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Repairing insurance markets: despite some setbacks, insurance markets have become more competitive. (Insurance).

Article Excerpt
CONGRESS PASSED THE McCARRAN-Ferguson Act in 1945 in response to a U.S. Supreme Court decision that insurance transacted across state lines was interstate commerce and subject to federal antitrust law. The court decision challenged state insurance regulation and insurers' cooperative arrangements to fix prices through state ratings bureaus. The McCarran-Ferguson Act constrained the high court's decision by stipulating that state regulation is in the public interest, federal law does not apply to insurance unless specifically indicated, and federal antitrust law does not apply to insurance for activities that are regulated by the states and do not involve boycott, coercion, or intimidation. Despite periodic pressure and proposals for federal regulation, state insurance regulation has managed more or less to retain its exclusive franchise.

Most states enacted prior-approval regulation of property/casualty insurance rates immediately following passage of McCarran-Ferguson. The regulation required or strongly encouraged insurers to charge bureau rates, and the bureau rating system was gradually modified during the next two decades. Beginning in the late 1960s and early 1970s, a significant number of states adopted "competitive rating" for many types of property/casualty insurance. Rates generally had to be filed with regulators, but they did not need to be approved before use. Other states resisted the temptation to adopt competitive rating and, in some cases, have used regulation to constrain rate increases and restrict rate classification.

The last 25 years have witnessed a slow and non-monotonic expansion of competitive rating. That has included the substantial deregulation of property/casualty insurance rates and policy forms (i.e., contract terms and language) for "large" commercial buyers in approximately 20 states since 1998. However, rate regulation persists in many states. despite overwhelming evidence of abundant market competition and the counter-productive effects of rate regulation as practiced in some states. Representatives of certain segments of both the property/casualty and life/health/annuity sectors are now pressing for optional federal chartering and regulation that they hope will free their companies from the shackles of outmoded state regulation of rates and forms.

COMPETITIVE INSURANCE MARKETS

Market structure and ease of entry are highly conducive to vigorous competition in auto, home, and most other types of property/casualty insurance. Modern insurance markets that are relatively free from regulatory constraints on prices and risk classification exhibit pervasive evidence of competitive conduct and performance. Insurers vary substantially in terms of price, underwriting standards, and service. Property/casualty insurance profitability is modest compared to other sectors.

Competition creates strong incentives for insurers to forecast costs accurately and to price and underwrite each policyholder so as to avoid adverse selection. Thus, competition produces highly refined underwriting and classification systems. Prices vary across insurers in relation to he stringency of classification and underwriting standards. The pressure for increased accuracy is relentless. Insurers that predict claim costs better than their competitors prosper. Insurers that respond slowly end up insuring a disproportionate volume of business at inadequate rates; they lose money and either take corrective action or disappear.

Competitive insurance markets allow policyholders to spread the risk of unexpected loss. Insurance involves cross-sub sidies ex post: Policyholders whose losses turn out higher than predicted are indemnified, de facto, by policyholders whose losses turn out lower than predicted, with insurer capital serving as a buffer when aggregate losses are unexpectedly large.

Competitive insurance markets minimize cross-subsidies ex ante: Prices vary in relation to buyers' expected claim costs (or, more formally, in relation to insurers' conditional expectations of buyers' claim costs), given available information to form expectations. Policyholders with relatively high (or low) predicted claim costs pay relatively high (or low) premiums. The resulting system of "cost-based" pricing motivates parties with relatively high risk to take precautions and alter their activities.

Absent long-term contracts that shift to insurers the risk of changes in expected losses over time, changes in competitive premium rates largely reflect changes in conditional expectations of claim costs. Intertemporal variation in competitive premium rates therefore provides information about variation in expected losses and again motivates desirable risk management.

To be sure, competitive insurance pricing is unavoidably imperfect because of inherent uncertainty about future behavior...