Costs and Consequences: Rate-of-Return Biases, Rate Suppression, and Market Incentives for Quality in Property/Casualty Insurance Regulation

The imposition of legal and regulatory constraints on market prices—price controls, or rate suppression in the case of the property/casualty insurance market—is an important tool with which public officials can effect wealth transfers among groups and economic sectors.

Rate suppression can take the form of allowed rates too low to compensate insurers for expected costs and/or a rate structure that engenders cross-subsidies among consumer groups. Such regulatory policies are analogous to a tax imposed upon the market, which must be borne by someone. Because insurers must acquire capital in a competitive international capital market, it is unrealistic to assume that insurers will bear the burden of this implicit tax, except perhaps in the short run.

Several important biases are inherent in the rate approval process, particularly in terms of determination of the allowed rate of return to investment, all of which have the effect of raising the cost of capital. The empirical literature on the effects of rate suppression and other regulatory efforts is largely consistent with these observations and with the prediction of economic analysis that consumers writ large cannot be made better off with such interventions. Moreover, market forces provide powerful incentives to invest in the optimal level of insurance quality, that is, insolvency risk, and solvency regulation may or may not contribute to that goal.

The historical political response to large increases in insurance costs—California in the 1980s and Florida in this decade provide useful examples—has been to impose ever-more stringent regulatory constraints on the market. The discussion in this paper suggests that a strengthened reliance on competitive market forces would yield more salutary outcomes.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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