Why Do We Regulate Insurance? Markets, not government regulators, provide consumers with better services at better prices

by Wayne T. Brough, PhD
Citizens for a Sound Economy

2003-01-15

As the economy has evolved, insurance markets have become more diversified, more efficient, and more accurate in assessing risk. Today, consumers have a wide variety of options when shopping for insurance, which has become a major industry in the United States, with revenues of roughly $800 billion and net income of around $40 billion annually. Numerous brokers and agents supply a wide variety of products to meet the needs of consumers. At the same time, insurance instruments are available from a greater number of sources, including self-insurance and financial services providers. Where allowed, competition has generated the results that would be expected in any competitive market—lower prices, a wider variety of goods and services, and more fully informed producers and consumers who can make more knowledgeable decisions about the insurance products they need. Nonetheless, insurance markets in most states remain heavily regulated, which raises costs for consumers.

The prospect of a more competitive insurance market offers the potential for significant consumer gains. As early as 1973 Professor Joskow at Massachusetts Institute for Technology demonstrated that markets for insurance had no characteristics suggesting a need for regulation. To varying degrees, states are evaluating the possibility of increasing the degree of competition in the insurance industry. Technological advances, financial services deregulation, and more effective risk management tools have compelled many states to reconsider the role of competition.

Insurance, as an industry, has long operated under the watchful eye of regulators. As the industry matured in the 19th century, concerns about financial solvency and consumer information led many states and localities to regulate the operations of insurance providers. A primary concern was the ability of insurers to cover the losses of their customers in the case of a widespread catastrophe. Fire, in particular, was a major issue in the in the 19th century. With lower building standards and dense construction in urban areas, fires spread quickly and heavy losses tallied just as swiftly. Fearing that some providers did not have the reserves required in the event of a disaster, regulations were put in place to govern reserve requirements for insurance providers. As in other industries, concerns arose over the potential for “ruinous competition” that would lower prices to the point where insurers would not be operating with sufficient reserves to fulfill their obligations to customers.

Despite the public interest language endorsing insurance regulation, there were clearly selfish incentives at work promoting entry restrictions and price regulation. As in other regulated industries, fears of ruinous competition and bad actors could be used to establish a new regulatory regime that protected incumbents at the expense of consumers and potential new entrants. Indeed, the fact that government charters and regulation provided a secure revenue stream can be traced back to the creation of England’s first insurance businesses: “In 1720, reputedly succumbing to a bribe of £300,000, King George I consented to the establishment of the Royal Exchange Assurance Corporation and the London Assurance Corporation, the first two insurance companies in England, setting them up ‘exclusive of all other corporations and societies.’”

In the United States, regulatory approval offered states a method of intervention in establishing rates on property-casualty insurance firms that operated as a cartel. With restrictions on entry and uniformly regulated rates, consumers had little recourse in the marketplace. Regulators took on the mantle, therefore, of ensuring that rates were “adequate, not excessive, and not unfairly discriminatory.” Adequate rates minimize the risk of insolvency, while rates that are not excessive or unfairly discriminatory allegedly protect consumers from price gouging and market misconduct.

In practice, state regulators employed two tactics pursuing this goal. Prior approval was the first, and restrictions on risk classification was the second. Prior approval can entail regulatory clearance of rates, forms, or both by a state insurance agency. If, however, an industry is actually competitive, such requirements can limit the ability to provide consumers with the services they need in a timely manner. As noted earlier, economists find little or no evidence of market power in the insurance industry, and the lack of entry and exit (for the most part) barriers suggest that competitive forces will provide consumer benefits. These benefits arise not only from the potential for lower rates, but also from the increased flexibility that allows producers to quickly adjust rates to reflect current market conditions, and reduced compliance and administrative costs.

In fact, a more open and competitive market would help all state regulators achieve their goal of “adequate, not excessive, and not unfairly discriminatory” rates. By definition, insurance that is priced based upon a careful assessment of all information generated in the market cannot be discriminatory. Loss ratios would accurately depict the risk. In this case, competition between insurers would enhance the accuracy of the information used to forecast loss ratios, while at the same time eliminating excess profit. Charging excessive rates or biasing loss ratios in a discriminatory fashion would not be conducive to long-term survival in the insurance market.

Today, there is little economic justification for the theory that insurance only can be provided efficiently in a regulated industry. Indeed, even a historical survey of the early years of the industry finds the marketplace for insurance highly competitive. This is hardly symptomatic of anti-competitive behavior. As technology and underwriting have improved, insurers have reduced costs and identified new products that more closely fit the needs of individual consumers. Yet the current regulatory regime continues to limit the ability of insurance providers to implement these innovations in ways that help consumers.

With technology and the marketplace in a state of flux, regulators are re-evaluating the role of prior approval regulation. These efforts should be encouraged; replacing the current system with a more competitive system adds the flexibility necessary to respond to changing market conditions and provide consumers better services at better prices.