The Impact of Rate Regulation on Claims: Evidence from Massachusetts Automobile Insurance

1. The Impact of Rate Regulation on Claims: Evidence from Massachusetts Automobile Insurance Sharon TennysonDepartment of Policy Analysis and ManagementCornell Universityst96@cornell.edu Richard A. DerrigOpal Consulting, LLCRichard@derrig.com CAS Spring Meeting Quebec City, CanadaJune 16-18, 2008

2. Impact of Rate RegulationAGENDA • 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. 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 Why (now) Do States Regulate P-C Insurance Rates?

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 at times • Cost inefficiencies • Politicized ratemaking environment • Less recognized problem: In the aggregate, regulation drives overall claims costs higher

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 RegulationState 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 Lst = ß0 + ß1CSYearst + ß2MAsCSYearst + γ’Xst + ß4StateRegsst + ß5StateRegsstCSYearst + as + Tt + εst CSYears = 1978-1998 or 1978-1995 Test ß2> 0 Control variables = traffic density, cost of hospital stay, per capita income, rate regulation, nofault, PIP limits, compulsory insurance minimums asand Tt are state and year fixed-effects Adjust S.E. for arbitrary heteroskedasticityand for arbitrary correlation within state

19. State Estimation Results

20. State Regression Estimates Lst = ß0 + ß1CSYearst + γ’Xst + ß4StateRegsst + ß5StateRegsstCSYearst + as + Tt + εst 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. Impact of Rate RegulationTown 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

25. Town Regression Estimates %ΔPPit = ß0 + ß1Subsidyit-τ + ß2PPit + ß3%ΔACRFit + ß4%ΔExposuresit + ß5%ΔDensityit + ß6Bostoni + Tt + εit Use subsidy from year in which losses were generated Test ß1> 0 Adjust S.E. for arbitrary heteroskedasticityand for arbitrary correlation within state

26. Pure Premium Growth Estimates

27. Impact of Rate RegulationCalifornia 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 • Implementation gradual; full for 7-1-08 • 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

28. Impact of Rate RegulationCalifornia 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)

29. Papers • R.A. Derrig and S. Tennyson (2008), The Impact of Rate Regulation on Claims: Evidence from Massachusetts Automobile Insurance, www.casact.org, Spring Meeting, Quebec City, Discussion Paper Program. • S. Tennyson (2007), Efficiency Consequences of Rate Regulation in Insurance Markets, Networks Financial Institute Policy Brief, www.networksfinancialinstitute.org

30. 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.