rates.
• States began to move away from prior approval.
• Where allowed, large deviations from bureau rates took place.

Question 10

Describe 2 criteria for efficient regulation?

Answer 10

• there should be demonstrable market failure
• there should be substantial evidence that regulation can address that failure efficiently
→ benefits of regulation outweigh direct and indirect costs

Efficient regulation must match appropriate regulatory tool to the specific market failure.

Question 11

Does prior approval rate regulation pass the test for efficient regulation?

Answer 11

Is Prior Approval Rate Regulation Efficient?
• market structure and ease of entry are highly conducive to competition in most PL lines
• prior approval rate regulation does not meet the criteria for efficient govt intervention
• insurance markets that are relatively free from regulatory constraints on prices and risk classification exhibit competitive conduct and performance

Question 12

What incentives does competition give to insurers?

Answer 12

1. Forecast costs accurately
2. Price and underwrite so as to avoid adverse selection
3. Create refined systems of rate classification
4. Minimize claim costs and settlement expenses

Question 13

List the 5 advantages of competitive rating and risk classification

Answer 13

1. Promote coverage availability
2. Give rise to smaller residual markets
3. Create incentives for higher risk buyers to take control of their losses
4. Creates strong incentives for insurers to forecast costs accurately and price and underwrite so as to avoid adverse selection
5. Encourages insurers to minimize claim costs and settlement expenses

Question 14

Arguments for prior approval rate regulation

Answer 14

1. Ins. industry’s exemption from federal antitrust law facilitates collusion among insurers to increase prices
2. Consumers need protection from inadvertently purchasing coverage from high price insurers
3. When purchase of ins is compulsory, ins rates need to be regulated
4. Selective suppression of rates thru regulation can be advantageous if it encourages some parties to buy insurance
5. Restrictions on risk classification could achieve greater equity or fairness

Question 15

Counter-arguments for prior approval rate regulation

Answer 15

1. • P&L mkt prices and UW stnds are heterogeneous
     - structure of ins mots is inconsistent with collusion to raise rates
     - rt advisory orbs provide low cost info re. prom. LCs
     - If exemption led to anti-compttv. behavior, solution would be to deregulate prices
2. If consumers have difficulty and govt action needed, preferred mode of regulation is greater info disclosure
3. Inelastic demand doesn’t produce excessive profits in competitive markets
4. Price regulation is a crude method of providing subsidies to low income buyers
5. • risk classification restrictions require rates for some buyers to increase beyond fair price
     - risk classification restrictions reduce incentives for PHs to control losses

Question 16

What are the possible adverse effects of prior approval with regulatory lag?

Answer 16

1. Costs of administration and compliance
2. Delays in adjusting rates to trends in losses and expenses
3. Greater variation in coverage availability over time
4. Greater variation in insurer profits over time
5. Higher long-run prices

Question 17

What are the possible adverse effects of prior approval with binding rate floors?

Answer 17

1. Inefficient non-price competition (excessive service)
2. Slower expansion of efficient firms
3. Higher prices

Question 18

What are the possible adverse effects of prior approval with average rate suppression?

Answer 18

1. Larger residual market
2. Reduced service
3. Increased risk for insurers and increased insolvency risk
4. Adverse spillovers on other states
5. Reduced insurer investment in infrastructure
6. Reduced entry and increased exit

Question 19

What are the possible adverse effects of restrictions on classification?

Answer 19

1. Costs of administration, enforcement and classification compliance
2. Larger residual market
3. Lower (higher) prices for high (low) risk buyers
4. Inefficiently low (high) incentives for loss control for high (low) risk policyholders

Question 20

Name some other problems with prior approval regulation.

Answer 20

1. Costs of administration\compliance ult borne by consumers
2. Rate approval process has been biased toward rate suppression which impacts availability
3. Ins depts that spend a lot of the budget on rate regulation may not address other problems efficiently, such as insolvency risk
4. Prior approval regulation won’t affect profits in the long run; insurers must expect a decent profit in order to provide coverage
5. Regulatory delay tends to produce fewer larger rate filings, greater swings in availability of coverage and insurer profitability
6. Regulatory rate suppression can reduce voluntary market sales, increase residual market size, reduce entry by new insurers, reduce
   incentives to provide valuable services
7. Restrictions on classification result in larger residual markets and reduced incentives for loss control

Question 21

Briefly describe 4 benefits of commercial lines deregulation to a commercial lines insurer

Answer 21

• insurer can react quickly to changing market conditions
• flexibility in product offerings
• reduced expenses due to less regulatory intervention
• allow insurers to be free of onerous form and rate restrictions which would enhance operating efficiency

Question 22

Briefly describe 3 benefits of commercial lines deregulation to a commercial insured

Answer 22

• competitive market’s result in increased availability and a greater variety of rates and underwriting guidelines
• can obtain coverage and rates that are appropriate to risk
• better availability

Question 23

Identify 2 possible adverse effects of prior approval with regulatory lag

Answer 23

• costs of administration and compliance
• delay adjustment of rates to reflect trends
• greater variation in coverage availability over time
• greater variation in insurer profits over time
• higher long-run prices

Question 24

Identify 2 possible adverse effects of prior approval with binding rate floors

Answer 24

• delay growth of efficient insurers
• increase prices over long run
• inefficient non-price competition

Question 25

Identify 2 possible adverse effects of prior approval with average rate suppression

Answer 25

• high risk for the insurer and high insolvency risk
• larger residual market
• reduce entry and increase exit from market
• reduced service
• reduced insurer investment infrastructure

Question 26

Identify 2 possible adverse effects of restrictions on classification

Answer 26

• lower prices for high risk buyers
• cost of administration, enforcement, and compliance
• inefficient incentives for loss control
• larger residual market

Question 27

5 arguments and counter-arguments in support of insurance rate regulation when the purchase of insurance is compulsory

Answer 27

• insurers will earn excessive profits
• consumers may inadvertently choose higher priced insurance
• regulation should be used to prevent excessive profits when purchase of insurance is compulsory
• insurance should be affordable if it is compulsory
• regulation needed to prevent insurers from colliding to increase prices

Counter:

• inelastic demand does not lead to excessive profits in competitive market
• rate regulation is a crude way to address this. A better way would be information disclosure
• regulation is a crude cost to promote subsidy. A better way is to provide subsidy
• market structure doesn’t support collusion - significant heterogeneity in pricing and underwriting

Question 28

Growth of competitive rating in P&C markets during latter half of 20th century reflected variety of forces. Describe two.

Answer 28

• growing evidence that prior approval rate regulation could neither persistently lower average rate levels nor expand availability
• restrictions on insurer rate classification were costly to enforce, inconsistent with widespread availability of coverage in voluntary market, and inconsistent with enhancing overall affordability of coverage