RiskProf

In a Nutshell, Part I of II

One of the problems between insurance companies and consumer advocates (and some states) is a significant difference over how insurance prices should be calculated.  In fact, the problem is not that they can not agree on the pricing model, but the underlying assumptions are in dispute.

In this series of two posts, I'll talk about the pricing problem.  And while I will talk about two equations, one need not understand anything other than addition and subtraction to get the points I will make.  Part I will cover the first equation and part II will cover the second equation.

Equation (1) above shows the basic pricing model.  Prices are equal to the present value of losses plus company expenses, minus investment income allocated to the policy, and the cost of capital.

The present value of the losses are based upon the expected claims (known and estimated) that will come in during the policy year.  There is some academic debate over the accuracy of these reported estimates, but it is not clear how important any error is for the typical company.  Expenses are essentially labor expenses associated with underwriting, paying and adjusting claims, managing the investment portfolio or the costs of services like advertising and legal services the insurer uses.  The term iI represents the investment return earned on surplus (the amount available to pay claims if needed). While technically possible to come up with some method of allocating surplus back to particular policy, I have never seen it done in practice for an individual policy, but at some level it must be done in order to determine whether a book of business is profitable.  However, financial economists have tested aggregated models (with groups of policies) and shown that it occurs (See Cummins JRI 1991 for theory at JSTOR). 

We have also seen a big debate about investment returns in the med mal arena by consumer advocates who claim the reason med mal prices increased dramatically during the early 2000s was because of poor investment choices by insurers.  Poor investment choices mean a lower investment return, and thus higher insurance prices. (see e.g. here for Public Citizen's take).  This is not really so much of an issue of poor investment management, but merely lower market returns as most of property-liability insurers' assets are in relatively high-quality /low risk bonds. In fact, if the consumer advocates position were the truly the case every time, the market had a downturn it would be due to poor investment management.

Finally, the last term rK, represents the cost of capital for the insurer.  Equation (2) described in more detail in the next post, shows some of the factors which go into how much the insurer must pay its investors to attract investment into the firm.  A more risky firm, all other things being equal, will have to pay more to attract capital.  Everyone knows this and there is little debate about this in concept.  Where the big debate is whether the firm is risky or not.  Economists, for example, would states a high rate of return is associated with risk.  Mr. Robert Hunter, a consumer advocate, thinks that profits are a sign of regulatory failure rather than risk.  He also believes that insurance is a low risk investment, not deserving of a high cost of capital.

Others, like the firms which are leaving high risk areas of the country, believe that they can not attract capital as they can not afford to pay investors what they demand for investing in high risk investments.  I think this is essentially Allstate's position and the rational for having a Federal Government intervention.

So the major question left unresolved is what is the appropriate cost of capital for insurers.

In part II of this nutshell, I'll talk about the determinants of the cost of capital (shown in equation 2) which include bankruptcy risk, line of business risk (LOB), geographic risk(GEO), legal and regulatory risk, managerial ability, diversification, and σ for uncertainty.

A Little Research Report on Tort Reform

One of the major themes of the tort anti-reform movement has been the assertion  insurance premiums have not fallen after tort reform.  Ty and I are doing some research on this (which we will post after it is finished).  However, one of the things I was reading was the paper put out by the Center for Justice & Democracy entitled Premium Deceits.  In it, they count the number of major tort reforms in a state and then they look at whether the change in premiums over the period 1985-1998 is related to the number of major reforms.  They find that price changes over the period are not related to the number of reforms.  The report then makes the claim, that tort reform is deceptive and that it will not have an effect on lowering premiums.

I thought I'd talk about two things I noticed in the report.  While the report was carefully done in terms of enumerating the states' reforms, it doesn't necessarily make sense just to add the reforms up into an index of tort reform.  For example, one state may have a collateral source rule change and a damage cap enactment.  Another state may have a damage cap enactment and a change in joint and several liability . ... both would count as a '2', but they may or may not have similar impacts.  So, I thought this is a problem and is generally treated in academic papers by using a dummy variable for each significant tort reform.

So what if I disaggregated the Center's tort reform index and made a dummy variable for those states with two tort reforms and those with three tort reforms?  To see the effect of this minor change in defining the index, I estimated two regressions. (If your eyes are glazing over just skip down to the § symbol below.)

I estimated a simple regression (something the Center did not do in the report) of the form:  percentage change in products liability premiums = a + b*Number of Major Tort Reforms Enacted.

I obtained the following results:

*** significant at the 0.001 level.

This is essentially the conclusion that the authors made.  Tort reform was not statistically related to reductions in the change in prices over the period.

However, if I were to break out the number of reforms into two dummy variables (TR2 =1 if state has enacted 2 tort reforms, and 0 otherwise, TR3 =1 if the state has enacted 3 tort reforms and 0 otherwise) I get a slightly different result:

***significant at the 0.001 level and ** significant at the 0.05 level.

§This result suggests the tort reform does have an effect on lowering prices, but the number of reforms that accomplished this goal is 2.  This result refutes the Center's conclusion (at least for products liability) as the coefficient on TR2 is significant at the 0.05 level.  In simple terms, two tort reforms were associated with a 26 percent reduction in the percentage change in product liability premiums over the period in question.

This is still unsatisfactory, though, as one can not really add the state's tort reforms up to get a simple additive index of tort reform.  I don't even believe that two reforms make a difference but three do not.  So as all good academics are wont to claim, more study is needed.

FYI:  The data used are all available in the appendix of the Center for Justice and Democracy's paper which I linked to above.

Again: Med Mal Rates

NC Trial Lawyers say mutual med mal insurer charges too much.

Again:  It is a mutual insurance company.  Any surplus belongs to the policy holder physicians.  If the insurer has too much surplus, eventually the consumers (physicians) get it back with interest.  If an insurer has too much surplus, it may imply that the insurer is worried about being able to cover its eventual liabilities. 

I also can see a legitimate suit against the directors of a mutual company for not being prudent if they did not carry the necessary surplus for a med mal insurer.

Again, if you can do  better (as Ted Frank suggests)  form your own company. 

Again:  It is Jay Angoff saying this.

I think it is interesting to see that the trial bar is interested in insurance prices.  Perhaps it is feeling guilty?

Times is Tough ....

Business Week (1/8/06) claims that business has “trounced the trial lawyers”.

In late November about 300 attorneys descended on the W Dallas-Victory hotel for the annual conference of the Texas Trial Lawyers Assn. But rather than plotting the next industry-threatening mega-litigation, their goals were decidedly more modest. Attendees could sign up for a full-day "car wrecks seminar." One presentation explored whether an automobile manufacturer's failure to include electronic stability control on a crashed vehicle could be the basis for a negligence claim. Another offered tips on creating "trial exhibits on a budget."

 

Yes Virgnina, There is No Free Lunch.

Ted Frank posted this from via Kevin MD (which I could not find on his blog)…( I am quoting verbatim from his post, but check out his related coverage at Overlawyered)

A dose of reality

September 1 UPI interview with William Plested III, president of the American Medical Association (via Kevin MD):

Q: Ken Suggs, head of the Association of Trial Lawyers of America, recently told UPI that doctors and lawyers should stop fighting each other and unite against the medical malpractice insurance companies who keep hiking insurance premiums to push their profits higher. How would you respond?

A: Do you have any idea what happened with medical malpractice insurance? It's almost totally in the hands of doctor-owned companies; doctors who put together their finances to get a company to give them insurance, because the for-profit insurers all ran. There is no profit in this; (the insurers) left it. And people who are not out to make a profit, they're just out to protect doctors (via) their own insurance companies, they're the one who are left.

We posted about this same issue two years ago (here and here).  As I have said before, I can just picture the doctors sitting around a smoke filled room thinking about ways to charge themselves more for med mal coverage.  

 

September 1 UPI interview with William Plested III, president of the American Medical Association (via Kevin MD):

Q: Ken Suggs, head of the Association of Trial Lawyers of America, recently told UPI that doctors and lawyers should stop fighting each other and unite against the medical malpractice insurance companies who keep hiking insurance premiums to push their profits higher. How would you respond?

A: Do you have any idea what happened with medical malpractice insurance? It's almost totally in the hands of doctor-owned companies; doctors who put together their finances to get a company to give them insurance, because the for-profit insurers all ran. There is no profit in this; (the insurers) left it. And people who are not out to make a profit, they're just out to protect doctors (via) their own insurance companies, they're the one who are left.

We posted about this same issue two years ago (here and here).  As I have said before, I can just picture the doctors sitting around a smoke filled room thinking about ways to charge themselves more for med mal coverage.  

 

Tort Reform: A Different Kind of Cap

From  The Conservative Voice

We can go a long way toward [tort reform] by requiring public universities that have programs in both law and science to enroll more students in science and fewer in law. By my count, of the 194 ABA-accredited law schools, 80 – a little less than half - are affiliated with public universities. Most of these schools also offer degrees in the sciences. I believe we need sensible legislation at both the state and federal levels that would require public schools to decrease law school enrollment by 25% while concurrently increasing enrollment in the hard sciences by 25%. To accomplish this shift, schools will need to work harder to promote and support their science programs and they will need to cap student admissions in their law programs at a more conservative number. Continued federal and state funding should be made contingent on reaching this change in enrollment within the next two years.

While not endorsing this view, I have always wondered why we subsidize professional education (like law, medicine, and business) for in-state students at state schools.  Presumably, we distort the incentives to make more people interested in going to professional school.  Maybe one can make an exception for medical students (the public good and all that), but for accounting? Law?  On the other side, we’d probably have to pay American students to go into the sciences.

Consumer Dis-Advocate Angoff

Former Missouri Insurance Director Jay Angoff (who has been discussed here, here, and here) is now the subject of a bit of press attention.  It seems his actions as Missouri’s Director of Insurance are being questioned. (Belleview News Democrat ) While he was Insurance Commissioner he fought damage caps and lo and behold, it turns out that Mr. Angoff is a trial lawyer Seeker of Justice.  While there is nothing nefarious in those two positions, other people are finally starting to realize that he is not an impartial observer of the med mal system.

via Walter Olson at Point of Law.

Update:  Ray Lehmann, while not necessarily a supporter of Mr. Angoff, has a reasonable but different take on the Belleview News article linked above. 

Tort Reform for Liberals

Over at Point of Law, Bill Childs of TortsProf Blog is guest blogging this week and is making the “liberal case” for tort reform.  So far there is not much to disagree with.  However, I don’t think that tort reform is a liberal or conservative notion.  The idea behind tort reform should be to minimize the cost of tort losses to society.  Sometimes expansion of tort liability can do that and sometimes limiting the effects of tort liability can do that.  For example, in theory people who suffer non-pecuniary damages should be compensated for their real (but hard to prove) losses.  Similarly, restrictions on how one calculates these losses keeps these losses from being over-estimated.  Both of these are tort reforms: allowing pain and suffering for losses yet restricting the amounts that can be assessed.  Thus, I don’t see this as a liberal/conservative debate as much as an economics debate about how we should measure the costs and benefits of the liability system.  After saying this, of course, I realize how laughable this sounds as I sit in my ivory tower above the fray.  I am absolutely cracking myself up!  But I really believe this too… honestly.

 

Front Groups

One man’s freedom fighter is another’s front group.

via Walter Olson (my favorite consumer Dis-advocates get top billing!)

A New Med Mal Study

Alexander Tabarrok of (MR fame) and Amanda Agan have a new study on Medical Malpractice sponsored by the Manhattan Institute’s Center for Legal Policy.  Read the summary here.  Make sure you note footnote 9.  It is important that you do so.

I like the study and it has one of those “Dang, I wish I had thought of that” sections.  One of the big problems with med mal studies in the past is that there is generally only a weak link between premiums and awards.  There are a number of reasons why this might be so, but it would really be nice to show this once or twice if it is, in fact, true.  Tabarrok and Agan do a relatively simple statistical test called co-integration which examines how two series move together over time.  In a sense it shows the times series correlation between doctors damage pay outs and insurance premiums.  Many believe there is a relationship and Tabarrok and Agan find that there is indeed co-integration.

This research relates to something I have wanted to post about since Ted Frank and I wrote the AEI Liability Outlook critiquing the consumer advocate approach to med mal.  One of the more recent critiques they have come up with is that the problem is the fault of the insurance cycle. Note that the Tabarrok and Agan results does not depend on the existence of a cycle. The consumer advocates believe that the med mal crisis is caused by regulatory failure.  If the regulators would just keep prices from going up then we would not have this problem because it is this dang cycle that causes the problem.  A problem with this is also that the regulators would have to prohibit med mal carriers from reducing prices in the good times.  A have a hard time envisioning consumer ado vacates fighting price decreases.

Ted and I wrote that the cycle is not really a cycle. (Mr. Hunter then called us “flat-earthers” because everyone knows there is a cycle).  The whole notion of a cycle is really the wrong word to use here.  There are ups and downs in prices, but are they cyclical in the sense of a regular, predictable pattern that repeats over time?  I think the question is still open for a debate.  Thus, I am not a flat earther, but someone with an open mind on the issue. 

In a paper I wrote with a colleague in the early 1990’s I found that there was a co-integrating relationship over time between insurance “prices”, short term interest rates and GDP.  Interest rates and GDP are not something the insurance industry has control over and thus they have to react to changes in these variables. In fact, the relationship between the interest rates and the insurance rates was quite striking.   Decreases in interest rates generally cause insurance prices to rise (for example).  A question arises whether managers can immunize themselves to changes in the interest rate environment.  Maybe, by purchasing potentially expensive derivative contracts.  However, consumer advocates probably wouldn't want to allow these expenses to be considered part of the price of medical malpractice coverage either.  This interest rate/pricing relationship made me think that there wasn't’t really a cycle, but a relationship to the general economy that might influence pricing movements.

At the same time others started proposing theories of market behavior that did not depend on nice regular cycles.  Ralph Winter (1994) and Anne Gron (1994) separately proposed models of how insurance markets may behave which depend more on reactions to shocks.  Others such as Harrington and Cagle (1995) provide some additional empirical support for this non-cyclical behavior.  Thus, instead of a regular and predictable cycle, there is an unanticipated shock followed by a reaction and then a general return to equilibrium.