Tort reform and mandated insurance rate rollbacks.
In response, at least in part, to these perceptions, the Texas legislature in 1995 passed a tort reform bill, addressing many of the factors deemed responsible for the insurance (and litigation cost) inflation. Because tort reform legislation should result in lower claims costs for insurers, and because lawmakers felt that these reduced costs should be prospectively passed on to the consumer, the legislature also mandated rate rollbacks in certain lines of insurance most affected by the enacted tort reforms. The Commissioner of Insurance, directed to promulgate specific rate rollback percentages in certain lines of insurance, recommended rate rollbacks in excess of the amount recommended by the insurance industry and by his staff (but lower than those designated by the legislature).
The problem in determining insurance rate rollback percentages, however, is that an actual actuarial assessment of the effects of the tort reform measures on insurance costs will not be available for several years. How is one to estimate the savings, if any, that will accrue to the different insurance lines because of the reforms, and how much "behavioral modification" on the part of the claimants will result from the reforms?
An Overview of Texas Insurance Markets and Competitive Pricing
In order to understand the impact of the 1995 tort reforms on actual insurance rates, it is useful to understand the competitive nature of the Texas insurance market. Insurance can be viewed as a form of financial intermediation: the premiums are collected, the money invested, and, subsequently, the premium dollars plus investment income are available for paying contingent claims as they arise. Because a large bulk of the profits in the insurance business come from the investment (the financial intermediation) and not the underwriting (excess of premiums over claims for a particular policy) side of the business, the competition for premium dollars is fierce.
By many standard measures, the Texas insurance market is very competitive. For example, the 1991 Annual Report of the Texas Department of Insurance lists 1,050 insurers (277 domestic and 773 foreign insurers) competing in the Texas property and liability insurance market. While not all insurers write in all lines of insurance, they are all potential competitors facing comparatively low barriers to entry and exit, making the Texas insurance marketplace very contestable. If a particular line of insurance is found to be very profitable (defined here as excessive returns generated on an investment for a given level of risk exposure), new companies flock to the market, the supply of the coverage increases, and prices of the product, by the law of supply and demand, drop until the perceived excess profit disappears. Similarly, if a particular insurance market is found to produce an excessively low return given its level of risk exposure, insurance companies curtail their writings in this line of business, supply falls, and prices rise - again by the law of supply and demand - until the perceived risk-adjusted rate of return comes back into line.
Moreover, in a competitive insurance market, the competition for increased risk-return payoffs is not restricted only to consider the risk return trade-off curves within the industry. The level of return corresponding to the perceived level of risk also must be concordant with the return corresponding to the same perceived level of risk exhibited in the general capital market. Otherwise, investors would sell their noninsurance industry stocks to buy insurance stock and obtain the excessive rate of return (or, in the case of excessively low-risk adjusted rates of return, sell their insurance company stocks and buy other industry stocks), driving the price and asset base of the insurance industry in a corrective direction until the return on investment again aligns with that available in the general capital markets. The moral is that in a competitive marketplace, prices must reflect current market opinion about the perceived risk of the product. The competition for capital drives prices toward expected costs plus reasonable profit based on the level of risk. Thus, the determinant attribute becomes the uncertain costs associated with supplying the product.
Insurance Rate Rollbacks Calculations
As discussed previously, an over- or underpriced insurance product cannot continue to exist in a competitive market. Accordingly, from an economic perspective, the problem of how much to roll back insurance prices due to tort reforms in a competitive insurance market might be viewed as a self-correcting issue. However, if prospective estimates of rate rollbacks are mandated (as done by the 1995 Texas state legislature), then past claims data may be used to shed light on the changes in loss costs that would have accrued had the new reform laws been imposed on the historical data.
By looking at the percentage by which the past expected claim costs would have decreased had the new laws been imposed on the historical data, an estimate of the percentage reduction in loss costs to be expected can be developed. If historically no claims would have been affected by imposing the new law (i.e., the law imposes nonbinding constraints), then no effect of the law can be justified (and no rollback justified in a competitive market). Similarly, if, for example, fewer than one percent of the past claims would have been affected by imposing these new legal standards on the historical claims data, then a mandated rollback of 30 percent seems economically unjustified - and runs the risk, in a competitive capital market, of driving fluid capital out of the insurance industry and into other investment vehicles with a more positive risk-reward tradeoff. The only way in which overly large mandated rollbacks could be justified is if it is presupposed that the insurance was "overpriced" in the first place.
In the summer of 1995 the Texas Department of Insurance issued a special data call for claims in certain affected lines of insurance. One variable in this data call delineates the number of claims that occurred in 1994 and for which the claim would have been affected by the 1995 tort reforms. The results of this study are given in the table. For example, for private passenger automobile insurance, only 13.6 percent of the claims would have been affected by the tort reform changes. Moreover, inasmuch as the tort reforms only apply to the bodily injury protection of the automobile insurance, and the premium for bodily injury protection only accounts for about 65 percent of the gross premium for automobile coverage, the real effect of the tort reform on gross automobile premiums would be substantially smaller.
Insurance prices are based on forecasts of future loss costs (moderated by competitive market conditions). Hence, the 1995 Texas tort reforms are a positive step toward controlling escalating insurance costs. The initial data, however, indicate that the enacted reforms only constrain a relatively select percentage of claims, as opposed to affecting all insurance policy claims. Tort reform, for example, has a smaller impact on the majority of private passenger automobile insurance claims than on product liability or toxic tort claims.
1994 Claims That Would Have Been Affected by 1995 Tort Reform Laws
Line of insurance Number and percentage
Private passenger auto 18 of 1321 records, or 13.6% Home 2 of 410 records, or 0.48% Farm 0% Personal umbrella 0% Product liability 1 of 123 records, or 0.8% General liability 1 of 195 records, or 0.5% Commercial auto 0% Commercial multi peril 1 of 228 records, or 0.44% Other professional liability 1 of 174 records, or 0.57%
Texas Department of Insurance, 1994 Special Claims Data.
Moreover, there appears to be little evidence in the empirical literature to support the hypothesis that tort reforms will produce claimant behavioral changes that will reduce claims costs. As yet, there is little if any actual historical data on how much the tort reforms will affect actual insurance loss costs. So whether or not the prospective rate rollbacks ordered by the Commissioner actually reflect this savings is unknown. Given the competitive nature of pricing in the insurance industry and the nature of profit control exerted by a competitive capital market, however, the answer will be seen in the marketplace and the change in the availability of insurance.
Dr. Patrick L. Brockett Gus Wortham Chaired Professor of Risk Management and Insurance Director of the Risk Management Program University of Texas at Austin
Christopher A. McClellan Attorney-at-Law Long, Burner, Parks & Sealy Austin, Texas
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|Author:||Brockett, Patrick L.; McClellan, Christopher A.|
|Publication:||Texas Business Review|
|Date:||Feb 1, 1996|
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