Insurance Reform in the State of Texas

Starting today, the state of Texas will be taking a sorely needed step in the direction of more competitive insurance markets by reforming insurance regulation. The specific reform involves the adoption of an alternative rate regulation protocol known as “File and Use” in place of “Prior Approval”. Under Prior Approval, insurers must submit information concerning the rates they wish to charge to the state insurance regulator and get these rates formally approved prior to their use. While the File and Use protocol requires that rate information be submitted to the state insurance regulator, the submitted rates do not require formal regulatory approval.[1]

As an applied economist, I candidly find the notion that insurance rates ought to be regulated by regulatory fiat rather than competitive markets to be somewhat peculiar. In the economics literature, typical arguments for regulation of prices rely upon the existence of monopoly or some form of market failure. In the case of the insurance business, neither argument is particularly compelling. If anything, a more compelling argument is that society is better served by relying upon competitive markets rather than regulatory fiat. Anyway, in what follows, I will sketch some of the public policy issues that are at play in this particular insurance reform.

1. Theory of price regulation[2]

According to George Stigler, public price control has two aspects:

1. Correction of monopolistic pricing (e.g., most public-utility regulation in the United States).

  • By granting firms monopoly licenses in various local domiciles, policymakers are hoping to take advantage of economies of scale in production. If there are scale economies, monopolists will face significantly lower costs of production on a per unit basis than will firms competing with each other in a competitive market environment.
  • This is a “have your cake and eat it too” strategy. Without price regulation, the benefits of these scale economies would naturally accrue to the owners of such firms. However, price regulation is imposed so that benefits accrue instead to consumers in the form of lower prices.
    • Ideally, the objective is to regulate rates so that the firm still earns a “fair” return while providing the scale economies which lead to lower consumer prices.
    • The “fair” return standard was set by a U.S. Supreme Court case which was argued in 1943 and decided in 1944 (Federal Power Commission et al. v. Hope Natural Gas Co.).
    • By providing a “fair” return, the government does not violate the “Takings” clause of the U.S. Constitution (the last clause of the 5th amendment, which reads, “nor shall private property be taken for public use, without just compensation”).

2. Provide private benefits at public expense to special interest groups.

  • Prices of farm products are regulated (raised) in most nations with the intention of improving farmers’ incomes.
  • Prior to the deregulation of the banking industry more than twenty years ago, the fixing of interest rates paid by banks was undertaken to improve bank earnings.
  • Such policies are invariably defended on various economic and ethical grounds but reflect primarily the political strength of large and well organized interest groups.

There are no natural scale economies in the production of insurance services. This is a fact that is well documented by at least two generations of rigorous empirical research. Therefore, it would appear that Stigler”s second rationale better fits the case of insurance. Originally, insurance rate regulations were imposed because there was a stated concern that insurers might be motivated to cut prices to unsustainably low levels as a way to acquire market share. Therefore, it would seem that price regulations were initially intended to benefit producers of insurance services by providing excess rates of return on their investments in the insurance business. The argument here is that such groups were successful in coalescing and bringing political pressure to bear on the regulatory authorities to produce such an outcome. This idea of regulatory “capture” was quite insightful and profound, and it (among other things) helped Stigler win the Nobel Prize in 1991.

In recent years, however, the pendulum has swung in such a way that rate suppression (as opposed to expansion) has become more the rule rather than the exception. The special interests here include regulatory agencies, the plaintiff”s bar, and consumer groups.[3] Economic theory suggests that over time, persistent regulatory suppression of insurance rates will likely cause product quality to deteriorate and limit insurance availability as insurers seek opportunities to exit the market (sound familiar?).

2. Empirical evidence on the effects of rate regulation[4]

Previous studies (using U.S. and Canadian data) have found that rate regulation:

  • reduces competition,
  • reduces availability of coverage, and
  • increases volatility of insurance premiums.

Competition is reduced by prior approval regulation because the ability to compete on price is by definition (arbitrarily) limited by the state. Availability is reduced by prior approval regulation because this form of rate regulation tends toward rate suppression; since one cannot earn a fair return in a rate-suppressed environment, there is little incentive to expand one”s business of writing insurance policies! Finally, increased volatility in insurance premiums likely results from delays in the rate approval process under prior approval rate regulation. Regulatory lags typically produce lower rate increases during periods of rapid cost growth and larger rate increases or a slower rate of reduction in periods of stable or declining claims costs (see Harrington, 2001 AEI-Brookings, available at”id=48).

The state of Illinois is unique because it does not have any formal rate regulation of automobile insurance rates whatsoever. Steve D’Arcy notes that the Illinois auto insurance market is amongst the most competitively structured insurance markets in the U.S. economy.[5] He finds that insurer loss ratios and premiums are less volatile than in regulated markets, and premium levels tend to be lower than in comparable areas. Illinois also boasts the lowest percentage of uninsured drivers, one of the lowest residual market shares, and lowest costs of insurance regulation in the entire U.S. economy.

3. Texas has a longstanding reputation for suppressing auto insurance and workers compensation rates

Although the Kramer study cited below is obviously dated, its findings are qualitatively consistent with Texas”s longstanding reputation of persistent regulatory suppression of insurance rates.

Kramer (1991) Study Rate Suppression States
Private Automobile Insurance Workers’ Compensation Coverage
Delaware Alabama New Hampshire
District of Columbia Arkansas New Mexico
Louisiana Florida North Carolina
Massachusetts Georgia Oregon
Nevada Iowa Pennsylvania
New Hampshire Kansas Rhode Island
New Jersey Kentucky South Carolina
Pennsylvania Louisiana South Dakota
Rhode Island Maine Tennessee
South Carolina Massachusetts Texas
Texas Mississippi Vermont
Missouri Virginia

Source: Kramer, S. Rate Suppression and Its Consequences. New York: Insurance Information Institute Press, 1991.

[1]For a more detailed explanation and analysis of insurance rate regulation, see the recently published Insurance Information Institute white paper entitled Rates and Regulation, available on the web at

[2]This section elaborates primarily upon George Stigler”s excellent essay entitled “Economic Theory: Price”, available online at, and applies his insights to an analysis of the insurance industry in particular.

[3]The cynical view here is that by suppressing rates, regulatory agencies are given more work to do, which enables them to expand their staffing and overall influence. The plaintiff”s bar likes rate suppression because this process renders the insurance ratemaking process into a very opaque and largely unintelligible process which makes it all the more difficult for consumers to discern the relative magnitude of the impact that the U.S. civil justice system has upon insurance rates. The reason why consumers” groups prefer low rates should be apparent, but an often overlooked second order effect derives from that fact that many of these groups are funded primarily by plaintiff”s attorney associations (e.g., Ralph Nader”s Public Citizen group is known to receive as much as 2/3 to 3/4 of its funding from plaintiff”s attorneys).

[4]For more detailed information concerning empirical evidence on the effects of rate regulation, see the recent working paper by Leadbetter, D., J. Voll, and E. Wieder, 2004, The Effects of Rate Regulation on the Volatility of Auto Insurance Prices: Evidence from Canada, presented at the 38th Annual Meeting of the Canadian Economics Association, June 2004, Ryerson University, Toronto, Ontario (available at

[5]See D’Arcy, Stephen P., 2001, “Insurance Price Deregulation: The Illinois Experience”, paper presented at the Brookings Institution Insurance Rate Regulation Conference (January 18, 2001).

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