Rhetorical Heatwave Envelopes California

No one will ever mistake Insurance Commissioner John Garamendi for Theodore Roosevelt, physically or philosophically.   Still, there is a strong temptation to invoke TR-centric clichés such as "big sticks" and "bully pulpits" in pondering the Commissioner's latest moves in his ongoing dispute with the insurance industry over automobile rate regulation.*

Looking for a Certain Ratio

Displeased with the industry's publicity campaign against his proposed regulations, the Commissioner has unleashed a multi-front assault featuring his own press releases, and the threat of further public hearings and additional regulation, to compel insurers to reduce rates in both personal auto and homeowners insurance markets. 

The main fusillade comes in a Press Release issued today:

Commissioner John Garamendi Discloses Apparent 'Excess Profits' by Homeowner and Auto Insurers

SACRAMENTO – Today, Insurance Commissioner John Garamendi released a new report on the burgeoning profitability of Homeowners and Private Passenger Automobile Insurance companies.  The study discloses that for the past two years insurance companies have enjoyed a scenario in which the amount they pay for claims has dwindled, while the money they keep has soared.  The Commissioner has scheduled a hearing for July 20, at which he will examine this issue.  The following is his statement:

'For the past two years homeowners and automobile insurance companies in this state have profited immensely at the expense of consumers.  A new study from my office shows that the more money these companies keep from your premiums, the less they pay out in claims.  In my view, Californians are due for a break.  If my understanding of these results is confirmed by my full review and hearing, I am confident that I will be ordering a significant number of insurers to reduce their rates. . . .'

The study to which the release refers bears the benignly non-argumentative title, "Lower Claims, Higher Profits: Where Do Your Premium Dollars Go?" [PDF].  It does not, however, answer the question that its title poses, and gives a very incomplete picture of "profits" of any kind, let alone "excessive" profits.

The focus of the study is on the "loss ratio" reported by various insurers.  The loss ratio for a given period of time is calculated by dividing the insurer's earned premium in to the sum of claims or losses paid and claims-related expenses incurred in that period.  A loss ratio of .67, for instance, indicates that $.67 of every $1.00 of earned premium was spent paying or adjusting claims.

While a lower loss ratio improves an insurer's odds of being profitable, it does not tell the entire story.  In addition to the cost of claims paid on its policies, an insurer must also carry the additional costs of selling, underwriting and administering those policies.  If an insurer went an entire year without having a single claim, it would still have to bear those expenses; the premium received would never, even in the most claim-free year, become "pure profit" because those underwriting expenses would still be incurred.  Those expenses -- the costs of doing business other than loss-related costs and any dividends paid to policyholders (by a mutual insurer) -- are reflected in the "expense ratio," calculated by dividing the earned premium into the total of non-claim/non-dividend expenses.

To more accurately assess profitability, we need to look to the "combined ratio," in which the loss ratio is added together with the expense ratio (and the dividend ratio, if applicable) to provide a total overview of how much of each premium dollar is consumed by necessary costs generally.  If a company's combined ratio is a number less than 1.00, there is something left over the technical term for which is "underwriting profit"; if the ratio is greater than 1.00, then more than one dollar of every premium dollar is being consumed by costs and the insurer experiences an "underwriting loss." 

As exemplified in the charts and statistics in this article and elsewhere, combined ratios of less than 1.00 are the exception, rather than the rule, in the property/casualty insurance business.  Of course, insurers can still wind up ahead, and often do, thanks to their investment income, but profitability based solely on the amount charged to the consumer for the product, the insurance policy, is a relative rarity.  This is especially true with a product such as auto insurance, in which each insurer's policy is largely identical in coverage to every other insurer's policy, so that "low price" becomes the primary point of competition among insurers.

Maybe, just maybe, it is true that the industry is reaping "excessive" profits based on "overcharging" for auto or homeowners policies.  Whether or not that is the case, looking only at loss ratios as the Commissioner's report does, rather than the broader picture provided by combined ratios and other statistics, will not provide the answer to that question -- and the Commissioner should be clever enough to know it.

• [UPDATE 05/27/06:  Doug Simpson on his always excellent weblog, Unintended Consequences, cross-references Commissioner Garamendi's allegations while providing an overview of the issues that are raised by accusations of "excessive" profits in general, with a particular focus on the FTC's recent report on claimed "price gouging" in petroleum markets.  Read it here: "FTC Post-Katrina Gas Price Study Useful Re Other Market-Driven Industries."]

A Pro-Garamendi Editorial Cuts Both Ways

Even before today's Press Release, the Commissioner had added a number of links on the Department of Insurance home page responding to the industry's publicity campaign.  Among them is a page collecting editorials that favor his proposed regulations.  One of them, from the Modesto Bee of March 14, begins in a questioning vein:

What should be the most important criteria for determining how much you pay for auto insurance?

Most people believe their rates should be based on three things: Driving record (tickets, accidents, etc.), miles driven (do you commute or just go for groceries?) and driving experience.

That's why voters passed Proposition 103 in 1988, making those the most important criteria in setting prices for auto insurance.  That proposition should have forced insurance companies to change the way they do business.  But it didn't. . . .

I suspect insurers, too, would "believe" the driving record, etc., should be the primary factor in pricing their product -- if driving record gave an accurate indication of the risk being undertaken.  Unfortunately, the potential for an automobile to be lost, damaged, involved in an accident, etc., is dependent not just on the Very Excellent Driver who owns it, but also on the Not-So-Excellent Motorists with whom that driver shares the road and the Persons With Honesty Issues who might attack it or steal it.  The bigger picture comes out further down the page, where the ModBee editorialist writes:

The insurance companies are making some scary claims about how Garamendi's proposed changes will affect rural ratepayers.  They say the new rules will force rural residents to pay more for insurance so that city residents can pay less.  Such arguments are supposed to resonate in places such as Modesto and Turlock.

That's unlikely.  Modesto's ZIP codes are well-known to the National Insurance Crime Bureau, which compiles the auto-theft rankings that Modesto has led for the past two years.  The commissioner's office and the industry each did actuarial studies, which concluded that drivers in only five California counties would see rates go down; Stanislaus [County, in which Modesto is located] was one of the five.

So it seems that even supporters of the proposed regulations agree: No matter what they tell you in the movies, "believing" in a thing doesn't make it so.

* Organization, Man

* Administrative Note: Rather than provide post-by-post links to earlier Decs&Excs coverage of these issues, I have launched a new archive category, "Politics of Insurance - Campaign 2006," in which the continuing saga of Commissioner Garamendi, automobile rate regulation, the 2006 statewide election cycle and related hurly-burly can be followed blow by staggering blow.