Rethinking Rate Regulation

While auto insurance rate rebates, rollbacks and freezes attract Canadian newspaper-readers’, another less publicized form of price control exists and has as great, or even greater – effect on the driving public. This is the rate approval process itself.

The industry’s 2001-2004 price strengthening cycle was unprecedented in many ways, not the least of which was its overlap with eight Canadian elections. Consequently, the politics of rising insurance prices found their way into many political campaigns. Newly elected governments created new boards with rate-setting mandates or further expanded the powers of existing rate boards to oversee insurance prices on an ongoing basis. While this is not new, it is contrary to what is happening internationally where there is a movement away from more invasive and burdensome rate filing processes and insurance regulation practices toward a general rebalancing of regulation to support competitive markets (see chart one, page 29).

In a number of non-insurance sectors in Canada we see provincial and federal governments supporting “smart regulation” or “outcome based regulation”. This concept is based on identifying public policy objectives and using industry self-regulation through corporate governance and audit procedures combined with regulatory oversight to meet these objectives. As part of this “smart regulation” initiative, highly regulated industries such as airlines and trucking have been opened to competitive forces resulting in positive outcomes for consumers and businesses alike.

In the insurance industry, the typical response to price strengthening markets has been to enforce more stringent price regulation. It is uncertain what these reactionary approaches have accomplished other than giving governments and regulators the perception that they are solving the problem. There is no evidence that these solutions work to lower prices or improve stability or availability of insurance premiums in the long run. If they did, these problems would not remain in existence today.

RATE INSTABILITY

Rate regulation has a number of impacts on consumers as well as insurance companies – and “premium stability” is not among them. Academics on both sides of the border have studied this issue extensively over the past 30 years. Recently, Canadian research using the same methodologies has replicated the U.S. findings. This body of research shows that rate regulation does not produce stable insurance prices. In fact, it has been found to limit competition, reduce availability of coverage and increase the volatility of insurance premiums. Without question, premium regulation exacerbates the insurance cycle – making the ups and downs more severe than they would otherwise be.

Notably, the insurance cycle is not a Canadian phenomenon. Virtually every insurance marketplace around the globe experiences periods of market softening characterized by declining prices, weakening underwriting results and flagging profitability of insurers, which is followed by abrupt corrections. What has become increasingly anomalous is Canada’s response to this predictable pattern – the perpetuation and growth of price-setting rate regulatory regimes.

From the journals of academia to the venerable Canadian Institute of Actuaries (CIA), it is well-established that claims costs are the principle driver of insurance premiums. Accordingly, the right place to focus attention to ensure stability in auto insurance premiums is not on prices but on claims costs trends.

RATE ORIGINS

Rate regulation has been around in the U.S. since 1921 when it was introduced primarily as a solvency supervision tool. In the absence of the sophisticated capital tests and accounting conventions that we have today, the primary means to ensure the solvency of insurance companies was to make sure that prices were set sufficiently high. This simple methodology ensured that sufficient funds were available to pay potential claims. In 1945, the “McCarran-Ferguson Act” was passed stating that if insurers were regulated at the state level they could be exempt from federal anti-trust laws. In a hurry to capture authority over the insurance marketplace and retain further clout relative to the federal government, the U.S. states quickly adopted the National Association of Insurance Commissioners’ (NAIC) model of statutes. The adoption of the NAIC model led to the implementation of a formal regulatory prior-approval process of setting insurance rates. By 1944, all but three states had statutes designed to control insurance rates. Of these states, 33 jurisdictions had a formal mechanism in place that, at a minimum, provided for routine review of rates by the insurance commissioner.

California was the only state that did not accept these national statutes and retained a “no-filing” system of competitive insurance pricing. Illinois initially adopted the model statute but repealed it in 1971 in favor of a fully competitive rating system. As Nathaniel Shapo states: “Since 1971, Illinois has allowed competition to regulate homeowners and auto insurance rates for thirty years, with excellent results for consumers. There is no review of rates for excessive or inadequacy. Instead, the most ruthless regulator known to economics, supply and demand, ensures that prices are appropriate.”

Many other states have since reduced or begun to phase out strict price regulation of insurance. At its peak, auto insurance was price-regulated in 37 of 50 states in the 1970s, a marked trend towards deregulation and competitive market-determined prices has since ensued, picking up steam in recent years (see chart-2).

In Europe, during the early 1990’s, the Third Council Insurance Directives (TCID) introduced the “freedom of service principle” and completed the establishment of a single European insurance marketplace. The idea was to create a common market where consumers would have access to the entire range of insurance products available throughout the European Union (E.U.) while creating a level playing-field for insurance companies. This resulted in the removal of price regulation in European countries after 1992. Currently, European supervisory authorities have limited means of interfering with insurers’ premium-setting practices and momentum towards competitively-determined insurance rating systems is well established.

In comparison with US and European experience, active price regulation is a relatively recent phenomenon in Canada limited to the province of Ontario until 2003. Prior to 1989, auto insurance in Canada operated under a competitive rating model. However, following the hard market of the late 1980s and the election of the left leaning New Democratic Party (NDP) in 1990, Ontario implemented a strict prior-approval regime of rate regulation.

Until recently, other regions such as, Alberta and the four Atlantic Provinces maintained variations on a competitive system where automobile insurers were required to file rates and after a period defined in legislation, acquire “deemed approval” for use. However, over the past two years (and in contrast to the rest of the world), a significant deepening of price controls and government intervention in price-setting has occurred in these provinces. In particular, the new Alberta Insurance Rate Board is now setting prices outright for a significant proportion of the driving population. Newfoundland and Labrador have introduced a system of strict prior-approval of premiums, moving away from a benchmark system.

Elsewhere in the world, jurisdictions as far flung as India, Poland and Hong Kong are committing their insurance markets to competitively determined prices and dismantling or resisting the creation of rate regulatory regimes. International supervisors are championing this direction, both as a result of evidence from jurisdictions elsewhere in the world and academic research. A great advocate of competitive insurance markets and principle/risk based regulatory regimes is the International Associat
ion of Insurance Supervisors (IAIS). A paper released by IAIS in February of this year states: “The diversity of markets and the wish to stimulate an ongoing improvement of risk management practices require the common structure and standards for solvency assessment to be principles-based.” Recent trends in Canadian policy with regard to regulation of insurance rates are clearly out of step with the international community in both the developed and developing world.

NEW APPROACHES

The Canadian Council of Insurance Regulators (CCIR) is presently studying risk-based regulatory frameworks to assess the role they could play in supporting a healthy and prosperous insurance marketplace. The IBC, acting on behalf of insurers, is actively working on a number of joint projects with regulators and governments to develop a more modern regulatory system. These efforts include looking at jurisdictions such as Illinois and South Carolina which present interesting case studies.

Illinois, a jurisdiction similar to Ontario in terms of population and the relative importance of key industrial sectors, does not regulate rates and offers consumers greater certainty in budgeting for their family’s insurance needs. Nevertheless, over the 1988-2001 period, premiums in Illinois changed by a modest 2%-4%. In comparison, over this same time period, heavily regulated jurisdictions such as South Carolina and Ontario delivered swings in premium growth of over 10 percentage points.

This is not to say that all regulation should be abolished, quite the contrary. Regulation plays an important role in ensuring confidence in our financial system. Important work remains to be done to develop leading indicators, new tools for system stewardship and to advance transparency and disclosure. The role of price controls in all of this, however, deserves a serious re-think.

From peace keeping to solvency oversight of financial institutions, Canada is paving the way as a world leader. Unfortunately, the state of price regulation remains a striking example of one area in which we have, in some provinces, taken preliminary steps forward, but remain by most accounts, lagging on the global stage.