Competition, Regulation and Insurance

In the current Texas legislative session, Senate Bill 249 and House Bill 1532 would, among other things, eliminate competition as a factor in determining whether medical malpractice insurance rates are excessive (and therefore subject to regulation by the Texas Department of Insurance).  As I have previously noted in “Insurance Reform in the State of Texas“, the notion that insurance rates ought to be regulated by regulatory fiat rather than competitive markets is somewhat peculiar.  In the United States and most other developed economies, insurance regulation typically involves the monitoring of solvency and market conduct, and to a lesser extent, the regulation of insurance rates.  Historically, Texas has been one of the more aggressive regulatory domiciles with respect to rate regulation, so from this perspective it may not come as that much of a surprise that our legislators are currently debating this issue.

In the economics literature, arguments in favor of rate regulation typically rely upon the existence of monopoly or some form of market failure.  Neither argument is particularly compelling in the case of the insurance business.  Indeed, Epstein (1999) notes that the setting in which the case for introducing rate regulation is at its low ebb is in the market for insurance.  Furthermore, there is a substantial literature on the economic consequences of competition and regulation for the performance of insurance markets.  In what follows, I will briefly review some stylized facts concerning the medical malpractice insurance crisis, summarize the theory and empirical evidence concerning the economics of insurance regulation, and finish with some concluding remarks.

The Medical Malpractice Insurance Crisis

It is important to put the recent affordability and availability “crisis” in medical malpractice insurance into a broader perspective; specifically, this crisis was a national as well as local phenomenon.  Premium increases (adjusted for inflation, particularly for internists, general surgeons and OB/GYN’s) have accelerated in recent years, while capacity has diminished (e.g., exit from this market by major firms such as St. Paul Co.).  This most recent crisis followed an unusually long period of flat or modest premium increases and widespread availability, which in turn followed severe crises of insurance affordability in the 1980’s and of affordability and availability in the mid-1970’s.

Responses to this and previous crises in medical malpractice insurance have included various public policy responses, including things like tort law reforms designed to reduce the level and unpredictability of claims; e.g., caps on awards for non-economic damages, formation of alternative markets, and regulatory reforms.   Given the market evidence (e.g., moderating prices, more competition, and greater availability), it would appear that these reforms have worked in the sense that the most recent crisis has clearly abated.

Economics of insurance regulation

The public interest view of regulation is that explicit regulation should be applied only in cases where market conditions deviate significantly from the ideal of a competitive market; i.e., a market that is characterized by the existence of many buyers and sellers, where firms can freely enter and exit.  Even if markets are relatively concentrated, so long as they are contestable, then this notion still applies (e.g., the operating system software market, though dominated by Microsoft, is contestable (e.g., Linux, Mac OS X)).

The public interest perspective has important implications for insurance rate regulation.  Specifically, it implicitly recognizes that rates cannot be excessive if markets are sufficiently competitive or contestable.   In other words, if the market is either competitive or contestable, then this constitutes a sufficient condition for rate fairness.  To claim that rates are excessive when markets are competitively structured represents a reductio ad absurdum argument.

George Stigler’s “capture” theory (i.e., the notion that regulators are at risk of being “captured” by either the industry they regulate or other third parties whose self interests may be at odds with industry) describes well the historical record of insurance regulation.  During the early to mid 20th century, insurance rates were typically regulated out of the stated concern that insurers might be motivated to cut prices to unsustainably low levels as a way to acquire market share.  If this were the case, then such pricing behavior could trigger insurance insolvencies.  The empirical reality, at least during this earlier period of insurance regulation, was that rate regulations were implemented so as to make it possible for insurers to earn excess rates of return by charging excessive rates.  In recent years, however, the pendulum has generally swung more toward rate suppression.  The “special interests” that benefit from rate suppression include regulatory agencies, lawyers, consultants, and consumer groups.

The economic theory and corresponding empirical evidence pertaining to insurance regulation clearly demonstrates that it cannot possibly be in the public interest to eliminate competition as a factor in rate making.  A recently published book entitled “Deregulating Property-Liability Insurance: Restoring Competition and Increasing Market Efficiency” (see AEI-Brookings Joint Center for Regulatory Studies (2002)) notes that property-liability insurance regulation generally makes consumers worse off by limiting availability of coverage, reducing the quality and variety of services available in the market, inhibiting productivity growth, and increasing the volatility of insurance prices paid by consumers.

Concluding Remarks

In a free market economy, capital is allocated to its most highly valued use; therefore, if one state suppresses rates, then companies are free to go elsewhere.  Limiting exit rights (e.g., as has occurred in states such as Massachusetts and New Jersey in response to crises in these states’ auto insurance markets) is both unfair and counterproductive, and measures like these do not make insurance any more affordable or available in the long run.

Once we eliminate the competitive market as a regulator, we must rely upon the insurance regulator to “stand in the gap”.  If the insurance regulator is benevolent and wishes to maximize social welfare, then this individual will recognize that he or she has the very difficult task of mimicking what might otherwise occur in a competitive market environment.  However, the empirical evidence generally suggests that regulators are subject to political pressures from interest groups and therefore are not likely to be benevolent central planners.  Depending upon the political equilibrium that obtains, this may result in excess profits or losses for the regulated industry.  In the current political environment in Texas and many other states, one would expect that this equilibrium will most likely continue to be characterized by the suppression of rates.

In conclusion, removing competition as an objective method for benchmarking whether a rate is fair takes us onto a public policy slippery slope.  The economics of such a position are fundamentally unsound.  Furthermore, this position has virtually no precedent in the theory and practice of insurance regulation, and it unnecessarily subjects policyholders to the risks of “unintended” consequences.  Past experience with insurance regulation suggests that these “unintended” consequences imply that even more availability and affordability problems may be on the horizon.


References

AEI-Brookings Joint Center for Regulatory Studies, 2002, Deregulating Property-Liability Insurance: Restoring Competition and Increasing Market Efficiency, edited by J. D. Cummins, American Enterprise Institute Press.

Epstein, R., 1999, “Exit Rights and Insurance Regulation: From Federalism to Takings”, George Mason Law Review, Vol. 7, No. 2, 293-311.

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