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Before the Department of the Treasury
Washington, DC 20220 November 21, 2007
Review by the Treasury Department of the Regulatory Structure Associated with Financial Institutions
Before the Department of the Treasury
Washington, DC 20220 November 21, 2007
Review by the Treasury Department of the Regulatory Structure Associated with Financial Institutions
FreedomWorks is an 830,000-member grassroots organization that promotes market-based solutions to public policy issues. Established in July 2004 through a merger of Citizens for a Sound Economy and Empower America, FreedomWorks has consistently pursued policies that foster free-enterprise and competition. FreedomWorks has been actively involved in a number of regulatory issues and has been particularly interested in bolstering competition and consumer choice in the insurance sector. It is critical that the regulatory framework adapt to the realities of the marketplace so that consumers are not unnecessarily restricted in their choices and the degree of competition in the marketplace is maximized.
We submit these comments in response to your questions with respect to the insurance industry. In many instances state-level regulations have posed as a barrier to competition that ultimately harms consumers. Given the difficulties of regulatory reform at the state level, FreedomWorks has encouraged legislators to consider implementing an optional federal charter, which would provide insurers the choice of state or federal regulation. Not only would this facilitate competition, but it would also create incentives for regulators at all levels to improve their regulatory structures.
The issue of competition in the insurance industry tracks closely with debates over market structure in the other industries operating under economic regulation. Regulatory oversight expanded from the start of the 20th century, as regulators sought to improve upon market behavior. However, beginning in the late 1970s, academic research and public policy practitioners demonstrated that competitive markets served consumers better than regulated markets. Since that time, economic regulation has waned as competition has been introduced into such industries as airlines, trucking, electricity, telecommunications and railroads. In all cases, competition provided lower prices and quality that equaled—if not improved upon—the existing industry standards. In one study, deregulation was found to provide consumers with benefits of at least $50 billion annually.
The prospect of a more competitive insurance market offers similar potential for consumer gain. As early as 1973 Professor Joskow at Massachusetts Institute for Technology demonstrated that markets for insurance had no characteristics suggesting a need for regulation. To varying degrees, states are evaluating the possibility of increasing the degree of competition in the insurance industry. Technological advances, financial services deregulation, and more effective risk management tools have compelled many states to reconsider the role of competition. Progress has been slow, however, and some members of Congress have proposed an optional federal charter as an alternative approach to a more streamlined regulatory framework.
Regulated industries also generate substantial compliance and administrative costs. The insurance industry, for example, is regulated by agencies in every state. The average staff size for state insurance agencies was 168 in 1994, with an average annual budget of $12.2 million. In addition, insurance companies participating in various state markets must allocate significant resources to address the concerns raised by state regulatory agencies and state legislators. To the extent markets can replace political decision-making, these costs can be minimized.
Since the 1970s, economists have been reshaping their views of economic regulation. Many previously regulated industries—airlines, trucking, railroads, natural gas, and to some extent telecommunications—have undergone the transformation to competitive markets, and inroads are being made in the insurance industry. The general view among economists has been that economic regulation has served consumers poorly and the potential welfare gains of deregulation can be significant. As the chart below indicates, consumers enjoyed significant price reductions in the wake of deregulation.
Unlike other industries, however, the insurance industry is regulated primarily at the state level, mainly due to ratemaking practices that evolved in the insurance industry. Given the nature of risk and actuarial practices, sound, cost-based pricing required the analysis of large volumes of data across companies. A niche emerged for companies that pooled information to more effectively evaluate risk. More accurate evaluation led to better loss ratios, which reduced the potential for excessive competition that threatened the solvency of the industry. The practice was common in the 19th century and was formalized by the early 20th century through the use of rating bureaus. State governments often encouraged the use of rating bureaus, and rating bureaus often fell under state regulatory oversight.
This degree of collusion in pricing policy among private companies was unique, and, given the concerns of insolvency, was allowed to continue even after the advent of federal antitrust laws. An 1869 Supreme Court decision, Paul v. Virginia, held that insurance was exempt from laws governing interstate commerce because insurance was not a form of interstate commerce.
Despite the public interest language endorsing insurance regulation, there were clearly selfish incentives at work promoting entry restrictions and price regulation. As in other regulated industries, fears of ruinous competition and bad actors could be used to establish a new regulatory regime that protected incumbents at the expense of consumers and potential new entrants. Indeed, the fact that government charters and regulation provided a secure revenue stream can be traced back to the creation of England’s first insurance businesses: “In 1720, reputedly succumbing to a bribe of £300,000, King George I consented to the establishment of the Royal Exchange Assurance Corporation and the London Assurance Corporation, the first two insurance companies in England, setting them up ‘exclusive of all other corporations and societies.’”
Anti-competitive behavior was at the heart of the federal government’s 1942 case against the SouthEastern Underwriters Association, which was a large rating bureau. The government brought a wide array of charges against the bureau, including price fixing, monopolization, and various other anti-competitive practices. The case was initially thrown out by the federal district court based on the interstate commerce exemption established in Paul v. Virginia. The case ultimately went to the Supreme Court which overturned Paul v. Virginia, acknowledging that insurance was, in fact, a form of interstate commerce, which meant that Congress could regulate the insurance industry and the Sherman Antitrust Act was relevant.
The Supreme Court decision challenged both state regulatory and industry practices. With a vested interest in the status quo, both regulators and insurers turned to Congress for clarification. The response was the McCarran-Ferguson Act of 1945, which re-affirmed the primacy of state regulation of insurance and limited the reach of most federal statutes in the insurance industry. It is important to note, however, that some elements of the federal antitrust statutes do apply to the insurance industry to the extent that state regulators have failed to act. For example, under an open competition model, the McCarran-Ferguson Act offers no shield from federal antitrust statutes.
In the wake of McCarran-Ferguson, state regulators were faced with the need to expand regulatory oversight of the industry or yield to federal regulation. Not only did regulatory oversight increase over insurers, but rating bureaus were brought under closer state scrutiny as well. This move, in effect, formalized the ratemaking process and established the process of rate approval by state regulators. Interestingly, this move also created an early rift in the industry between rate bureaus who required state-based regulation to avoid the antitrust laws, and the large independent insurers who set their own rates and saw no benefit in establishing a strong state regulatory system. In 1945 the National Association of Insurance Commissioners introduced model legislation calling for states to implement rate regulation. Three models of rate regulation were listed: mandatory bureau rates, prior approval, and open competition. By the early 1950s, in the wake of the Supreme Court’s decision against the rate bureau and the enactment of the McCarran-Ferguson Act, almost all states had established a system of state rate regulation relying on prior approval.
“Adequate, Not Excessive, and Not Unfairly Discriminatory”
As states expanded their regulatory oversight to ward off federal regulators, procedures were implemented to require regulatory approval before insurers could adopt the rates established by a rating bureau. In a regulated market with limited competition, these prior approval requirements set statewide standards on allowable rates. There was a clear regulatory philosophy that relied on state regulators rather than competition to discipline the insurance market. Regulatory approval provided the states a method of intervention in establishing rates on property-casualty insurance firms that operated as a cartel. With restrictions on entry and uniformly regulated rates, consumers had little recourse in the marketplace. Regulators took on the mantle, therefore, of ensuring that rates were “adequate, not excessive, and not unfairly discriminatory.” Adequate rates minimize the risk of insolvency, while rates that are not excessive or unfairly discriminatory protect consumers from price gouging and market misconduct.
In practice, state regulators employed two tactics pursuing this goal. Prior approval was the first, and restrictions on risk classification was the second. Prior approval can entail regulatory clearance of rates, forms, or both by a state insurance agency. When dealing with property-casualty insurance, rate regulation addresses both personal and commercial lines of insurance. In recent years, however, commercial line regulation has eased to some extent under the precept that commercial customers have access to information and negotiating skills that eliminate the need for regulatory protections.
Even though most states require approval of rates and forms, the degree of oversight can vary greatly from state to state. The most rigid requires the use of state-adopted rates or forms. Prior approval requires insurers to submit their rates and forms for approval prior to use. Some states operate under prior approval with a deemer clause that assumes a rate or form is approved if the state has not disapproved the submission within a stated time frame. A more flexible file-and-use plan is used in some states, where insurers are required to file with the regulatory agency before the proposed effective date. Use-and-file allows insurers to proceed, but the rate or form must be filed within a given time frame after the effective date. Finally in some states filing is required, without any reference to the effective date, and in a few states, no filing is required at all.
The push towards more competitive and open insurance markets entails a shift away from prior approval in favor of use-and-file, or ultimately, no filing at all. As noted earlier, economists find little or no evidence of market power in the insurance industry, and the lack of entry and exit (for the most part) barriers suggest that competitive forces will provide consumer benefits. These benefits arise not only from the potential for lower rates, but also from the increased flexibility that allows producers to quickly adjust rates to reflect current market conditions, and reduced compliance and administrative costs.
In addition to prior approval requirements, regulators often impose restrictions upon risk classification that can have a significant impact on the ability of insurers to operate within a given market. Risk classification restrictions impose limits on the information insurers can use to assess the risk of loss for different consumers. For example, there may be restrictions that prohibit distinctions between young and old drivers, or distinctions between urban and rural customers. From an economic perspective, such restrictions are clearly inefficient. To be competitive, insurers must determine loss ratios as accurately as possible, based upon as much information as possible. Limiting the use of information hampers the ability of insurers to make the best decision. Ultimately, it will be consumers who bear the costs of these mistakes.
With risk classification restrictions, there are often underlying social or policy questions that must be addressed. Yet however compelling the issue, it makes little sense to resolve it by making economic transactions less efficient. If, indeed, there is a political question, an open, public discussion of the issue can generate a far more efficient solution. While some may suggest that legislative solutions are difficult to achieve due to budget constraints, it is disingenuous not to acknowledge that addressing these concerns through restrictions on risk classification does not avoid the budgetary question. In fact, insurance companies become unwitting tax collectors as the costs of these social policies become embedded in their premiums. A more prudent approach would require such political questions to be addressed in the legislature, where solutions can be fully vetted.
In summary, a more open and competitive market would help all state regulators achieve their goal of “adequate, not excessive, and not unfairly discriminatory” rates. If insurance regulators focused more directly on questions of adequacy to address concerns of insolvency, competition would provide consumers rates that are neither excessive nor unfairly discriminatory. By definition, insurance that is priced based upon a careful assessment of all information generated in the market cannot be discriminatory. Loss ratios would accurately depict the risk. In this case, competition between insurers would enhance the accuracy of the information used to forecast loss ratios, while at the same time eliminating excess profit. Charging excessive rates or biasing loss ratios in a discriminatory fashion would not be conducive to long-term survival in the insurance market.
Deregulating personal lines has been a more contentious issue, with many regulators raising concerns that individual consumers do not have the information or ability to effectively negotiate with insurers in an open market. Consequently, fewer states are considering open competition in personal lines. But as with small commercial customers, a more competitive market would be much more responsive to consumer demand. Inefficiencies in the market would be minimized as firms compete for customers. In any market, competition forces providers to eliminate the inefficiencies that Harvey Leibenstein identified as symptomatic of markets where competition is absent. At the same time, efforts to attract and retain customers forces producers to offer innovative products that provide greater value to consumers.
The market for personal lines exhibits no signs of market power, with few barriers to entry and numerous sellers. As noted above, where allowed to operate, open competition has fared well. Competitive markets perform at least as well as regulated markets, while allowing more innovation, more choice, and fewer administrative and compliance costs. If regulators limited their activities to questions of solvency and market conduct and abandoned rate and form regulation, competitive forces would provide the market discipline necessary to produce rates that are not excessive or discriminatory.
Yet many critics of competition point to information asymmetries that distort the market and make it difficult for consumers to make informed decisions about insurance. The inability to ascertain how insurers characterize and assess risk does not allow consumers to accurately evaluate different insurance products. For this reason, many advocate full information disclosure by insurers with respect to underwriting rules, rating tiers, and credit reports.
Disclosure does not guarantee lower prices or better service for consumers. In fact, disclosure requirements that force companies to disclose proprietary information can actually reduce innovation and limit the forces of competition. In one sense, such disclosure requirements eliminate the incentives for insurance writers to develop new products or invest resources in identifying better ways to serve consumers. These adverse outcomes arise because disclosure requirements allow competitors access to information that enables them to copy any beneficial practices. In this setting, it no longer pays to invest in innovation; the rational strategy is to free ride on the efforts of others. Unfortunately, if this strategy prevails among all firms, little innovation occurs, and consumer choice is restricted.
In fact, mandatory disclosure requirements may simply institutionalize the collusive cartel model that dominated the industry at the turn of the century. However, rather than rating bureaus, industry practices and standards would be driven by public information requirements that provide all insurers the information they need to engage in cartel behavior—restricting output and raising prices to the detriment of consumers. In short, rather than facilitate competition, forced disclosure of proprietary information may encourage behavior that requires more regulatory oversight than the present market.
This is not to say that information is not important to a functioning market. Information is important to both consumers and producers, and both groups have an incentive to invest in information. Producers will invest significant resources to identify better ways to identify risk. Consumers will also invest in search costs to identify the product that suits their need most efficaciously. Knowing that such information has value, markets have emerged to provide such information to consumers. In recent years, technology has reduced these search costs and it has become relatively easy to compare different insurance products.
Competition provides discipline necessary to drive market performance. A market that is not characterized by barriers to entry suggests that actors within that market will act competitively in order to maximize profits. The insurance industry has been identified as competitive by numerous studies and the costs of the current regulatory regime have also been identified. Nonetheless, efforts to introduce competition have been slow. With most economists in agreement on the benefits of competition, it is perhaps political intractability that accounts for the resistance to change. As Scott Harrington notes: “Resistance to competitive pricing and underwriting persists in modern times because competitive insurance markets are successful at classifying buyers with widely different risks of loss into reasonably homogeneous groups on the basis of expected costs. Some critics of the insurance industry object to competitive classification because it disadvantages some consumers compared with others.”
In the wake of financial services deregulation, the insurance industry is facing a new source of competition. In addition to self-insures and off-shore insurers, the industry now faces competition from investment banks and others who are beginning to offer insurance products under alternative regulatory frameworks, that may be more flexible than insurance regulation. As the distinctions between these markets become less distinct, it is important to reassess the existing framework to identify new avenues for establishing a competitive market.
Regulators continue to focus on ensuring rates are “adequate, not excessive and not unfairly discriminatory.” In an industry characterized by a competitive market structure, competition goes far in meeting these goals. Indeed, if regulators focused on monitoring market misconduct and the financial solvency of market participants while moving from prior approval to use-and-file, rates would meet the desired goal. Open competition is perhaps the most effective measure for eliminating excessive rates. At the same time, market-based rates by definition are not unfairly discriminatory; market-based rates are the most accurate assessment of the risk of insuring a given individual or enterprise. Firms will continue to refine their abilities to characterize such risks, because in an open market, the most accurate classification of risk is the most competitive classification of risk.
With technology and the marketplace in a state of flux, regulators are re-evaluating the role of prior approval regulation. Many are considering more flexible rating systems. These efforts should be encouraged; replacing the current system with a use and file system (or a no-file system) adds the flexibility necessary to respond to changing market conditions. This means providing consumers with better services and better prices.
As the regulatory framework is examined, there are several important issues to consider:
Regulators should focus on monitoring financial solvency and market conduct. Competitive forces will define market structure, and competition will generate efficient prices while protecting consumers from price gouging.
Light-handed regulation that includes a well-defined safe harbor should replace the current system of prior approval. Given the overwhelming evidence of competition in the insurance industry, regulators should allow competition to discipline the industry. Concerns over monopolistic practices should be directed at specific targets, allowing firms to compete unimpeded within a safe harbor should they meet all the necessary criteria.
Rate and form regulation should not be replaced with new regulations that generate the same restrictive results. In the process of removing rate and form regulation, it is important to ensure that no new requirements are adopted that would stifle market activity. For example, new disclosure requirements that reduce incentives to innovate or promote collusive behavior should be avoided.
Regulators should foster the development of niche markets that identify new consumers needs. Insurers and others require the flexibility to respond to new consumer demands or utilize new information in order to develop new products.
Regulatory half steps can be problematic. As seen in other regulated industries—airlines, electric utilities, telecommunications—poorly conceived reforms or limited reforms can adversely affect consumers. Open competition should be pursued in a comprehensive fashion wherever possible.
 Robert Crandall and Jerry Ellig, Economic Deregulation and Customer Choice: Lessons for the Electric Industry, Center for Market Processes, Fairfax, Va.: 1996.
 Joskow, Paul L., “Cartels, Competition, and Regulation in the Property-Liability Insurance Industry,” Bell Journal of Management Science, 1973, vol. 4: 375 - 427.
 “Over-reaching Authority: An Analysis of Regulatory Excess,” National Association of Independent Insurers, November 1995, p. 8.
 Economic regulation refers to price and entry restrictions established by public utility commissions. In this sense, economic regulation is distinct from health and safety regulation, which has become more prominent in recent years.
 See Robert Crandall and Jerry Ellig, “Economic Deregulation and Customer Choice: Lessons for the Electricity Industry,” Center for Market Processes, George Mason University (1997) and Clifford Winston, “Economic Deregulation: Days of Reckoning for Macroeconomists,” Journal of Economic Literature, vol. XXXI (September 1993), pp.1263-1289, and Clifford Winston, XXXXXXXXXX, Journal of Economic Perspectives, Jerry Ellig, “Economic Deregulation and Re-regulation: Benefits and Threats,” Citizens for a Sound Economy Foundation, Washington, D.C.: March 20, 2001.
 Paul v. Virginia (75 US 168)
 Against the Gods, p. 91.
 See Scott E. Harrington, “Insurance Deregulation and the Public Interest,” AEI-Brookings Joint Center for Regulatory Studies, Washington, D.C.: 2000.
 It should be noticed that other significant regulatory burdens exist, such as licensing requirements and numerous limitations on different trade practices. However, this paper is focusing primarily upon price deregulation and does not address the issues raised by these regulations.
 Leibenstein (1966).
 Osborne, D. K., "Cartel Problems," American Economic Review, 66 (1976): 835-844.
 Scott E. Harrington, Insurance Deregulation and the Public Interest, 2000.