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Press Release

Issue Analysis 107 - Competition Serves Consumers Better Than Regulation


The practice of insurance has a long and rich history that parallels our willingness to undertake risky endeavors. As early as 1800 BC, the Code of Hammurabi was used in Babylon to promote and protect maritime commerce. Risk management became an important element of commerce and specialized agents emerged in Europe to help individuals protect their property and their lives. First guilds and then businessmen offered risk management services. Increasing urbanization brought new concerns, such as fire protection and prevention that spawned some of the first insurance businesses. Settlers almost at the inception of the United States adopted these practices; the American Revolution spurred the burgeoning domestic industry, which was needed to replace insurance previously supplied by English insurers.[1]

As the economy has evolved, insurance markets have become more diversified, more efficient, and more accurate in assessing risk. Today, consumers have a wide variety of options when shopping for insurance, which has become a major industry in the United States, with revenues of roughly $800 billion and net income of around $40 billion annually. Numerous brokers and agents supply a wide variety of products to meet the needs of consumers. At the same time, insurance instruments are available from a greater number of sources, including self-insurance and financial services providers. Where allowed, competition has generated the results that would be expected in any competitive market—lower prices, a wider variety of goods and services, and more fully informed producers and consumers who can make more knowledgeable decisions about the insurance products they need. Nonetheless, insurance markets in most states remain heavily regulated, which raises costs for consumers.

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.[2]

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.[3] 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.

A Brief History of Regulation

Originally viewed as a tool to curb market power in industries considered natural monopolies, economic regulation has its roots in the progressive era of American political thought. Both contemporary economic and legal thought supported government oversight, particularly in those industries said to be “clothed in the public interest.” Specifically, economic analysis suggested that many industries were natural monopolies that needed to be regulated to ensure the benefits of scale economies while mitigating market power and protecting consumers from high prices. At the same time, the Supreme Court addressed a number of constitutional questions that, when taken in aggregate, tended to support an expansive view of state action, with a broad scope of government involvement in economic activity:

“The Fifth Amendment, in the field of Federal activity, and Fourteenth, in the field of state action, do not prohibit governmental regulation of the public welfare. They merely condition the exertion of the admitted power, by securing that the end shall be accomplished by methods consistent with due process. And the guaranty of due process…demands only that the law shall not be unreasonable, arbitrary, or capricious, and that the means selected shall have a real and substantial relation to the object sought to be attained.” [4]

With a broad view of the public interest, federal and state regulators gained authority over a wide variety of industries. Trucking, railroads, utilities, airlines, telecommunications, and insurance all faced regulations over price, quality, and entry under the pretext of promoting the public interest and protecting consumers. Traditionally, regulators relied on "rate-of-return" regulation to achieve these goals. Under rate of return regulation, regulators provide a return that cover's a firm's costs plus a "reasonable" profit to induce the necessary capital investment.[5] Perhaps the fundamental difficulty that arises with real-world applications of rate-of-return regulation is that there is no scientific or economic answer to what defines a "fair" rate of return. Typically it is politics, not economics that guides the determination of the fair rate of return. As Alfred Kahn states, "The process has inevitably reflected a complex mixture of political and economic considerations. Governmental price-fixing is an act of political economy."[6] Under such circumstances, the consumer's interests may be subsumed to more politically organized groups that can effectively negotiate a "fair" rate of return.

More recent insights into market structures and competition further warrant a reassessment of economic regulation. The work of economist Harold Demsetz and later work by others on contestability theory concluded that even a monopolist could not charge a monopoly price as long as there are no barriers to entry (or exit). This suggests that regulators should focus on easing entry conditions within the industry, not restricting entry and controlling prices.[7] Note that this does not necessarily mean regulators will abandon efforts to ensure the financial health of the market. Significant steps can be taken to ease entry requirements without raising the specter of insolvency. For example, regulators may facilitate entry by out-of-state firms who meet all financial requirements, or allow incumbent firms to enter new markets or product lines.

Moreover, the historical record of rate-of-return regulation is plagued with inefficiencies. In a seminal paper, economists Harvey Averch and Leland Johnson demonstrated that rate-of-return regulation created a bias toward excessive capital expenditures, which could be recouped in the rates charged to consumers.[8] Harvey Leibenstein offered further insights that suggested the inefficiencies of monopolies were worse than originally thought.[9] When firms are insulated from competition, no competitive pressures exist to keep them operating efficiently. So not only do entry barriers misallocate resources by raising prices above market levels, but incumbent firms have no incentive to keep their cost structures in line, either. Consequently, the costs of production increase unnecessarily, diverting even more scarce resources from other uses.

As economists reshaped their understanding of market structures, they also reshaped their assessment of government behavior. In many ways the public interest approach to government has been supplanted by a more realistic "public choice" view, which more correctly assumes that all economic actors pursue their self interest—seeking gains through both the public and private sectors of the economy. In the public sector, narrowly defined interest groups have greater incentives to ogranize and influence policies than broad groups with disparate interests. As Barry Weingast and Mark Moran state, "The modern theory of political allocation parallels the theory of markets. In both cases, agents pursue their own self-interest through interaction with one another . . . . Because certain groups are more likely to form than others, these groups enjoy a disproportionate share of political benefits."[10] Evidence suggests that the nascent regulated industries may have used regulation and the creation of state regulatory agencies to insulate the existing firms from competition.[11]

This raises another cost associated with regulatory industries. Given that rate decisions are political in nature, market participants will expend resources to affect legislative or regulatory change.[12] Incumbents may expend resources to protect their competitive position, new entrants may expend resources to break into a market, and even firms focused exclusively on market activity rather than political activity may need to enter the political marketplace in response to the political actions of others. Other groups, representing particular interests may also participate in the regulatory and legislative process, making decisions more political than they would be in a competitive market. The costs of such activities, referred to as rent seeking, can be substantial. Importantly, these expenditures represent resources that have been diverted away from more productive activities.

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.[13] 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.[14] 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.[15] As the chart below indicates, consumers enjoyed significant price reductions in the wake of deregulation.

Real Price Reductions in the Years Following Deregulation

2 Years
5 Years
10 Years

13% (1977-79)
12% (1977-82)
29% (1977-87)

4% (1980-82)
20% (1980-85)
44% (1980-90)

Standard Telephones
14% (1984-86)
33% (1984-89)
65% (1984-94)

Long Distance
5%-16% (1984-86)
23%-41% (1984-89)
40%-47% (1984-94)

Wireless Telephone
17% annually

Source: Taken from Jerry Ellig, “Economic Deregulation and Re-regulation: Benefits and Threats,” Citizens for a Sound Economy Foundation, Washington, D.C.: March 20, 2001

Before turning towards a more direct discussion of insurance regulation, it is important to note that recent upheavals in “deregulated” markets, such as the recent California electricity crisis or the burgeoning airline capacity crisis, provide important lessons for future efforts at deregulation. In these and other cases, real capacity constraints and other relics of regulation continue to limit the development of markets. California’s electricity crisis is the result of a substantial imbalance between the supply of electricity, which has remained relatively stagnant in California and demand, which has grown considerably. Environmental and siting regulations hampered efforts to increase supply, and the state’s “deregulation” attempt included many regulatory mandates, such as divestiture, mandated use of a state-run electricity market, and restrictions on the types of contracts power suppliers could use. These restraints generated the market inefficiencies (which were magnified by rising natural gas prices and a drought in the Pacific Northwest) that led to the current crisis.[16]

Similarly, airline deregulation is incomplete by any definition. Significant portions of infrastructure remain under government control and have been unresponsive to dramatic shifts in market demand. Despite significant increases in passenger and freight travel, airport capacity has remained woefully inadequate. Airport construction requires a lengthy regulatory approval process, and the air traffic control system is outdated from a technological perspective. Flight delays, cancellations, and overcrowded airports are symptoms of the continued regulatory restraints in air travel.[17]

Insurance Regulation

Insurance, as an industry, has long operated under the watchful eye of regulators. As the industry matured in the 19th century, concerns about financial solvency and consumer information led many states and localities to regulate the operations of insurance providers. A primary concern was the ability of insurers to cover the losses of their customers in the case of a widespread catastrophe. Fire, in particular, was a major issue in the in the 19th century. With lower building standards and dense construction in urban areas, fires spread quickly and heavy losses tallied just as swiftly.[18] Fearing that some providers did not have the reserves required in the event of a disaster, regulations were put in place to govern reserve requirements for insurance providers. As in other industries, concerns arose over the potential for “ruinous competition” that would lower prices to the point where insurers would not be operating with sufficient reserves to fulfill their obligations to customers.

Other characteristics of insurance also suggested the need for regulatory oversight. The fact that insurance contracts can be complex and confusing to the consumer, as well as the fact that the consumer must pay before the insurer fulfills the contract raised the potential for market abuses. By the mid-1800s most states had begun granting charters to insurance companies, in effect, instituting entry regulation in the insurance market. In 1851, state oversight was formalized in New Hampshire with the creation of an official regulatory agency for insurance. New York followed shortly after, and by the turn of the century most states had followed suit.[19] Through the early 20th century, as economic regulation in general expanded, insurance regulation increased as well. As in other industries, regulations targeted entry and exit, prices, and service quality. Licensing requirements were established, along with solvency requirements, and rate regulation was introduced. Trade practices were subject to regulatory oversight as were policy forms.

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.[20]

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.’”[21]

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.[22]

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.[23] Prior approval can entail regulatory clearance of rates, forms, or both by a state insurance agency.[24] 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.

Do Consumers Benefit from Competition?

Although most states adopted prior approval as the primary form of regulation, there were states, including California, that chose open competition as a regulatory model. Open competition proved effective in meeting the goals of reasonably priced insurance and solvent insurance companies. Based upon lower administrative costs and risk portfolios, large direct insurers were granted flexibility in setting rates that differed from those established by rate bureaus. With greater flexibility and streamlined approval processes, a more market-oriented approach toward insurance pricing and practices was put in motion. As others sought to compete with the direct writers, the use of approved rates began to chafe, limiting the ability of carriers to match the products of direct insurers. As regulators responded with more flexibility, market structure in the industry became more competitive.

The benefits of the competition model in these states encouraged other states to re-examine the role of rate regulation. The New York Insurance Department released a study in 1969 advocating the state adopt an open competition model, which the state did in 1970. Illinois also shifted to an open competition model, which, by default, eventually became the state’s regulatory model for insurance. As Professor Stephen D’Arcy notes, “With the risk of catastrophic losses having been reduced significantly, competition could work effectively to maintain reasonable rates within the industry.”[25]

While New York and Illinois adopted open competition as a model, other states eased prior approval requirements without abandoning the rate regulation model. Academic and government studies demonstrated the positive effects of competition. Although it is difficult to directly measure benefits of competition, examining characteristics of markets with and without prior approval requirements provides important insights. Typically, where prior approval is required, there are fewer insurers in the state, and direct writers—typically lower cost policies—have a smaller market share. This suggests that consumers in these states may have fewer choices and higher priced options. Prior approval may reduce rates, at least temporarily, but this comes with a trade-off. Artificially low rates drive out insurers, which is consistent with the increased concentration and fewer low-cost writers found in prior approval states.[26]

Another measure of market efficiency is the size of the residual market, or the market supplying services to those unable to acquire insurance in the voluntary insurance market. As fewer insurers become willing to write policies within the state, the residual market increases, as consumers have no other options. Examining the markets in states that have opted for open competition, empirical studies confirm that the size of the residual market tends to be larger in states with a greater degree of regulation.

In Illinois, for example, D’Arcy finds, “The Illinois experience indicates that even though private passenger automobile insurance is not subject to rate regulation, the system appears to work just as effectively as other states with competitive types of rating laws….The evidence seems to suggest that restrictive regulation induces market failure. In contrast, not regulating auto insurance rates seems to work.”[27]

Professors Grace, Klein, and Phillips find similar results when examining the auto insurance market in South Carolina, a state with a long history of active intervention into the insurance market.[28] After almost 30 years of heavily regulating the auto insurance market, South Carolina was confronted with a market that exhibited all symptoms of failure: High costs, a large residual market, consumer dissatisfaction, and a shrinking pool of insurers. Finally, in 1999, South Carolina enacted significant reforms that eased both rate regulations and risk classification restrictions. Although it remains too early to definitively assess, the early results are promising: More insurers have entered the market in South Carolina, consumer policy choices have expanded, rate levels are falling, and the residual market has shrunk considerably.[29]

These results confirming the ability of competitive markets to provide consumers more choices at competitive prices can be contrasted with the performance of auto insurance markets in New Jersey, historically one of the most regulated insurance markets in the country. Price caps, barriers to exit, a large residual market, low rates of market participation by direct writers—all signs of a regulated, ineffective market—are characteristic of New Jersey’s auto insurance market. New Jersey’s consumers have suffered under regulation. As Professor John D. Worall concludes: “The [New Jersey] state law is an exercise in social engineering, affecting firms’ market shares, dictating whom a firm can take as a customer and preventing market exit. The state probably has fewer firms writing business and less competition than it would, under different regulatory schemes. The law and its administration have subjected drivers and insurers to unnecessary costs and burdened them with needless administration. It limited the choices that would enable families with different resource levels to make insurance selections that are in their own best interest.”[30]

Commercial lines

State regulators have been receptive to insurance industry concerns that regulation has hindered performance with respect to commercial lines. Growth in commercial lines has been stagnant, and as alternatives to traditional commercial insurance became available, the industry was losing ground to new competitors. In response, a number of states have moved forward with proposals to deregulate commercial lines. Four states have moved forward with deregulation and 16 others have proposals to do the same.[31]

The case for deregulating commercial lines is strong; the market structure is competitive and there is no evidence of anti-competitive behavior in the market. In addition, buyers and sellers are all knowledgeable actors. Concerns over information asymmetries that has slowed personal lines deregulation are not applicable to large commercial buyers. Such customers typically employ risk managers who can effectively evaluate different policy options. At the same time, there is considerable evidence that the existing regulatory structure does increase costs for commercial lines that is ultimately borne by consumers. In 1997, the National Association of Insurance Commissioners released a study finding that regulatory compliance costs were $1 billion annually for industry, and state regulatory agencies spent $40 million to $55 million annually processing rate and form regulation.[32]

Although most states now look favorably toward commercial line deregulation, remnants of regulation continue to hamper growth and innovation. For example, commercial line deregulation typically falls short of open competition for all commercial customers. Restrictions continue to limit competition only to large customers; smaller commercial customers are considered to be at an informational disadvantage and therefore operate under continued regulation. As states move forward most competition models include a definition of “large commercial buyer” that limits the scope of deregulation.

In a sense, such efforts to limit competition minimize the benefits associated with an open market while stunting growth in the industry. Large commercial buyers may already enjoy the benefits of deregulated commercial line insurance through the use of alternative sources of coverage. As the market evolves in the wake of financial services deregulation, traditional commercial line writers face even more challenging prospects as the number of competitors and alternatives for coverage expands even further. As large commercial buyers seek new avenues that provide cheaper and more flexible risk management tools, continued form and rate regulation will restrict the choices of smaller commercial customers. Restrictions imposed by form regulation make it difficult to adapt or innovate in ways that adds value for customers.[33] To achieve the benefits of an open market, efforts should be made to expand the role for competition to all commercial buyers rather than limit those benefits to a group of consumers that already can avail themselves of the benefits of competition.

Personal lines

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.[34] 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.

It should be noted, however, that even questions of solvency may be problematic for regulators, particularly when regulators are elected officials. Political pressures may generate incentives to alter pricing in ways that distort the market. For example, in a political race there may be incentives to keep prices low. If the politically determined price is below the market price the market does not function efficiently, which can limit consumer choice and create inefficient cross subsidization practices. Alternatively, if insurance suppliers can effectively pressure regulators, efforts may be made to keep low cost providers out of the state under the guise of protecting solvency in the insurance sector. In either case, political pricing cannot match the efficiencies of market-based pricing, particularly in a sector that is commonly viewed as competitive.

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.[35] 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.”[36]

Technological and Institutional Change

Technological change in regulated industries has transformed the relationship between regulated industries and regulators. The deregulation of many industries that began in the 1970s offers the most obvious example, but questions surrounding the duties of regulators and the rights of the regulated have been explored throughout the development and industrialization of the United States. As new technologies replace old ways of doing business, entrenched industries must adapt or yield to new competitors. In the marketplace, this is the creative destruction that drives progress. In the regulated sector, however, technological change poses unique challenges because price controls limit the ability of firms to adapt to new technologies. Change requires action by both the regulators and the regulated.

The technological transformation of the U.S. economy is providing significant benefits for the insurance industry. The Internet creates new opportunities for commerce than can help both firms and consumers. But more importantly, a major component of technological change has been information management. Access to new information and new capabilities in transforming information allows underwriters to far more accurate risk assessments. In turn, this allows insurers to provide new products that are more aptly suited to the needs of their customers. For example, Progressive Casualty Insurance Company is testing a GPS-assisted usage base rate for automobile insurance.[37] Continued rate and form regulation creates a regulatory lag that makes it difficult to adopt new technologies in ways that benefit consumers.

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 differences between these markets become less distinct, it is important to reassess the existing framework to identify new avenues for establishing a competitive market.

A More Open Market for Insurance

Today, there is little economic justification for the "natural monopoly" theory that insurance only can be provided efficiently in a regulated industry. Indeed, even a historical survey of the early years of the industry finds the marketplace for insurance highly competitive. This is hardly symptomatic of anti-competitive behavior. As technology and underwriting have improved, insurers have reduced costs and identified new products that more closely fit the needs of individual consumers. Yet the current regulatory regime continues to limit the ability of insurance providers to implement these innovations in ways that help consumers.

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.


[1] For a general survey of risk management and the role of insurance, see Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk, New York (John Wiley & Sons, Inc.): 1996.

[2] Robert Crandall and Jerry Ellig, Economic Deregulation and Customer Choice: Lessons for the Electric Industry, Center for Market Processes, Fairfax, Va.: 1996.

[3] Joskow, Paul L., “Cartels, Competition, and Regulation in the Property-Liability Insurance Industry,” Bell Journal of Management Science, 1973, vol. 4: 375 - 427.

[4] Roberts for the majority Nebbia v. New York, 291 U.S. 502, 525 (1934).

[5]See Kenneth E. Train, Optimal Regulation, Cambridge: The MIT Press (1991).

[6]Alfred Kahn, The Economics of Regulation, Vol. I, Cambridge: The MIT Press (1995), p. 42.

[7]See Harold Demsetz, "Why Regulate Utilities?" Journal of Law and Economics, 1968, vol. 11, no. 1, pp. 55-65 and William Baumol, J. Panzar, and Robert Willig, Contestable Markets and the Theory of Industry Structure, New York: Harcourt Brace Jovanovich (1982).

[8]Harvey Averch and Leland Johnson, "Behavior of the Firm Under Regulatory Constraint," American Economic Review, 1962, vol. 52, no. 5, pp. 1053-1069.

[9]Harvey Leibenstein, "Allocative Efficiency vs. X-Efficiency," American Economic Review, June 1966, vol. 56, no. 3, pp. 392-415.

[10]Barry R. Weingast and Mark J. Moran, "Bureaucratic Discretion or Congressional Control? Regulatory Policymaking by the Federal Trade Commission," in Public Choice and Regulation, Robert J. Mackay, James C. Miller, III, and Bruce Yandle (eds.), Stanford: Hoover Institution Press, (1987), p. 34.

[11]For an example in the electricity industry, see Gregg A. Jarrell, "The Demand for State Regulation of the Electric Utility Industry," Journal of Law and Economics, October 1978, vol. 21, no. 2, pp. 269-295.

[12] Gordon Tullock, “The Welfare Costs of Monopolies, Tariffs, and Theft,” Western Economic Journal, 1967 first examined these costs associated with regulated industries.

[13] “Over-reaching Authority: An Analysis of Regulatory Excess,” National Association of Independent Insurers, November 1995, p. 8.

[14] 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.

[15] 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 Jerry Ellig, “Economic Deregulation and Re-regulation: Benefits and Threats,” Citizens for a Sound Economy Foundation, Washington, D.C.: March 20, 2001.

[16] George Passantino, “State Meddling, Not Deregulation Behind Electricity Crunch,” Reason Public Policy Institute,

[17] Steven Morrison and Clifford Winston, “The Remaining Role for Government Policy in the Deregulated Airline Industry,” in Sam Peltzman and Clifford Winston, eds., Deregulation of Network Industries: What’s Next?, AEI-Brookings Joint Center for Regulatory Studies, Washington, D.C.: 2000.

[18] For a survey of the evolution of the insurance industry, see D’Arcy (2001).

[19] Q & A Property-Casualty Regulation … and how state insurance regulation works, National Association of Independent Insurers,

[20] Paul v. Virginia (75 US 168)

[21] Against the Gods, p. 91.

[22] See Scott E. Harrington, “Insurance Deregulation and the Public Interest,” AEI-Brookings Joint Center for Regulatory Studies, Washington, D.C.: 2000.

[23]“ Statement of the Shadow Insurance Regulation Committee on Deregulation of Insurance Prices,” at,March 1, 1999.11

[24] 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.

[25] Stephen P. D’Arcy, “Insurance Price Deregulation: The Illinois Experience,” paper presented at the Brookings-AEI Insurance Rate Regulation Conference, January 2001, p. 11.

[26] D’Arcy, p 13.

[27] D’Arcy, p. 20.

[28] Martin F. Grace, Robert W. Klein, Richard Phillips, “Auto Insurance Reform: Salvation in South Carolina,” Center for Risk Management and Insurance Research, Georgia State University, January 6, 2001.

[29] Grace et al., p. 46.

[30] John D. Worrall, “Private Passenger Auto Insurance in New Jersey: A Three Decade Advert for Reform,” paper presented at the AEI-Brookings Conference on Insurance Rate Regulation, Washington, D.C.: January 8, 2001.

[31] Figures as of March 1999. See “Commercial-Lines Deregulation Gains Momentum Nationwide,” Best Week, March 29, 1999, Special supplement.

[32] Quoted in BestWeek, March 1999, p. 2.

[33] Richard Butler, “Form Regulation in Commercial Insurance,” paper prepared for AEI-Brookings Joint Center on Regulatory Studies Conference on Insurance Rate Regulation, January 2001.

[34] Leibenstein (1966).

[35] Osborne, D. K., "Cartel Problems," American Economic Review, 66 (1976): 835-844.

[36] Scott E. Harrington, Insurance Deregulation and the Public Interest, 2000.

[37] Progressive Casualty Insurance Company, “Progressive Awarded Second Patent for Usage-Based Auto Insurance Rating System,” press release, July 13, 2000.