Auto Insurance Chaos in California; D. Armentano

93 Auto Insurance Chaos in California by D. T. Armentano I n November 1988,California voters changed the rules of the game in the automobile insur ance industry. In passing Proposition 103, they decided, among other things, to vote them selves a 20 percent reduction in automobile insur ance rates and to remove the insurance industry's antitrust exemption. In May 1989, the California Supreme Court sustained that vote with some im portant 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 mak ing extraordinarily high profits, then prices might be regulated downward. But if, as many of the in surance companies contend, they were experienc ing a loss underwriting auto insurance in Califor nia, then insurance rates might have to be increased to restore a "reasonable" level of prof itability. Indeed, many California auto-insurance carriers already have filed for rate increases con sistent with the state Supreme Court ruling.

The political fight to lower auto rates in Califor nia wasled by prominent consumer advocates who first greeted the Court decision warmly. After all, had they not argued that the unregulated insur ance market was incapable of setting fair and effi cient prices for auto insurance? Government reg ulation 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 Professor Armentano teaches in the Department of Eco nomics at the University of Hartford in Connecticut. allowed the insurance companies opportunities to collude in restraint of trade. Ending the exemp tion, they argued, would end the collusion, in crease competition, and lead to lower insurance prices. Although the consumer advocates got what they wanted from the political process, they al ready are having second thoughts. And well they should. This "new" system of regulation is open to massive abuse by both the regulators and the reg ulated. The central difficultyis 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 appro priate 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 insur ing a motorist, for instance, can be known only at the expiration of the auto-policy period. This un certainty concerning loss costs can be alleviated somewhat by the inter-firm pooling of historical loss experience in an attempt to better predict fu ture costs. But these predictions often go wildly astray in the short run, and they contribute to the cyclicalnature of insurance profitability.

Prior to Proposition 103, the competitive mar ket process determined the ultimate reasonable94 THE FREEMAN • MARCH 1990 ness of insurance rates and profits in California. Insurance firms that met modest capital and sur plus 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 proper ty/casualty business, pricing (and profits) were de termined 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 Cali fornia 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 pro cesswillbe able to work efficiently.To put the mat ter bluntly, how can the regulators rationally de cide which costs and expenses are appropriate and which rates of profit are reasonable?

ConsumersNot WellServed Regulatory history in insurance and other in dustries demonstrates that the regulated firms of ten have the upper hand in this process. For exam ple, 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 oth er hand, if the insurance regulators are "tough" and systematically underestimate costs and ex penses, or decide (as they recently have done in California) to freeze auto rates while they deliber ate questions of "unreasonableness," then the in surance 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 Califor nia 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 shar ing 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 inter vention into auto insurance would improve con sumer 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 insur ance. 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 compa nies (Proposition 103does allowbanks to sellinsur ance); 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, allstate regulation of insurance products and services should be cur tailed.

The crisisin auto insurance is due to inappropri ate regulation (Massachusetts is an even better ex ample than California) and uncertain and wildlyir rational tort law decisions. State governments would do well to fix their tort law crises and leave the insurance industry alone. D 95 Friendly Societies: Voluntary Social Security And More by John Chodes I n his retirement speech as Speaker of the . House, Tip O'Neill contrasted the world of small government in the 1930s, when he entered politics, with today's big government emphasis on social services, which he helped cre ate: "Health insurance wasout of the question. For the elderly,life was filled with uncertainty, depen dency and horror. Only the lucky few had pen sions.There was no such thing as social security."1 O'Neill waswrong. Workingclassfamilieshad a "safety net" long before Uncle Sam became involved.Our grandparents and even great-grand parents had benefit plans that protected them when they were sick, injured, out of work, or too old to work. Millions of workers belonged to "friendly societies."