The Regulated Insurance Market
Property and casualty insurance reduces policyholders' exposure to certain risks by pooling large numbers of individuals, averaging the pool's financial losses, and spreading the cost across the participants. Many individuals would rather suffer a small, known loss (the premium) than be exposed to the possibility of a random event with potentially unlimited financial consequences. Thus, they are happy to join such pools. Unlike banking which, through the mechanism of credit expansion, creates new systemic risks, a well designed insurance contract reduces the negative effect of risks which are already present in the world.
As new risks constantly emerge in our complicated economies, new types and classes of insurance evolve to provide protection against them. The most innovative global insurance markets can be found in Bermuda and the City of London. The United States is not in the forefront of insurance innovation.
Why is the United States innovative in so many industries but not home to leading insurance institutions comparable to Lloyd's of London or the Bermudan reinsurance market? Why did a sophisticated, international financial market, but not its insurance equivalent, evolve in the United States? One important reason is the absurdly restrictive US insurance regulation.
How Does US Insurance Regulation Work?
The US property- and casualty-insurance regulation system claims to perform two main functions. The first is to ensure insurers hold enough capital to remain solvent. All developed countries regulate solvency of their insurance companies in one way or another. Smart government solvency regulation probably reduces the risk of individual companies going bankrupt. Stupid government solvency regulation replaces this risk with the systemic risk of the whole market going bust. (It is often hard to tell smart from stupid before it is too late.)
The second function of US insurance regulation is to make insurance "affordable." This means price control. There are differences between states, but in most of the country, insurers need to have their rates authorized if they want to write insurance using them.
The main argument used to justify this type of regulation is that insurance needs to be affordable because it is a "necessity." This is a bad argument, considering that gasoline and bread are also necessities, but the government does not control their prices.
There is a fundamental conflict between the solvency and "affordability" functions of insurance regulation. The simplest way of improving insurer's solvency is to keep the premiums high. The simplest way of improving affordability is to keep the premiums low. Regulators claim they know how to strike the perfect balance, but they don't.
The Perils of "Affordability"
The "affordability" function of US property and casualty regulation in its current form resulted from the Sherman Antitrust Act. Historically, it was common practice for insurers to share their claims data for the purpose of insurance-rate making. Having access to good claims data meant that insurance companies could price and manage their business better, and expand and enter new market segments.
The Sherman Act became effective for insurance in 1944, when the Supreme Court decided that insurance was interstate commerce and therefore should be regulated by Congress. As a result, the useful practice of data sharing, which looked a lot like price fixing, was automatically outlawed by federal antitrust regulation.
Unfortunately, before the era of cheap computers, insurance could not exist without the data-sharing arrangements. So the McCarran-Ferguson Act was introduced in 1945, allowing the industry to return to the old practices but instructing the states to "protect" customers. Hence, the main achievement of the Sherman Act in insurance was to mandate government involvement in rate making without eliminating the allegedly undesirable claims-data sharing.
As is usually the case with other forms of price control, insurance-pricing regulation creates shortages. For example, since 1977 the Massachusetts Division of Insurance has been setting individual auto insurance rates for the entire state. Every insurer operating in the Commonwealth has had to use the government rates or leave the state.
Over the years, many have done so. Since the system was introduced in 1977, the number of insurers has fallen from more than 100 to just 19. Last year the situation was so dire that the current commissioner actually decided to liberalize the regime slightly to prevent more citizens from driving uninsured.
Reducing competition and creating shortages of insurance is only one way price controls damage the insurance markets. Redistribution is another. Multiple examples show that extensive regulation often makes good drivers subsidize bad drivers. This means that bad drivers are incentivized to drive more, and good drivers to drive less.
Similarly, state-run insurance plans often force prudent home owners to subsidize those who choose to live in a house in a hazardous location. The example of Florida subsidizing its beach houses is an extreme case in point. It is difficult to see what socially useful end such subsidies seek to achieve.
Even the current administration in Washington agrees that there is something wrong with the way the insurance system is regulated. President Obama's white paper on financial regulation says,
For over 135 years, insurance has primarily been regulated by the states, which has led to a lack of uniformity and reduced competition across state and international boundaries, resulting in inefficiency, reduced product innovation, and higher costs to consumers.
It is sad that the only remedy proposed is the federalization of insurance regulation. This is likely to make the bad aspects of regulation even worse. The "affordability" function will most likely become more entrenched and, since there will be no way to compare the results of differing legislation between states, it will be more difficult to learn what does and does not work and why.
Comparison with Britain
It is interesting to consider insurance regulation in the United Kingdom. Until recently, British property and casualty pricing was totally unregulated. Regulators concentrated on the solvency function. The long tradition of freedom of enterprise resulted in the emergence of the unique London market of insurance.
For centuries, London was the only place on Earth where it was possible to place big and nonstandard risks. Even today, if one wants to insure a power plant or a system of telecommunication satellites, London is the place to get it done.
The lack of pricing regulation in the United Kingdom resulted in a large number of pricing innovations being developed and tested there. A good example is the so-called GLM statistical approach. This geeky mathematical methodology was developed by two British actuarial software companies in the late '90s. Stripped-down versions of this innovation have since been exported to the United States and implemented here with a few years' lag.
US actuaries had to learn the methodology from their British colleagues and also buy the software from British vendors. Eventually, even the regulators, whose bureaucratic attitude prevented new techniques from being developed in the United States in the first place, started using GLM for granting rate approvals.
The same process is happening with actuarial-reserving and capital-modeling techniques and software. Since excessive regulation in the United States cripples innovative actuarial thought, most of these inventions are being developed in the United Kingdom and simply shipped across the Atlantic.
But it is not just the technical innovations that make the British insurance market great. The less-regulated market gives Britons access to better insurance services. For example, a very sophisticated broker market has developed in the United Kingdom, providing policyholders with specialized products and advice.
Complex nationwide software platforms created by the broker community allow huge price-comparison websites to provide millions of policyholders with binding quotes from nearly a hundred insurers in a few minutes. This does more for the affordability of insurance in Britain than any government regulation will ever achieve in the United States.
Another example is the ease with which new insurance products can be created in the United Kingdom. In the United States, the state regulators get very involved in this process. They are interested in the classification rules, underwriting guides, and even wording of the insurance contract. As a result, most private motor policies written in the last 30 years in the United States have been written on one of the few standard ISO forms or some modifications of those.
In the United Kingdom, where consenting parties are freer to enter an insurance contract of their choice, independent insurance brokers provide dozens of different policy wordings tailored to specific market segments. This means more choice for the customer.
Who Pays the Bill?
The customer is the obvious victim of the US regulators. But harm is also done to the rest of society. Insurance commissioners across the country employ thousands of bright people to review and approve insurance rates. To satisfy these regulators, insurers have to employ thousands of actuaries and pricing staff to prepare rate filings. Society would surely benefit if these people used their time and brains in a more productive way.
Based on my private observations, I conclude that the US insurance companies also suffer as a result of the bullying regulatory culture, especially when they try to compete with more sophisticated insurers in the British market. There are many examples of successful US personal-lines insurers expanding in the regulated, continental European countries, but it seems to be very difficult for US insurers to establish a foothold in the United Kingdom. Competing on a free personal-lines-insurance market is not a skill they have developed.
Insurance regulation in the United States is not working because it makes insurance a static, uncreative and boring business. The best US insurance companies manage to achieve their greatness only because they do not give up their struggle, and they keep smuggling innovations through the regulatory checkpoints.
In insurance, as in many other industries, innovation and regulation do not go well together.