The Effect of Rate Regulation on Price and Competition Sharon Tennyson Department of Policy Analysis and Management Cornell University [email protected].

The Effect of Rate Regulation on Price and Competition

Sharon TennysonDepartment of Policy Analysis and ManagementCornell [email protected]

Richard A. DerrigOpal Consulting, [email protected]

CANE Meeting, Sturbridge, MA

September 18, 2007

Impact of Rate RegulationAGENDA

Regulation and Competition – The Rationale and the Reality

A Little Theory and Practice

Auto Insurance: Brookings/AEI Case Studies

The Case of Massachusetts

Implications for California

Why (now) Do States Regulate P-C Insurance Rates? Automobile insurance

Homeowners insurance

Workers compensation insurance

Medical malpractice insurance

Mandatory or socially desirable insurance

Uninsured parties shift financial risk to others in society

Some consumers face high prices

Some markets experience price shocks

Rate Regulation as Redistribution Not equally practiced in all regulated states or

lines Some regulated states lightly regulate voluntary

market rates Residual market rates are regulated in all states and

lines

Implications of redistributionPrice subsidies for some consumers

To high risk consumers From low risk consumers To high risk consumers From insurance company capital To all consumers From insurance company capital

Efficient Redistribution?

Not Likely: Not Sustainable

The Problem: Competitive Market Forces

Attempts to move prices a significant distance from competitively-determined prices will distort market functioning Company responses to regulation Consumer responses to regulation Regulator responses to the responses

Efficiency Consequences: Supply Rate suppression distorts insurance supply

Decreased writing of voluntary coverage Reduced innovation and quality of service Reduced entry of firms Increased exit of firms

Rate uncertainty distorts insurance supply All of the above effects Price stickiness and market volatility

Efficiency Consequences: Demand Rate subsidies distort consumer behavior: Insurance demand

Increased demand from high risk consumers Decreased demand from low risk consumers May cause low risk consumers to forego insurance

Safety incentives Prices are less responsive to changes in losses/risk

Claiming incentives Prices are less responsive to changes in losses/risk

Implications

Stringent regulation of insurance rates produces unintended effects: Reduced competition Higher cost inflation Lower insurance availability Greater market volatility

Regulated outcomes may even be contrary to the regulatory objectives pursued

What is the Empirical Record? On average and over the long run, rate

regulation has little effect on average loss ratios (Harrington, 2002) Not necessary for market functioning Creates uncertainty and costly compliance

In states and markets where rate regulation is stringently applied, empirical studies find effects supportive of theory

In states and markets where stringent rate regulation is dismantled, empirical studies find effects supportive of theory

Evidence from Massachusetts State regulation of private passenger auto

insurance rates has created widely-recognized market problems Exit of insurance providers, especially national firms Small number of suppliers Larger than normal residual market Cost inefficiencies Politicized ratemaking environment

Less recognized problem: In the aggregate, regulation drives overall claims costs higher

Table 1

Major Regulatory Changes, 1970-2000

Massachusetts Private Passenger Automobile Insurance

Year Regulation

1971 Nofault auto insurance effective

1975 State rate-setting extended to all auto coverages

1977 Competitive rate-setting allowed

1978 State rate-setting reinstituted

1989 Automobile Insurance Reform Law effective

1991 Insurance Fraud Bureau began operation

1996 Competitive Discounts and Deviations begin at -7.4%

2006 Competitive Discounts and Deviations stabilize at -1.7%

2007 Competitive rate-setting allowed 4/1/08

Table 2

Direction of Subsidies by Driver Class and Territory Compulsory Insurance Coverage 2004

Experienced Classes

Inexperienced Classes Business Classes

Non-Boston Territories

Average Premium $527.15 $1,220.54 $500.67

Average Subsidy -$26.00 $138.29 -$46.43

Cells Subsidized (%) 12.50% 42.71% 6.25%

Boston Territories

Average Premium $813.33 $1,434.04 $751.98

Average Subsidy $253.77 $520.09 $32.30

Cells Subsidized (%) 64.65% 72.73% 36.36%

Source: Authors calculations using data from Actuarial Notice 04-1, Automobile Insurers Bureau of Massachusetts, 2004. Compulsory coverages are Bodily Injury Liability (20/40), Personal Injury Protection (8,000), Property Damage Liability (5,000) and Uninsured Motorist (20/40)

Table 3

Massachusetts Private Passenger Automobile

Historical Summary of Industry Discounts/Deviations

Year Average Discount  Annual Change in

Discount

1996 -7.4%

1997 -9.2% -1.8%

1998 -9.2% +0.0%

1999 -6.5% +2.7%

2000 -5.5% +1.0%

2001 -3.0% +2.5%

2002 -2.2% +0.8%

2003 -1.9% +0.3%

2004 -1.7% +0.2%

2005 -1.8% -0.1%

2006 -1.7% +0.1%

2007 -1.7% est'd +0.0%

Source: Automobile Insurers Bureau of Massachusetts

Impact of Rate Regulation on Claims: First Cut: State-level data on average

loss costs50 states1972-1998 (before and after

Massachusetts effective subsidies)

Hypothesis: Massachusetts’ loss costs will be higher than otherwise predicted during period of stringent regulation

Impact of Rate Regulation on Claims Second cut: Massachusetts town-level

data on loss cost levels for 5 coverages360 townsBiennial data 1999-2007

Hypothesis: Loss cost growth higher in subsidized towns than in other towns

Figure 1: Average Annual Loss Costs per Insured CarMassachusetts vs National Average

0

100

200

300

400

500

600

72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98

Year

(Lo

sses

In

curr

ed/W

ritt

en C

ar

Yea

rs)

National Average

Massachusetts

State Data

Impact of Rate RegulationState by State Estimation

DATA: 1972- 1998 NAIC Coverage Variations Demographics Regulation METHOD: Panel Data Regression Models Ln(Liab. Loss / W Car Years)

State Regression EstimatesLst = ß0 + ß1CSYearst + ß2MAsCSYearst + γ’Xst + ß4StateRegsst + ß5StateRegsstCSYearst + as + Tt

+ εst

CSYears = 1978-1998 or 1978-1995Test ß2 > 0Control variables = traffic density, cost of hospital

stay, per capita income, rate regulation, nofault, PIP limits, compulsory insurance minimums

as and Tt are state and year fixed-effectsAdjust S.E. for arbitrary heteroskedasticity and for

arbitrary correlation within state

State Estimation ResultsExplanatory Variable CSYears 78-98 CSYears 78-95  

MA x CS Years 0.3781 *** 0.3663 ***

0.1543 0.1101

CS Years Dummy -0.0807 *** 0.0523 ***

0.0291 0.0181

Reg x CS Years 0.1097 *** 0.0418

0.0338 0.0260

Nofault x CS Years 0.0114 0.0046

0.0316 0.0245

R-squared 0.8742 0.8769

N 1334   1334  

State Regression EstimatesLst = ß0 + ß1CSYearst + γ’Xst + ß4StateRegsst + ß5StateRegsstCSYearst + as + Tt + εst

Estimate identical model specification without MA data or MA interaction term

Apply estimated coefficient vector to Massachusetts variable values, 1972-1998

Obtain predicted value of Massachusetts loss costs for each year

Compare Actual – Predicted value

Actual Losses Incurred vs Predicted Losses from Regression Model: Massachusetts 1972-1998

-150

-100

-50

0

50

100

150

72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98

Year

Pre

dict

ion

diff

eren

ce

Actual Loss - Predicted Loss

Actual – Predicted Losses

Impact of Rate Regulation on Claims:Second Cut Panel of Massachusetts town-level data on

loss cost indices for 5 coverages from AIB 360 towns Biennial data 1999-2007 Pure premium index Average class rating factor

Hypothesis: Indices will grow faster in subsidized towns than in other towns

Figure 2: BIL Pure Premium Index GrowthSubsidized vs Unsubsidized Towns

(1999=1)

0.88

0.9

0.92

0.94

0.96

0.98

1

1.02

1.04

1.06

1999 2001 2003 2005 2007

Rating Year

Ind

ex

Unsubsidized Towns

Subsidized Towns

Source: Automobile Insurers Bureau Filings on Territories and Actuarial Notices on Subsidies

Town Data - BIL

Impact of Rate RegulationTown Level Estimation DATA: 5 coverage Town DataAIB Territory FilingsRate Subsidies All YearsTown Index – Bayesian Estimate/Class Normalized (ACRF)

METHOD: Regression Models on Town Relativity Growth

Town Regression Estimates %ΔPPit = ß0 + ß1Subsidyit-τ + ß2PPit +

ß3%ΔACRFit + ß4%ΔExposuresit + ß5%ΔDensityit + ß6Bostoni + Tt + εit

Use subsidy from year in which losses were generated

Test ß1 > 0

Adjust S.E. for arbitrary heteroskedasticity and for arbitrary correlation within state

Pure Premium Growth Estimates  BIL   PIP   PDL   COL   COM  

Lag subsidy indicator

0.0717 ***

0.0566 ***

0.0112 **

0.0277 ***

0.0206 ***

0.0220 0.0184 0.0061 0.0088 0.0134

Lag pure premium

-0.059

8 ***

-0.0105

-0.003

5

-0.028

4 ***

-0.061

6 ***

0.0192 0.0076 0.0083 0.0101 0.0114

R-squared0.039

60.07

940.062

50.070

10.084

1

F-statistic 2.95 ***

19.22 *** 7.54 *** 7.51 *** 8.90 ***

N 1439   1439   1439   1439   1439  

Standard errors appear below the coefficient estimates, and are adjusted to allow for arbitrary heteroskedasticity and for arbitrary correlation in errors across years within each town. *** indicates statistically significant at the 1% confidence level *

Impact of Rate RegulationCalifornia Auto Territories

PROP 103 (1989) Driving History Emphasized for Relative Pricing; Mandatory and Optional Classes

April 2006 Change: Territory must be less “important” than Mandatory Prop 103 Factors: Annual Mileage, Driving Safety Record, Years Licensed

Effect yet to be seen but moves away from cost-based must introduce Mass-like subsides varying by insurer

Rural to Urban, High Income to Lower Income,

High Cost to Low Cost

Impact of Rate RegulationCalifornia Auto Territories

April 2006 Change: Optional Territory Frequency and Territory Severity (and 14 others) must each be forced to be less “important” (less relativity weight) than Mandatory Prop 103 Factors: Annual Mileage, Driving Record, Years Licensed

DOI Study Showed 3 Scenarios that implied:

Increases for 53 of 58 Counties (High +37%,Low 1.3%)

Decreases for 5 of 58 Counties (High -0.5%,Low -12%)

LA Zips (High – 6%, Low -11%),

Beverly Hills Zips (High -10%, Low -23%)

Corr Prem to LossPP, (Current 0.75, New 0.725 to 0.62)

Papers R.A. Derrig and S. Tennyson (2007), The

Impact of Rate Regulation on Claims: Evidence from Massachusetts Automobile Insurance, www.aria.org/meetings/ARIA_2007_Program.pdf

Concurrent session VD #3

S. Tennyson (2007), Efficiency Consequences of Rate Regulation in Insurance Markets, Networks Financial Institute Policy Brief, www.networksfinancialinstitute.org

References (Excerpt)Automobile Insurers Bureau of Massachusetts, Actuarial Notice -2: Subsidies in the

Rates, Boston, MA: AIB. Various years.Automobile Insurers Bureau of Massachusetts, 2006, AIB Recommendations for 2007

Private Passenger Automobile Insurance Territory Definiitons, MA DOI Docket R2006-03, May 15.

Blackmon, B.G. Jr. and R. Zeckhauser, 1991, Mispriced Equity: Regulated Rates for Auto Insurance in Massachusetts, American Economic Review, 81: 65-69.

Burnes, N.S., 2007, Opinion, Findings, and Decision on the Operation of Competition in Private Passenger Motor Vehicle Insurance in 2008, Massachusetts Division of Insurance Docket No. R2007-03, July 16.

Conger, R.F., 1988, The Construction of Automobile Rating Territories in Massachusetts, Proceedings of the Casualty Actuarial Society, 71: Part 1, 1-74.

Derrig, R.A.,1993, Price Regulation in US Automobile Insurance: A Case Study of Massachusetts Private Passenger Automobile Insurance 1978-1990, The Geneva Papers on Risk and Insurance, 18: 158-173.

Derrig, R.A., and Hilary N. Rowan, 2006, Written testimony of The California Farm Bureau, California Department of Insurance, Proposed Amendment of Title 10 of California Code of Regulations, Section 2632.8 – Optional Auto Insurance Rating Factors, CDI File #RH 03029820.

DuMouchel, W.H., 1983, The Massachusetts Automobile Insurance Classification Scheme, The Statistician, 32: 69-81.

Rottenberg, S., 1989, The Cost of Regulated Pricing: a Critical Analysis of Auto Insurance Premium Rate-Setting in Massachusetts, Boston: Pioneer Institute for Public Policy Research.

Tennyson, S., 1997, The Impact of Rate Regulation on State Automobile Insurance Markets, Journal of Insurance Regulation 15: 502‑523.