1. The Effect of Rate Regulation on Price and Competition Sharon Tennyson Department of Policy Analysis and Management Cornell University st96@cornell.edu st96@cornell.edu Richard A. Derrig Opal Consulting, LLC Richard@derrig.com CANE Meeting, Sturbridge, MA September 18, 2007

2. Impact of Rate Regulation AGENDA 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

3. 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

4. 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 redistribution Price 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. Table 1 Major Regulatory Changes, 1970-2000 Massachusetts Private Passenger Automobile Insurance YearRegulation 1971Nofault auto insurance effective 1975State rate-setting extended to all auto coverages 1977Competitive rate-setting allowed 1978State rate-setting reinstituted 1989Automobile Insurance Reform Law effective 1991Insurance Fraud Bureau began operation 1996Competitive Discounts and Deviations begin at -7.4% 2006Competitive Discounts and Deviations stabilize at -1.7% 2007Competitive rate-setting allowed 4/1/08

12. Table 2 Direction of Subsidies by Driver Class and Territory Compulsory Insurance Coverage 2004 Experienced Classes Inexperienced ClassesBusiness 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)

13. Table 3 Massachusetts Private Passenger Automobile Historical Summary of Industry Discounts/Deviations YearAverage 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

14. Impact of Rate Regulation on Claims: First Cut: State-level data on average loss costs  50 states  1972-1998 (before and after Massachusetts effective subsidies) Hypothesis: Massachusetts’ loss costs will be higher than otherwise predicted during period of stringent regulation

15. Impact of Rate Regulation on Claims Second cut: Massachusetts town-level data on loss cost levels for 5 coverages  360 towns  Biennial data 1999-2007 Hypothesis: Loss cost growth higher in subsidized towns than in other towns

16. State Data

17. Impact of Rate Regulation State by State Estimation DATA: 1972- 1998 NAIC Coverage Variations Demographics Regulation METHOD: Panel Data Regression Models Ln(Liab. Loss / W Car Years)

18. State Regression Estimates L st = ß 0 + ß 1 CSYears t + ß 2 MA s CSYears t + γ ’X st + ß 4 StateRegs st + ß 5 StateRegs st CSYears t + a s + T t + ε st CSYears = 1978-1998 or 1978-1995 Test ß 2 > 0 Control variables = traffic density, cost of hospital stay, per capita income, rate regulation, nofault, PIP limits, compulsory insurance minimums a s and T t are state and year fixed-effects Adjust S.E. for arbitrary heteroskedasticity and for arbitrary correlation within state

19. State Estimation Results Explanatory VariableCSYears 78-98 CSYears 78-95 MA x CS Years0.3781***0.3663*** 0.15430.1101 CS Years Dummy-0.0807***0.0523*** 0.02910.0181 Reg x CS Years0.1097***0.0418 0.03380.0260 Nofault x CS Years0.01140.0046 0.03160.0245 R-squared0.87420.8769 N1334

20. State Regression Estimates L st = ß 0 + ß 1 CSYears t + γ ’X st + ß 4 StateRegs st + ß 5 StateRegs st CSYears t + a s + T t + ε st 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

21. Actual – Predicted Losses

22. 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

23. Town Data - BIL

24. Town Data - PDL

25. Impact of Rate Regulation Town Level Estimation DATA: 5 coverage Town Data AIB Territory Filings Rate Subsidies All Years Town Index – Bayesian Estimate/ Class Normalized (ACRF) METHOD: Regression Models on Town Relativity Growth

26. Town Regression Estimates % Δ PP it = ß 0 + ß 1 Subsidy it- τ + ß 2 PP it + ß 3 % Δ ACRF it + ß 4 % Δ Exposures it + ß 5 % Δ Density it + ß 6 Boston i + T t + ε it Use subsidy from year in which losses were generated Test ß 1 > 0 Adjust S.E. for arbitrary heteroskedasticity and for arbitrary correlation within state

27. Pure Premium Growth Estimates BIL PIP PDL COL COM Lag subsidy indicator0.0717 *** 0.0566 *** 0.0112 ** 0.0277 *** 0.0206 *** 0.02200.01840.00610.00880.0134 Lag pure premium-0.0598 *** -0.0105-0.0035 -0.0284 *** -0.0616 *** 0.01920.00760.00830.01010.0114 R-squared0.03960.07940.06250.07010.0841 F-statistic2.95 *** 19.22 *** 7.54 *** 7.51 *** 8.90 *** N1439 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 *

28. Impact of Rate Regulation California 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

29. Impact of Rate Regulation California 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)

30. 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 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

31. 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.

32. Table 4 Summary Statistics Annual State-Level Data, 50 States 1972-1998 All StatesMassachusetts VariableMeanS.D.MeanS.D. Losses per Insured Car176.732111.304251.064132.407 Traffic Density0.530.401.210.21 Average Cost of Hospitalization492.72326.45618.04387.05 Per Capita Income13685.766815.4116728.448866.31 Rate Regulation Dummy0.600.491.000.00 Nofault Dummy0.2700.4441.0000.000 Addon Dummy0.190.390.00 Person Minimum Limit (000)18.436.8012.594.25 Property Minimum Limit (000)9.565.195.000.00 PIP Coverage Limit13077.7445667.224000.002882.31 Addon Coverage Limit802.962565.850.00

33. Table 7 Summary Statistics Annual Town-Level Data, Massachusetts 2001-2007 Territory Years VariableNMeanS.D. Pct change BIL PP Index14390.00060.1588 Pct change PIP PP Index1439-0.01910.1351 Pct change PDL PP Index1440-0.00480.0524 Pct change COLL PP Index1439-0.00560.0635 Pct change COMP PP Index14400.02100.0963 Lag BIL PP Index14400.74760.4503 Lag PIP PP Index14400.72030.5688 Lag PDL PP Index14400.84040.2344 Lag COLL PP Index14400.87770.2644 Lag COMP PP Index14400.85160.3896 Pct change BIL AC Index1440-0.00360.0175 Pct change PIP AC Index1440-0.00480.0196 Pct change PDL AC Index1440-0.00200.0130 Pct change COLL AC Index1440-0.00180.0177 Pct change COMP AC Index1440-0.00110.0153 Lag BIL AC Index14400.99510.0386 Lag PIP AC Index14400.98890.0463 Lag PDL AC Index14401.00000.0266 Lag COLL AC Index14400.99820.0336 Lag COMP AC Index14400.99740.0452 Subsidy Indicator (lagged)14390.07870.2694 Traffic Density144097.3263.63 Pct change Exposures14400.03990.0348