The Impact of Rate Regulation on Claims:
Evidence from Massachusetts Automobile
Insurance
Sharon Tennyson
Department of Policy Analysis and Management
Cornell University
st96@cornell.edu
Richard A. Derrig
Opal Consulting, LLC
Richard@derrig.com
CAS Spring Meeting
Quebec City, Canada
June 16-18, 2008
Impact of Rate Regulation
AGENDA

Regulation and Competition – The Rationale and the
Reality

A Little Theory and Practice

Auto Insurance: Brookings/AEI Case Studies

The Case of Massachusetts

Implications for California
Why (now) Do States Regulate P-C
Insurance Rates?

Automobile insurance

Homeowners insurance

Workers compensation insurance

Medical malpractice insurance

Mandatory or socially desirable
insurance

Uninsured parties shift financial
risk to others in society

Some consumers face high prices

Some markets experience price
shocks
Rate Regulation as Redistribution

Not equally practiced in all regulated states or lines
 Some
regulated states lightly regulate voluntary market rates
 Residual market rates are regulated in all states and lines

Implications of redistribution
Price subsidies for some consumers



To high risk consumers From low risk consumers
To high risk consumers From insurance company capital
To all consumers From insurance company capital
Efficient Redistribution?

Not Likely:
Not Sustainable

The Problem:
Competitive Market Forces

Attempts to move prices a significant distance from
competitively-determined prices will distort market functioning



Company responses to regulation
Consumer responses to regulation
Regulator responses to the responses
Efficiency Consequences: Supply

Rate suppression distorts insurance supply
 Decreased
writing of voluntary coverage
 Reduced innovation and quality of service
 Reduced entry of firms
 Increased exit of firms

Rate uncertainty distorts insurance supply
 All
of the above effects
 Price stickiness and market volatility
Efficiency Consequences: Demand

Rate subsidies distort consumer behavior:

Insurance demand
 Increased
demand from high risk consumers
 Decreased demand from low risk consumers
 May cause low risk consumers to forego insurance

Safety incentives
 Prices

are less responsive to changes in losses/risk
Claiming incentives
 Prices
are less responsive to changes in losses/risk
Implications

Stringent regulation of insurance rates produces
unintended effects:
 Reduced competition
 Higher cost inflation
 Lower insurance availability
 Greater

market volatility
Regulated outcomes may even be contrary to the
regulatory objectives pursued
What is the Empirical Record?

On average and over the long run, rate regulation has
little effect on average loss ratios (Harrington, 2002)
 Not
necessary for market functioning
 Creates uncertainty and costly compliance

In states and markets where rate regulation is
stringently applied, empirical studies find effects
supportive of theory

In states and markets where stringent rate regulation is
dismantled, empirical studies find effects supportive of
theory
Evidence from Massachusetts

State regulation of private passenger auto insurance
rates has created widely-recognized market problems
 Exit
of insurance providers, especially national firms
 Small number of suppliers
 Larger than normal residual market at times
 Cost inefficiencies
 Politicized ratemaking environment

Less recognized problem: In the aggregate,
regulation drives overall claims costs higher
Table 1
Major Regulatory Changes, 1970-2000
Massachusetts Private Passenger Automobile Insurance
Year
Regulation
1971
Nofault auto insurance effective
1975
State rate-setting extended to all auto coverages
1977
Competitive rate-setting allowed
1978
State rate-setting reinstituted
1989
Automobile Insurance Reform Law effective
1991
Insurance Fraud Bureau began operation
1996
Competitive Discounts and Deviations begin at -7.4%
2006
Competitive Discounts and Deviations stabilize at -1.7%
2007
Competitive rate-setting allowed 4/1/08
Table 2
Direction of Subsidies by Driver Class and Territory Compulsory Insurance Coverage
2004
Experienced
Classes
Non-Boston Territories
Boston Territories
Inexperienced
Classes
Business Classes
Average
Premium
$527.15
$1,220.54
$500.67
Average
Subsidy
-$26.00
$138.29
-$46.43
Cells
Subsidized (%)
12.50%
42.71%
6.25%
Average
Premium
$813.33
$1,434.04
$751.98
Average
Subsidy
$253.77
$520.09
$32.30
Cells
Subsidized (%)
64.65%
72.73%
36.36%
Table 3
Massachusetts Private Passenger Automobile
Historical Summary of Industry Discounts/Deviations
Annual Change in
Discount
Year
Average Discount
1996
-7.4%
1997
-9.2%
-1.8%
1998
-9.2%
+0.0%
1999
-6.5%
+2.7%
2000
-5.5%
+1.0%
2001
-3.0%
+2.5%
2002
-2.2%
+0.8%
2003
-1.9%
+0.3%
2004
-1.7%
+0.2%
2005
-1.8%
-0.1%
2006
-1.7%
+0.1%
2007
-1.7% est'd
+0.0%
Source: Automobile Insurers Bureau of Massachusetts
Impact of Rate Regulation on Claims:

First Cut: State-level data on average loss costs
 50
states
 1972-1998 (before and after Massachusetts effective
subsidies)

Hypothesis: Massachusetts’ loss costs will be
higher than otherwise predicted during period
of stringent regulation
Impact of Rate Regulation on Claims

Second cut: Massachusetts town-level data on
loss cost levels for 5 coverages
 360
towns
 Biennial data 1999-2007

Hypothesis: Loss cost growth higher in
subsidized towns than in other towns
State Data
Figure 1: Average Annual Loss Costs per Insured Car
Massachusetts vs National Average
600
(Losses Incurred/Written Car Years)
500
400
National Average
300
Massachusetts
200
100
0
72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98
Year
Impact of Rate Regulation
State by State Estimation
DATA: 1972- 1998 NAIC
Coverage Variations
Demographics
Regulation
METHOD: Panel Data Regression Models
Ln(Liab. Loss / W Car Years)
State Regression Estimates
Lst = ß0 + ß1CSYearst + ß2MAsCSYearst + γ’Xst +
ß4StateRegsst + ß5StateRegsstCSYearst + as + Tt + εst
CSYears = 1978-1998 or 1978-1995
Test ß2 > 0
Control variables = traffic density, cost of hospital stay,
per capita income, rate regulation, nofault, PIP limits,
compulsory insurance minimums
as and Tt are state and year fixed-effects
Adjust S.E. for arbitrary heteroskedasticity and for
arbitrary correlation within state
State Estimation Results
Explanatory Variable
MA x CS Years
CS Years Dummy
Reg x CS Years
Nofault x CS Years
R-squared
N
CSYears 78-98
CSYears 78-95
0.3781 ***
0.3663 ***
0.1543
0.1101
-0.0807 ***
0.0523 ***
0.0291
0.0181
0.1097 ***
0.0418
0.0338
0.0260
0.0114
0.0046
0.0316
0.0245
0.8742
0.8769
1334
1334
State Regression Estimates
Lst = ß0 + ß1CSYearst + γ’Xst + ß4StateRegsst +
ß5StateRegsstCSYearst + as + Tt + εst
Estimate identical model specification without MA data
or MA interaction term
Apply estimated coefficient vector to Massachusetts
variable values, 1972-1998
Obtain predicted value of Massachusetts loss costs for
each year
Compare Actual – Predicted value
Actual – Predicted Losses
Actual Losses Incurred vs Predicted Losses from Regression Model:
Massachusetts 1972-1998
150
Prediction difference
100
50
0
72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98
-50
-100
-150
Year
Actual Loss - Predicted Loss
Impact of Rate Regulation on Claims:
Second Cut

Panel of Massachusetts town-level data on loss cost
indices for 5 coverages from AIB
 360
towns
 Biennial data 1999-2007
 Pure premium index
 Average class rating factor

Hypothesis: Indices will grow faster in subsidized
towns than in other towns
Town Data - BIL
Figure 2: BIL Pure Premium Index Growth
Subsidized vs Unsubsidized Towns
(1999=1)
1.06
1.04
1.02
Index
1
0.98
0.96
Unsubsidized Towns
Subsidized Towns
0.94
0.92
0.9
0.88
1999
2001
2003
2005
Rating Year
Source:
Automobile Insurers Bureau Filings on Territories and Actuarial Notices on Subsidies
2007
Impact of Rate Regulation
Town Level Estimation
DATA: 5 coverage Town Data
AIB Territory Filings
Rate Subsidies All Years
Town Index – Bayesian Estimate/
Class Normalized (ACRF)
METHOD: Regression Models on Town
Relativity Growth
Town Regression Estimates
%ΔPPit = ß0 + ß1Subsidyit-τ + ß2PPit + ß3%ΔACRFit +
ß4%ΔExposuresit + ß5%ΔDensityit + ß6Bostoni + Tt + εit
Use subsidy from year in which losses were generated
Test ß1 > 0
Adjust S.E. for arbitrary heteroskedasticity and for arbitrary
correlation within state
Pure Premium Growth Estimates
BIL
Lag subsidy indicator
0.0717
PIP
***
0.0220
Lag pure premium
R-squared
0.0566
PDL
***
0.0112
COL
**
0.0277
COM
***
0.0206
0.0184
0.0061
0.0088
-0.0105
-0.0035
-0.0284
0.0192
0.0076
0.0083
0.0101
0.0114
0.0396
0.0794
0.0625
0.0701
0.0841
-0.0598
F-statistic
2.95
N
1439
***
***
19.22
1439
***
7.54
1439
***
7.51
1439
***
0.0134
***
***
-0.0616
8.90
***
***
1439
Standard errors appear below the coefficient estimates, and are adjusted to allow for arbitrary heteroskedasticity and for arbitrary correlation in errors across years within
Impact of Rate Regulation
California Auto Territories




PROP 103 (1989) Driving History Emphasized for Relative
Pricing; Mandatory and Optional Classes
April 2006 Change: Territory must be less “important” than
Mandatory Prop 103 Factors: Annual Mileage, Driving
Safety Record, Years Licensed
Implementation gradual; full for 7-1-08
Effect yet to be seen but moves away from cost-based
must introduce Mass-like subsides varying by insurer
Rural to Urban, High Income to Lower Income,
High Cost to Low Cost
Impact of Rate Regulation
California Auto Territories


April 2006 Change: Optional Territory Frequency and
Territory Severity (and 14 others) must each be forced to
be less “important” (less relativity weight) than Mandatory
Prop 103 Factors: Annual Mileage, Driving Record, Years
Licensed
DOI Study Showed 3 Scenarios that implied:
Increases for 53 of 58 Counties (High +37%,Low 1.3%)
Decreases for 5 of 58 Counties (High -0.5%,Low -12%)
LA Zips (High – 6%, Low -11%),
Beverly Hills Zips (High -10%, Low -23%)
Corr Prem to LossPP, (Current 0.75, New 0.725 to 0.62)
Papers

R.A. Derrig and S. Tennyson (2008), The Impact of
Rate Regulation on Claims: Evidence from
Massachusetts Automobile Insurance, www.casact.org,
Spring Meeting, Quebec City, Discussion Paper
Program.

S. Tennyson (2007), Efficiency Consequences of Rate
Regulation in Insurance Markets, Networks Financial
Institute Policy Brief,
www.networksfinancialinstitute.org
References (Excerpt)
Automobile Insurers Bureau of Massachusetts, Actuarial Notice -2: Subsidies in the
Rates, Boston, MA: AIB. Various years.
Automobile Insurers Bureau of Massachusetts, 2006, AIB Recommendations for 2007
Private Passenger Automobile Insurance Territory Definiitons, MA DOI Docket
R2006-03, May 15.
Blackmon, B.G. Jr. and R. Zeckhauser, 1991, Mispriced Equity: Regulated Rates for
Auto Insurance in Massachusetts, American Economic Review, 81: 65-69.
Burnes, N.S., 2007, Opinion, Findings, and Decision on the Operation of Competition in
Private Passenger Motor Vehicle Insurance in 2008, Massachusetts Division of
Insurance Docket No. R2007-03, July 16.
Conger, R.F., 1988, The Construction of Automobile Rating Territories in Massachusetts,
Proceedings of the Casualty Actuarial Society, 71: Part 1, 1-74.
Derrig, R.A.,1993, Price Regulation in US Automobile Insurance: A Case Study of
Massachusetts Private Passenger Automobile Insurance 1978-1990, The Geneva
Papers on Risk and Insurance, 18: 158-173.
Derrig, R.A., and Hilary N. Rowan, 2006, Written testimony of The California Farm
Bureau, California Department of Insurance, Proposed Amendment of Title 10 of
California Code of Regulations, Section 2632.8 – Optional Auto Insurance Rating
Factors, CDI File #RH 03029820.
DuMouchel, W.H., 1983, The Massachusetts Automobile Insurance Classification
Scheme, The Statistician, 32: 69-81.
Rottenberg, S., 1989, The Cost of Regulated Pricing: a Critical Analysis of Auto
Insurance Premium Rate-Setting in Massachusetts, Boston: Pioneer Institute for
Public Policy Research.
Tennyson, S., 1997, The Impact of Rate Regulation on State Automobile Insurance
Markets, Journal of Insurance Regulation 15: 502-523.