Five Steps to Make Prop. 103 Work : Insurance: Any regulatory scheme must produce the same results as would competition.

When Californians voted to roll back their insurance premiums by 20% and regulate future rate changes, the nation took notice. Since then, the question has been how to administer Proposition 103 and satisfy the California Supreme Court’s proviso that the resulting rates not deny insurance companies a fair return on their investments. The test is to devise a regulatory scheme that would produce the same results as would competition.

Regulation makes economic sense only if competition fails to keep insurance premiums from escalating. If rates are high as a result of losses beyond the insurance industry’s control, regulation would probably be futile. Attempts to set rates below competitive levels would do more harm than good: Policyholders would pay the price in reduced quality, variety and availability of coverage.

Furthermore, privately owned companies should not be forced to offer insurance coverage that denies them a return on their capital equivalent to what they could earn from comparably risky investments. If so, they would partly or completely withdraw from the market by, for example, refusing to insure above-average risks. Thus, setting rates above or below levels that competition would naturally decree is likely to hurt those it intends to help--the consumers.

Whichever regulatory scheme is adopted to administer Proposition 103 must recognize that, unlike public utilities, the hundreds of insurance companies operating in California compete for customers. They do so by offering innovative services at differing costs, with varying outcomes of financial reward and punishment. That is how competition works and is supposed to work.

Future regulators must respect the variety and versatility of the insurance companies’ services and their differing results. Competition would be frustrated if service offerings were standardized, alternative capital structures discouraged, or uniform rates of return imposed. And it would be foolish not to take advantage of what competition there already is.

There are five ways the Department of Insurance could build on existing competition and use it more effectively to promote consumer interests.

--Insurers should not be forced to charge different premiums for comparable policies merely because their costs differ. Cost-plus price setting is always an imperfect instrument, though it makes some sense for single-monopoly public utilities. It makes no sense for individual competitors. Where competitors offer similar services, they should be allowed to reduce rates below their full cost, at least to meet the competition. And, within limits, they should be allowed to increase rates if lower-cost suppliers are unable to satisfy total demand and higher-cost competitors are, as a result, successfully selling insurance of comparable quality at higher rates.

--A single standard of quality should not be enforced, either explicitly or by setting uniform rates calculated on the basis of the cost of providing some standard coverage.

--To help consumers make choices, the Department of Insurance should make all reasonable efforts to inform them about the differences among competing policies and the true value and quality of extra services. Helping consumers make intelligent choices is, of course, wholly consistent with Proposition 103’s goal of encouraging effective competition, because it would help the market weed out inefficient and costly offerings.

--Companies not only should have some latitude in deciding what policies to offer, but their methods of calculating premiums also should not be precisely determined. This doesn’t mean that companies would be able to set whatever prices they wish. The Department of Insurance would still have to approve or reject their rate-hike proposals. In part, it would do so by looking at the company’s past earnings and cost projections to determine if its rate-setting method indicates an upward or downward bias. The goal is to permit the kinds of variations among companies that would prevail in a competitive market, while regulating effectively.

--Finally, the commissioner should feel free to permit rate increases, as well as decreases, within a reasonable zone--possibly within the bands of latitude stipulated in Proposition 103 as permissible without a hearing. That, too, is how competition works.