Insurance Industry Fouls Its Own Nest

Last year, just as they had done in 1976, insurance companies dramatically raised the cost of liability insurance for businesses, doctors, local governments and others. Or they simply refused to provide coverage at any price.

And, as also was the case almost a decade earlier, the industry claimed that huge jury awards and a litigation “explosion” had left it with no choice but to raise rates and cancel policies.

Yet judges and juries did not get stingy in the intervening years. Nor did the number of lawsuits decline.

Rather, insurance premiums rose dramatically in 1976 and 1985 due to the cyclical nature of the insurance industry. Insurers cut their prices when interest rates, and thus their income from investing the premiums that they collect, are high. They raise rates when interest rates, and thus investment income, are low. They overreact at the top and bottom of the cycle.

In 1981, for example, with both interest rates and the rate of return on equity running near 20%, insurers were “begging for business, at any price, to get premium dollars to invest,” according to the president of a large New York insurance brokerage. Insurers even wrote policies for those harmed in the Las Vegas MGM Grand Hotel fire--after the disaster occurred. They believed they would earn more by investing their premiums immediately than they would lose by paying out claims in the future.

Today, on the other hand, interest rates have declined. The industry finds itself paying claims on policies that were written back in the days of hyperinflation, when its rates were too low. So, just as it did in 1976, the industry substantially raised rates--by an average of 72% for general liability policies--and reduced coverage. Meanwhile, the index of property/casualty-insurance stocks rose by 50%--almost twice as much as the Dow Jones industrial average.

To flatten out the insurance cycle, and thus bring down insurance rates and prevent sharp increases in the future, Congress should do the following:

--Subject the insurance industry to the antitrust laws, thus preventing insurers from acting in concert to raise prices. Since 1945 the McCarran-Ferguson Act has allowed insurance companies to fix prices, while price-fixing in other industries is punishable by up to three years in jail.

--Create a federal office of insurance to monitor the industry and establish standards for state regulators to follow. Although insurance is a national, $310-billion business, accounting for 12% of our gross national product, only the states regulate the insurance industry. Because state insurance commissions are often understaffed (half the states have no actuaries to analyze rate filings) and have a “revolving door” relationship with the industry (state insurance commissioners typically come from and return to the industry), state regulation has not always protected the public.

--Repeal the insurance industry’s exemption from Federal Trade Commission jurisdiction. In 1979, after the FTC published a study critical of the life-insurance industry, Congress prohibited the agency from ever again studying--let alone prosecuting--any sector of the insurance industry. There is no principled justification for this exemption.

--Expand the Risk Retention Act, which allows manufacturers--but not other businesses such as day-care centers and nurse-midwives--to join together to buy insurance at a lower rate. This would preempt state laws prohibiting such group buying. Automobile owners, for example, who must now buy insurance individually, could reduce their premiums by 10% a year by buying in groups.

--Establish a national reinsurance program to be funded by the insurance industry. Reinsurance is insurance for insurance companies: The insurer pays the reinsurer a premium, and the reinsurer agrees to share the risk with the insurer. The reinsurance market is dominated by Lloyds of London. Because neither the federal nor state governments effectively regulate Lloyds, American insurers have no recourse when the British firm raises its rates, as it did last year. An American reinsurance program would compete with Lloyds and exert downward pressure on reinsurance rates, which in turn would enable insurers to reduce their rates.

It is the insurance industry, not the legal system, that is most in need of reform. Placing limitations on jury awards will not bring rates down. Ending insurance rate cycles will.