By Martin Grace
Last week Evan posted the views of Allen Adomite, a tort reformer from the Illinois Civil Justice League, and then he posted his response. In Evan’s rebuttal he stated that everyone seemed to forget the role of the insurance companies in the medical malpractice crisis. Some particular problems that are often mentioned in criticizing the med mal insurance industry are:
- Insurers have poor investment performance and they are raising premium rates due to their mismanagement
- Insurers are colluding and raising prices
- Business practices of insurers cause high prices
Jay Angoff, the former Commissioner of Insurance for Missouri, provides a nice summary of the medical malpractice problem from the insurance point of view in Trial Magazine.
So, what is really going on here? Is it the insurers or is it something else?
Investment performance of an insurer is critical to how much an insurer charges. This is because insurers take premiums and invests them in the market (usually in the high quality bond market). If interest rates fall, then interest income falls. Since 9/11 even the insurers with the best investment staff and portfolios saw their investments decline. Investment income reductions are a reason that insurance prices are higher, but one needs to understand that when investment income is higher -- prices are also lower. When interest income is high no one argues that premiums should be raised. The thing to note is that all investors suffered losses over this period and that the insurer’s investment practices (due to regulatory restrictions and common sense) tend to be conservative. It’s not investment practices that caused the current problem.
A second potential criticism is insurers are colluding to set rates. Many states already regulate insurance prices and many have state antitrust laws that apply to the insurance industry even if the McCarran-Ferguson Act severely limits the law’s application to the business of insurance. One may argue about the degree of enforcement, but it should be pointed out that a major player in almost every state is the physician owned mutual. In fact, one the largest for-profit players in the market (St. Paul), left the market due to losses. In each of the last three med mal crises it appears that more of the for-profit insurers have left leaving a handful of national firms and a larger number of not-for profits remaining in the states to write medical malpractice. It seems illogical for physicians to sit around the table and figure out ways they can charged themselves more for medical malpractice insurance. Mr. Angoff does not believe insurers collude, but there is no real economic incentive to do so. Collusion is not the problem.
Now we get to business practices. This is an area pointed out by Mr. Angoff that has some meat to it. The problem he brings up is somewhat technical but I believe is the crux of the issue, but not exactly in the way he portrays. Mr. Angoff’s point is that while insures are not always subject to Generally Accepted Accounting Principles (nationally traded companies are), they are subject to statutory accounting (SAP) principles. SAP allows companies much discretion in determining how much they set aside in reserves to pay for future losses. So if you are a company that is risk averse you are likely to charge more to avoid the possibility of a bankrupt causing judgment against one (or more) of your insureds.
The way Mr. Angoff presents this issue it is as if the insurers did this to create a crisis. His evidence is that reserves are going up but payouts are not. This is important because reserves are not exactly correlated with payouts as they exist for future, not current, payouts. If the insurers expect higher payouts in the future, then they will reserve more. Current reserves have nothing to do with current payouts as payouts are based on events that occurred sometimes 2-3 or more years ago. A rational mutual medical malpractice carrier looks at the future to set rates. If there is an increase in the number of multi-million dollar awards, then the rational insurer will increase rates. I believe that insures are focusing on caps and the like to provide certainty. When losses are certain, then it is easier to price. An insurer does not need to over-reserve when it can forecast the future more accurately. The insurers do not create crises.
Well what does this all mean? To the extent that jurors can not give consistent judgments it makes it difficult for insurers to price medical malpractice insurance. If we look at the tort reforms they tend to be focused on the parts of the litigation process that yields the most risk to the defendant. First, of course, are the damage caps (see Rand Study). By limiting damage awards the risk of a new landmark judgment is reduced. Similarly, by making it harder to sue (through ex ante expert affidavit requirements, for example) the law suit lottery risk is reduced.
Finally, do tort reforms have an effect? It appears that tort reforms do not cause malpractice premiums to decline immediately, although some have. However, I don’t think there is enough economic evidence to make (peer reviewed) conclusions about this statement partially because it is not clear that tort reform will stick in a given state. Thus insurers, especially non-profit medical malpractice insurers, cannot bear the risk of adverse judgments and will over-reserve until they are certain the risk of “record setting” lawsuits is reduced. Insurers won’t know for many years whether a tort reform will be upheld.
Economics does not prohibit insurers from making mistakes, nor does it preclude insurers from being risk averse. However, insurers do not necessarily have incentives to make the problems worse. I believe the problems of the immediate crisis are due to a combination of low interest rates, high reinsurance prices, and an increased perception of risk of higher record breaking lawsuits.
About the Author: Martin Grace is a Professor of Risk Management and Insurance and a Professor of Legal Studies at Georgia State University. He can be found regularly in Atlanta and on his blog RiskProf.