Continuing the Med-Mal Debate: Insurance as a Whipping Boy?

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.

Comments

[Rufus]

I know very little about the med mal lines of business, but wouldn't it pay to take a look at the combined ratios of med mal insurers in order to determine whether they are gouging doctors on premiums or whether the premiums are sufficient to cover their losses? In other words, if med mal insurers tend to have a combined ratio of over 100, and in particular over 105, then I think there is a strong argument that premiums are fairly set to cover what they're paying out. And, indeed, perhaps doctors are even getting a break. If the combined ratios are between 95 and 100, then you could argue that the system is in balance, i.e., premiums are sufficient to cover the losses and to allow for a small underwriting profit prior to investment profit, which is where both sides of the equation -- insurers and insurerds -- should want to see the system. But if the combined ratios are under 95, then maybe plaintiffs lawyers have a point, high premiums are caused by insurers attempting to take large underwriting profits.

[Martin]

You have a point, but many of the largest players are non-profit companies owned by the doctors. So why do they charge themselves high premiums? I think they do it because they are afraid of a judgment against the company that is an order of magnitude higher than they currently can conceive. If losses don't increase in the future, then the doctors get a dividend for the unneeded premium plus some low rate of interest. So, mutual med mal insurers are really sensitive to perceptions (rightly or wrongly) about the litigation environment.

Note the question is answered differently if we are talking about for profit insurers. If losses do not materialize, then the profits go to the shareholders. However, for-profit companies do not seem to think this is a good business and they charge a higher premium too for the risk they believe they are bearing. It will take 3-10 years to really discern whether policies written this year are profitable. What would be interesting to do (from an academic point of view) is to go back to the crisis of the mid 80's and look at the long term profitability of those contracts. However, I think there are fewer for-profit companies writing this business and that suggests firms did not think it was a profitable line.

[Prof. Yabut]

Why would physicians in doctor-owned med-mal companies charge themselves high rates? Maybe to "prove" a crisis exists in order to get damage caps enacted. As you state, Martin, the reserves built up with high premiums will either be needed in the future or paid back to the doctor-owners as dividends. What do they have to lose?

With few insurers in each market, oligopoly interdependence would then allow the for-profits to piggy-back on the high premiums without fear of losing market share to the non-profits. [and you thought economists were cynical!]

[innerstation]

As for a company owned by doctors not having a motive to charge excessive premiums, the point that is not raised is that while the company may be owned by SOME doctors, it sells insurance to ALL doctors. Those stakeholder doctors certainly have a profit-motive. I assume that those stake-holder doctors are also going to be older, wealthier (and therefore less impacted by higher premiums)than the doctor population as a whole. Sure they may pay a more for their premiums, but what does that matter against larger capital gains and dividends?
Do you think the proposed reforms came from doctors? I doubt it. It is more likely that they were developed by lawyers (who represent doctors and insurers). Why would these lawyers have any interest in proposals that would have a negative financial impact on the legal industry (both plaintiff and defense attorneys)? What is their "economic incentive"? My guess is that it is because THEY are being paid to do it (or maybe they are just trying to 'do the right thing').

"Record Setting" Jury Awards & CAPS:
What does it matter to an insurer if a jury awards $150 million if there is only $1 million in coverage? What does it matter to a millionaire doctor if the jury awards $5 million or $50 million? Woudn't the bankruptcy be the same either way? How will CAPs improve the situation? Is it just because doctors would purchase lower limits policies? This is not entirely a rhetorical question - I really don't know, but I compare it to criminal law.
Courts convict innocent people (I've read it in the paper), some of those people spend incredibly long periods of time behind bars (horrible). To discourage this from happening, we should put Caps on the length of prison sentences (unless they cause economic damage). Does that make sense?

[Ted]

Rufus writes: if med mal insurers tend to have a combined ratio of over 100, and in particular over 105, then I think there is a strong argument that premiums are fairly set to cover what they're paying out. And, indeed, perhaps doctors are even getting a break. If the combined ratios are between 95 and 100, then you could argue that the system is in balance, i.e., premiums are sufficient to cover the losses and to allow for a small underwriting profit prior to investment profit, which is where both sides of the equation -- insurers and insurerds -- should want to see the system. But if the combined ratios are under 95, then maybe plaintiffs lawyers have a point

Rufus: the combined ratio for med-mal insurers in 2003 was 137.5. Once you pick your jaw off the floor, I'm curious what conclusions you derive from this.

To be fair, I think your equilibrium numbers are too low; though I don't know for sure, I strongly suspect that a med-mal insurer can be reasonably profitable with a combined ratio of 105 and maybe even 110 in a better investment environment. I defer to Martin's expertise there.

"Innerstation" misunderstands the nature of a mutual insurance company: a mutual is owned by the policyholders. So it's all doctors selling insurance to all doctors: if there are profits, they are rebated to the policyholders.

"Innerstation" also misunderstands the risk that an insurer faces if there is a jury award greater than the amount of coverage. Many states allow the plaintiff to then go after the insurer for "bad faith refusal to settle" for the difference in the policy coverage and the amount awarded. In other words, large lottery awards, even if technically they're not subject to coverage, (1) pose real risks of loss to insurers; and (2) create settlement pressure to settle at the amounts of the policy limits to avoid the risk of a second second-guessing jury finding the refusal to settle was in bad faith. (One could argue that this is perhaps another place where reform is appropriate.)

Yabut's conspiracy theory works only if market entry is exceedingly difficult. It's also inconsistent with the empirical evidence of for-profit insurers leaving the market and the combined ratios I discuss above. Premiums are high because losses are high.

[Rufus]

Thanks, Ted. In the casualty world, a combined ratio of 137.5 would be a good predictor of a future insolvency. I know at some companies that I might perhaps maybe a little familiar with there is a real expectation of a combined ratio under 100 and if it's over 100 heads roll. That number for med mal insurers indicates to me very poor underwriting or a lot of unexpected high claims. And remember, med mal policies are usually written on a claims made basis, which is suppossed to allow the underwriters to more accurately set premiums because there are fewer long tail exposures. Of course, there may be other explanations, such as bad claims handling or poor controls of hard costs. Regardless, I do interpret a combined ratio of 137.5 as a sign of poor health in the industry unrelated to the lack of investment profit.

[Martin]

Innerstation, medical malpractice mutuals are owned by every doctor with a current policy. Every doctor who pays premiums are equitable owners of the company. That is the (simple) legal definition of the mutual. There are likely some types of med mal companies that are owned by some physicians and sell to others. These would be stock for-profit companies. There are also some mutuals that have stock subsidiaries. Insureds of the stock subsidiary are not owners of the mutual parent. This is mildly confusing except for the fact that most physician mutuals are relatively simple mutual companies. (I just noted that Ted cleared this point up above).

Prof. Yabut asks an interesting question. Why not charge yourself more, create a crisis, get tort reform, and then get your money back anyway? Well, it turns out that Ted's other point about entry is important. If there are low barriers to entry, then if the mutuals charge people too much, doctors would rather have the lower premium and would choose from a competitive contract offer. One of the problems in Georgia is that no one wants to enter and there are people with all sorts of crazy (from an economics persepctive) plans to try to get more med mal insurers in the state. This suggests to me that for profit companies see no profit in the Georgia market. The reason they see no profit in Georgia is the same reason the domestic mutual charges high prices: Risk.

I believe that med mal has significant barriers to entry and this has to do with the ability to set proper actuarial prices. It has become more difficult to do so and this deters entry. This is not a barrier to entry caused by the incumbent, but one caused by the state's mal practice environment.

[E L Eversman]

It seems to me that some of the med-mal and tort reform debates occur in isolation. The greediness of plaintiffs and their lawyers are the cause of high premiums according to the popular cant. However, there are clearly interrelated issues that undergird some of the litigation which never seems to be brought to light.

For example, I believe a good deal of the med mal lawsuits would never be brought if health insurers would butt out of the business of medicine and get back to the business of insurance (what ever that may be a la McCarran-Ferguson). It seems that physicians are often hamstrung in practicing medicine and follow the dictates of insurers about which tests they can/should order, which prescriptions to write because it might not be covered by the patient's carrier, and a bunch of other silly hoop jumping administrative nonsense that detracts from their real jobs.

If doctors could go back to just practicing medicine, and we stopped allowing insurers to engage in acts that seem to me to be the unauthorized practice of medicine, I suspect we would see a rise in quality health care and a decrease in malpractice suits.

[Ted]

Eversman's argument is falsifiable: are patients who are members of HMOs more likely to suffer malpractice than those who aren't? I vote for the null hypothesis myself. Outside of John Grisham novels, there just aren't an appreciable number of incidents (if any) where HMOs required doctors to perform below the applicable standard of care. If anything, evidence is that the problem is the opposite one of too many unnecessary tests being run.

Another problem is, as doctors will happily tell you, the majority of malpractice lawsuits involve cases where no malpractice has taken place, so even if Eversman's theory that health insurers cause too much malpractice, it wouldn't solve the malpractice liability problem.

[Matt]

Medical Economics has a fair look at the issue here:

http://www.memag.com/memag/article/articleDetail.jsp?id=141338

[James]

Tort reform has not properly addressed the problem(s) of the ever increasing medical malpractice premiums, despite the fact that mostly all insurers have benefited greatly from an increased slowdown in the number of claims. The increasing medical malpractice situation will not be resolved until the industry and regulators properly address the other, apparently more important factors pusing premiums higher.