Professor Armentano teaches in the Department of Economics at the University of Hartford in Connecticut.
In November 1988, California voters changed the rules of the game in the automobile insurance industry. In passing Proposition 103, they decided, among other things, to vote themselves a 20 percent reduction in automobile insurance rates and to remove the insurance industry% antitrust exemption. In May 1989, the California Supreme Court sustained that vote with some important qualifications.
The Court held, consistent with a long legal precedent, that insurance rates could be lowered, but that the new rates must be sufficient to allow the private firms to earn a “fair and reasonable” rate of return. If, for instance, the firms were making extraordinarily high profits, then prices might be regulated downward. But if, as many of the insurance companies contend, they were experiencing a loss underwriting auto insurance in California, then insurance rates might have to be increased to restore a “reasonable” level of profitability. Indeed, many California auto-insurance carriers already have filed for rate increases consistent with the state Supreme Court ruling.
The political fight to lower auto rates in California was led by prominent consumer advocates who first greeted the Court decision warmly. After all, had they not argued that the unregulated insurance market was incapable of setting fair and efficient prices for auto insurance? Government regulation of insurance company classification and territorial rating plans was necessary, they held, to provide fair auto rates to consumers. In addition, they were convinced that the antitrust exemption allowed the insurance companies opportunities to collude in restraint of trade. Ending the exemption, they argued, would end the collusion, increase competition, and lead to lower insurance prices.
Although the consumer advocates got what they wanted from the political process, they already are having second thoughts. And well they should. This “new” system of regulation is open to massive abuse by both the regulators and the regulated. The central difficulty is one of information. In the absence of a genuinely competitive market process, neither the regulators nor the regulated can know which prices or profit levels are appropriate or reasonable. The pricing problem is made especially difficult in property/casualty insurance since most of the “costs of production”—the loss experience—can be known only after the policy period has ended. This ultimate indeterminateness of (loss) cost in insurance makes the governmental attempt to set fair rates doubly absurd.
Non-insurance firms know their expenditure costs before they determine suggested prices for their products or services. The insurance business is fundamentally different. The total costs of insuring a motorist, for instance, can be known only at the expiration of the auto-policy period. This uncertainty concerning loss costs can be alleviated somewhat by the inter-firm pooling of historical loss experience in an attempt to better predict future costs. But these predictions often go wildly astray in the short run, and they contribute to the cyclical nature of insurance profitability.
Prior to Proposition 103, the competitive market process determined the ultimate reasonableness of insurance rates and profits in California. Insurance firms that met modest capital and surplus requirements entered the market, pooled loss data, and wrote policies at rates that they expected to be profitable. Although entry and firm rivalry were restricted somewhat by law, and although the state regulated many other aspects of the property/casualty business, pricing (and profits) were determined essentially by market forces.
All of that has suddenly changed. Prices of auto insurance and the profitability of the insurance companies now must be determined by the California Insurance Department and, ultimately, by the courts. But given the fundamental subjectivity of costs and the inherent instability of profits in this industry, it is unclear how any regulatory process will be able to work efficiently. To put the matter bluntly, how can the regulators rationally decide which costs and expenses are appropriate and which rates of profit are reasonable?
Consumers Not Well Served
Regulatory history in insurance and other industries demonstrates that the regulated firms often have the upper hand in this process. For example, if the regulators rely on the firms for the essential expense and loss information (as they must), and if the state further restricts entry into the market, then the companies may be able to manipulate prices to near-cartel levels. On the other hand, if the insurance regulators are “tough” and systematically underestimate costs and expenses, or decide (as they recently have done in California) to freeze auto rates while they deliberate questions of “unreasonableness,” then the insurance companies may choose to reduce supply availability and even abandon the market. In either case, consumers of insurance services will not be well served.
Ending the state antitrust exemption in California also will hurt consumers. Since the carriers were using the exemption to share essential loss-experience information, ending the exemption will lead to higher information costs in the industry. Many of the larger carriers have a sufficient pool of experience to make rational rates without sharing information. But hundreds of small insurance firms rely on the sharing of industry cost data and would not be efficient without it. Thus, ending the antitrust exemption will force many insurance firms out of business or into consolidation with larger companies. None of these developments is unambiguously pro- consumer.
Consumer advocates in California misled voters into believing that additional governmental intervention into auto insurance would improve consumer welfare. But government regulation of prices and profit rates can hardly be a step forward for consumers. Indeed, rate-of-return regulation is an attempt to restore the economic past in insurance.
A genuinely open market, where firms are free to be rivalrous and cooperative, is the economic wave of the future. In insurance, this means that markets must be opened to non-insurance companies (Proposition 103 does allow banks to sell insurance); that firms must be free to share risk and loss experience data (their antitrust exemption should be retained); and that companies must be free to price their policies and earn any return based on their relative efficiency. In short, all state regulation of insurance products and services should be curtailed.
The crisis in auto insurance is due to inappropriate regulation (Massachusetts is an even better example than California) and uncertain and wildly irrational tort law decisions. State governments would do well to fix their tort law crises and leave the insurance industry alone.