0 Underwriting Strategy and Underwriting Cycle in the Medical Malpractice Insurance Industry Yu Lei Barney School of Business University of Hartford 200 Bloomfield Ave. West Hartford, CT Phone: 860-768-4682 Email: [email protected]Mark J. Browne 975 University Avenue Madison, WI 53706-1323 Phone: (608) 263-3030 Fax: (608) 265-4195 Email: [email protected]July 2012 To be Presented at the 2012 American Risk and Insurance Association Meeting Preliminary draft. Please do not quote without permission.
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Underwriting Strategy and Underwriting Cycle in the Medical Malpractice
Insurance Industry
Yu Lei Barney School of Business
University of Hartford 200 Bloomfield Ave. West Hartford, CT
Underwriting Strategy and Underwriting Cycle in the Medical Malpractice Insurance Industry
ABSTRACT
Even though underwriting cycles have been extensively studied, one area seems to receive little
attention. This article fills the gap by examining whether medical malpractice insurers’ underwriting strategy
exhibits any cyclical behavior. Our analysis of the NAIC data indicates that some aspects of malpractice
carriers’ underwriting strategy do show certain degrees of cyclical nature and they display trend that seem to be
opposite that of the combined loss ratio in medical malpractice insurance, which we use in this study as a
measure of the underwriting cycle. We find that when insurers’ underwriting performance worsens, there are
fewer insurers offering medical malpractice, there are more exits than entries, insurers are less geographically
concentrated in selling malpractice, and the significance of malpractice in terms of this line’s premium share
declines. Moreover, when we look at which states in which malpractice carriers do business, we see that the
percentage of safer states (states that have caps on general damages or patient compensation funds) in which
insurers write malpractice and the percentage of insurers that choose to do business only in safer states are both
negatively associated with the combined loss ratio of the medical malpractice insurance industry. Taken all
together, it seems that at the industry level, insurers’ underwriting performance has a negative association with
their risk taking behavior in terms of how much to focus on malpractice line of business and where to write such
business. Less focus on malpractice and wider distribution of malpractice products are seen to accompany
worsened underwriting performance.
We also test whether the capacity constraint theory can help explain the cyclical nature of medical
malpractice insurers’ underwriting strategy. We find that when the total surplus of all single-line insurers (those
only selling medical malpractice) shrinks, insurers are less likely to go single-line. We observe the same trend
when we examine single-state insurers (those selling medical malpractice in just one state) and ONLY-CAP-
State insurers (those selling medical malpractice only in states with caps on general damages). In other words,
our results provide some support for the capacity constraint theory which predicts an inadequate capacity will
shrink insurance supply.
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INTRODUCTION
It is well recognized that many property/liability insurance markets exhibit cyclical nature. Soft market
periods, where prices are low and coverage is abundant, are followed by hard markets, where prices are high
and coverage is scarce. Medical malpractice insurance, which provides coverage against professional liability
for health-care providers, is a great example of the recurring soft and hard markets. Over the past several
decades medical malpractice insurance has experienced periodic performance “crises” evidenced by rising
premiums and decreasing supply of malpractice carriers.
Even though underwriting cycles have been extensively studied, previous literature usually focuses on
the cyclical behavior of prices, premium growth, underwriting performance (loss ratios or combined loss ratios)
or insurance availability. On the other hand, most research on medical malpractice insurance crisis concentrates
on the causes of price volatility during hard markets.
This paper intends to examine one little-studied area of the medical malpractice insurance market. We
will examine malpractice insurers’ underwriting strategy during the underwriting cycle and see if it exhibits any
cyclical behavior. If so, we want to see whether the capacity constraint theory can help explain such
phenomenon.
This paper makes contribution to both the underwriting cycle study and the medical malpractice
insurance literature by focusing on various aspects of insurers’ underwriting strategy. When the insurance
industry swings from soft (or hard) to hard (or soft) markets, it is natural for insurers to re-evaluate and adjust
their underwriting strategy to gain a competitive hold. It is likely the underwriting cycle causes changes in
underwriting strategy, but it is also plausible for the modified underwriting strategy to have an impact on the
depth and length of the underwriting cycle. It is not this paper’s intention to discuss how the two-way feedback
works. We’ll instead try to identify if there is any cyclical pattern in insurers’ underwriting strategy during the
medical malpractice insurance cycle, which we will measure using the malpractice industry’s combined loss
ratios.
Insurers’ underwriting strategy could encompass many aspects. For instance, in response to medical
malpractice crises, do insurers establish tighter claims frequency and severity standards for potential insured
health care providers? Do they increase deductible amount and/or decrease the policy limit they’re willing to
insure? Do they choose to exclude certain high-risk specialties to cover? Ideally, we’d like to explore how
insurers adjust their underwriting strategy in reality. Unfortunately, we do not have such information available.
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Instead, we’ll utilize the National Association of Insurance Commissioners (NAIC) database and focus on the
following things which we call underwriting strategy in our paper.
First, do insurers choose to enter or exit the medical malpractice market? Lei and Browne (2008) study
malpractice insurers’ entry and exit during the period of 1994-2006 and find that exits are less frequent in states
where there are caps on general (noneconomic) damages. We extend their study by looking at how insurers
move in and out of the market in accordance with the underwriting cycle.
Second, when insurers do choose to enter the malpractice market, how much do they want to focus on
the malpractice line of business? Do they want to devote the entire business to malpractice or do they also write
other lines of business? In other words, we want to examine how the significance of medical malpractice (which
will be measured by malpractice line’s premium share) changes in accordance with the underwriting cycle.
Third, where do insurers sell medical malpractice? Do they write malpractice in just one state or
multiple states? When they go multi-state, how do they allocate malpractice premiums across states?
Fourth, do insurers choose to sell malpractice in safer states? In response to malpractice crises, many
states enacted tort reforms (such as caps on awards for non-economic damages) and/or created alternative
mechanisms (such as joint underwriting associations and patients’ compensation funds that provide coverage
for substandard risks or limit an insurer’s loss exposure on catastrophic claims). These efforts are intended to
reduce the claims cost as well as the uncertainty associated with them. In this paper, we call states with either
caps on general damages or patient compensation funds “safer states.” Viscusi and Born (2005) find that many
tort reforms help reduce losses, lower premiums, and enhance insurer profitability, with limits on noneconomic
damages being the most influential in affecting insurance market outcomes.
Lastly, do insurers choose to insure more physicians or hospitals? Or do they choose to specialize in
covering just one type of health care providers since different policyholders have different risk implications?
It is not hard to imagine that these various aspects of insurers’ underwriting strategy, namely, entry and
exit, geographic concentration of malpractice business, significance of malpractice line of business, distribution
of malpractice business between safer states and less safe states (those without tort reform measures in place),
and choice of prospective policyholders to cover, will have different implications on firms’ performance.
Different strategies may have their own comparative advantages and will likely affect insurers differently.1
1 There is not much study on the underwriting strategy mentioned here yet. The few available studies on geographic diversification and product diversification produce mixed results. Liebenberg and Sommer (2008) find that single-line property-liability insurers consistently outperform multiline insurers. Elango et al. (2008) discover that performance advantages associated with product diversification are contingent upon an insurer’s degree of geographic diversification. Their results indicate that a highly diversified product profile with low geographic diversification is associated with the highest performance. Insurers that have relatively low
We
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do not intend to evaluate the effectiveness of insurers’ underwriting strategy in this paper, but rather we will
show how they change in the underwriting cycle.
In the next section, we discuss our data and definitions of medical malpractice insurers. We generate two
samples for our empirical study and we offer a brief overview of the samples in the same section. In the next
five sections that follow, we show how the above-mentioned five aspects of insurers’ underwriting strategy,
namely, entry and exit, geographic concentration, significance of malpractice line of business, distribution of
malpractice business between safer states and less safe states, and choice of prospective policyholders to cover,
evolve as the underwriting cycle unfolds. We then test the capacity constraint theory in the subsequent section.
In the last section, we summarize our findings and conclude the paper.
DATA AND DEFINITION OF MEDICAL MALPRACTICE INSURERS
We utilize the 1992-2010 NAIC property/casualty data to conduct our research. Since our focus is the
underwriting strategy of medical malpractice insurers, we need to define such carriers in the first place. A
natural response is to include all insurers that report positive direct premiums written in medical malpractice.
We call the resulting sample “Large Sample.” This sample includes all possible medical malpractice insurers,
yet some of them report to the NAIC even after they have stopped selling new policies. They continue to report
positive premiums from existing relationships, but are not truly active in the market. To account for this issue,
we also follow Nordman, Cermak and McDaniel (2004) and define a medical malpractice insurer as one that
wrote at least 2 percent of the medical malpractice premium in at least one state in that year. We call the
resulting sample “Small Sample.”
Since we need to examine insurers’ geographic concentration, we make use of the state-level financial
information in the NAIC database. The major financial statement we rely on is “Exhibit of Premiums and
Losses” in different states, which we refer to as the “Stage Page” throughout the paper. The Stage Page provides
information on premiums written/earned, losses incurred/unpaid/paid and loss adjustment and other expenses by
line of business for each firm in all 50 states and Washington D.C. each year. With such information, we can
analyze the underwriting performance of medical malpractice insurers both at the state-level and at the country-
level.
product and geography diversification have medium level performance. Lei and Schmit (2008) find no significant impact of geographic diversification on firm performance of malpractice insurers, but show that more product diversification is associated with stronger firm performance.
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Using our two definitions of medical malpractice insurers and the Stage Page, we generate our Large
Sample and Small Sample. Table 1 provides a snapshot of the two samples. Table 1: Comparison of Large Sample and Small Sample
As we can see from both samples, the majority of premiums are written to cover physicians, followed by
hospitals. Over the years, there is some fluctuation in physicians’ premium share, though hospitals’ premium
3 Note the total numbers somehow differ from our earlier analysis based on the State Page. The reason is that not every firm provides information on both the State Page and the Supplement “A” page.
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share remains relatively stable. Also hospitals tend to have higher loss ratios which explain why insurers cover
less of them. As a matter of fact, many hospitals formed self-insured entities and do not report to NAIC.
Since there are no earlier years of premiums/losses breakdown by types of health care providers, we do
not observe significant trend during the years 2001-2010 by examining providers’ premium share and loss ratios.
We next turn to specialists that cover only one type of health care providers. Table 12 shows the percentage of
such specialist-insurers as well as their premium shares. We graph the same information in Figure 20.
Table 12: Analysis of Specialists Covering Only One Type of Health Care Providers
Year
Large Sample Small Sample % of Number of Firms
Covering Only Premium Share of Firms
Covering Only % of Number of Firms
Covering Only Premium Share of Firms
Covering Only HS PH OP OF S HS PH OP OF S HS PH OP OF S HS PH OP OF S
Note: total surplus refers to the total surplus of all single-line insurers (or single-state insurers, etc.) each year. Similarly, overall loss ratio is that for all single-line insurers (or single-state insurers, etc.) Source: authors’ analysis of NAIC data.
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In the large sample, we also find that overall loss ratio of single-line insurers has a negative impact on
firms’ decision to go single-line. In other words, if loss ratios for single-line insurers go up, insurers are less
likely to just sell medical malpractice. This makes sense since insurers tend to move away from less profitable
business. In our small sample, we find that firm-specific loss ratios play a more significant role in determining
insurers’ likelihood of becoming single-state or only_CAP_state firms.
Table 14: Logistic Regression: Y=Specialist, Probability modeled is Y=1
Variables Large Sample N=2424 Small Sample N=947
Estimate ProbChiSq Estimate ProbChiSq Intercept 0.6348 0.0849 -0.3988 0.2755 Lagged Total Surplus <0.0001 0.4920 <0.0001 0.9275 Lagged Overall Loss Ratio -1.3382 0.0003 -0.9989 0.0218 Lagged Firm-specific Loss Ratio -0.0002 0.4237 0.0244 0.8551 -2 Log L 3299.446 1122.922 Note: total surplus refers to the total surplus of all specialist insurers each year. Similarly, overall loss ratio is that for all specialist insurers Source: authors’ analysis of NAIC data.
With regard to our last dependent variable “Specialist,” since the data is drawn from Supplement A, our
large sample has 2424 observations and small sample has 947 observations. Again here the surplus is the total
surplus of all specialist insurers. In both samples, we find no evidence that surplus has a significant impact on
insurers’ decision to be a specialist. This is not too surprising given the data is only available since 2001 and
there is no significant cyclical market swing since then. Yet we do find that overall loss ratio negatively affect
insurers’ decision to cover just one type of health care providers, which is consitent with our observation earlier
on.
Conclusion
This article examines the underwriting strategy movement during the medical malpractice underwriting
cycle. Even though underwriting cycles have been extensively studied, one area seems to receive little attention.
This article fills the gap by examining whether medical malpractice insurers’ underwriting strategy exhibits any
cyclical behavior. Our analysis of the NAIC data indicates that some aspects of malpractice carriers’
underwriting strategy do show certain degrees of cyclical nature and they display trend that seem to be opposite
that of the combined loss ratio in medical malpractice insurance, which we use in this study as a measure of the
underwriting cycle. We find that when insurers’ underwriting performance worsens, there are fewer insurers
offering medical malpractice, there are more exits than entries, insurers are less geographically concentrated in
selling malpractice, and the significance of malpractice in terms of this line’s premium share declines.
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Moreover, when we look at which states in which malpractice carriers do business, we see that the percentage
of safer states (states that have caps on general damages or patient compensation funds) in which insurers write
malpractice and the percentage of insurers that choose to do business only in safer states are both negatively
associated with the combined loss ratio of the medical malpractice insurance industry. Taken all together, it
seems that at the industry level, insurers’ underwriting performance has a negative association with their risk
taking behavior in terms of how much to focus on malpractice line of business and where to write such business.
Less focus on malpractice and wider distribution of malpractice products are seen to accompany worsened
underwriting performance.
We also test whether the capacity constraint theory can help explain the cyclical nature of medical
malpractice insurers’ underwriting strategy. We find that when the total surplus of all single-line insurers (those
only selling medical malpractice) shrinks, insurers are less likely to go single-line. We observe the same trend
when we examine single-state insurers (those selling medical malpractice in just one state) and ONLY-CAP-
State insurers (those selling medical malpractice only in states with caps on general damages). In other words,
our results provide some support for the capacity constraint theory which predicts an inadequate capacity will
shrink insurance supply.
References 1. Elango B, Y Ma, and N Pope, 2008, “An Investigation Into The Diversification-Performance Relationship In The
U.S. Property-Liability Insurance Industry,” Journal of Risk and Insurance, 75 (3): 567-591.
2. Lei, Yu and Mark Browne, Fall 2008, “Medical Malpractice Insurance Market Entry and Exit: 1994-2006,”
Journal of Insurance Regulation, 27 (1), 47-71.
3. Lei, Yu and Joan Schmit, 2010, “Influences of Organizational Structure and Diversification on Medical
Malpractice Insurer Performance,” Journal of Insurance Issues, 33 (2): 152–177.
4. Liebenberg AP and DW Sommer, 2008, “Effects Of Corporate Diversification: Evidence From The Property-
Liability Insurance Industry,” Journal of Risk and Insurance, 75 (4): 893-919.
5. Nordman, E., D. Cermak and K. McDaniel, 2004, Medical Malpractice Insurance Report: A Study of Market
Conditions and Potential Solutions to the Recent Crisis. Kansas City, Mo.: National Association of Insurance
Commissioners.
6. Viscusi, W Kip and Born, Patricia H, 2005, “Damages Caps, Insurability, and the Performance of Medical
Malpractice Insurance,” Journal of Risk and Insurance, 72 (1): 23-43.
7. Weiss, Mary A. and Joon-Hai Chung, 2004, “U.S. Reinsurance Prices, Financial Quality, and Global Capacity,”