Anyone to can who buy testify drives liability to a car, automobile the and high is cost prudent insurance, of this enough kind of insurance. In parts of our country, premiums in excess of $200 a year are not uncommon, and every year increases in these premium rates are almost as regular as clockwork. Most people, of course, see this as one of the inevitable effects of inflation. What, after all, doesn’t cost more these days? And the insurance industry, for its part, can give very compelling reasons for the necessity of the rate increases: the rising accident rates, high jury verdicts, the increase in cost of medical and hospital treatment and of car repair. In fact, the insurance companies are prepared to show that nearly every year they have lost money writing liability insurance, and that the rate increases they request are merely what they need to stay solvent. So it would seem that the high and rising liability insurance rates are justified. Or are they? How are the casualty insurance companies actually doing? As of fact the insurance in-
As a matter of fact the casualty insurance industry has never had a year in which it has lost money on its total operations. The reason is very simple. Although the principal function of a casualty insurance company is to provide insurance for its policyholders, insurance companies are to a large measure sell-financing. Investment earnings and appreciation of their investment assets play a vital role in the industry’s phenomenal growth. An insurance company, although it needs claims adjusters, attorneys, a clerical staff, and office space, has, nevertheless, a low overhead and does not require investment in machinery or real estate to carry on its business. Therefore, it invests most of the money it takes in as premiums, usually in stocks and bonds, and its main profit comes not from the selling of insurance, but from investment income. The insurance companies are virtually all in excellent financial shape. When they cry about their losses, they are talking about their losses from underwriting insurance. Their total operations show huge profits.
When a casualty insurance company sells you an auto policy, it receives a premium from you as payment for its acceptance of a possible future financial obligation. One day you may be in an accident, and the insurance company will have to pay up. But in the meantime, the company puts your money in a reserve required by state law called the “unearned premium reserve,” together with money received from other policyholders. This reserve money is invested in stocks and bonds, including tax-exempt bonds. These stocks and bonds pay dividends, and the stocks increase in value. This profit from the reserve monies can be reinvested in more stocks and bonds or can be used, for example, to build an office building containing the company’s offices and excess office space rented out to other firms. Eventually, in theory, the bulk of the unearned premium reserves will be returned to you and the other policyholders in the form of claims settlements, but in the meantime the insurance companies have received handsome profits from the use of this money. And these huge profits need not be reported to the state insurance commissions when the companies are seeking a rate increase.
There is another way insurance companies make profits on policyholders’ money. Suppose one of the company’s insured is in an accident which is his fault, and the other party brings a claim for injury. At the time of the accident, of course, the insurance company doesn’t know the amount of the claim or how much they will have to pay out in the end. But informed by their client of the accident and their possible liability, the company makes a preliminary investigation and estimates the amount of money it will eventually be required to pay. The amount is put into a “loss reserve.”In addition, the company estimates the cost of settling the claim and puts this money in a “claims adjustment reserve.”If, for example, it estimates the claim at S2000 and the claims expense at $500, $2500 is immediately charged as an expense against present income, even though this money is still in the company’s hands and is earning interest. The total of the “loss” and “claims expense “reserves of all auto insurance companies amounts to more than one half of the unearned premiums reserve—approximately $2 billion.
This makes up a sort of trust fund for the accident victims, but the interest earned here, like that of the unearned premium reserve, is not used in rate determination either. Nor does this interest end up in the hands of the victims for whom the money is held in trust. The rule in nearly every state is that the legal rate of interest will run only from the date of judgment, not front the date of the accident. Thus, if the amount put in the loss reserve was set at $2000, and the case was settled two years later for the same amount, the insurance company has earned $160 on this money at 4 percent interest, actually reducing the amount they have to pay the accident victim. Four percent of the $2 billion total loss reserve is SSo million. The insurance companies are making a huge amount of income from investing this interest.
How much money do the insurance companies earn on these reserves: the unearned premium reserve, the loss reserve, and the claims expense reserve? We are not talking about profits or investment income on any past accumulated profits (earned surplus) of the company, or about the appreciation of the assets, but only about profits on reserves that the insurance companies obtain because they are doing present business and holding in trust the money of their present policyholders.
The answers are startling. According to a brief filed on behalf of the AFL-CIO opposing a rate increase in Ohio in 1967, “the size of the investment gain by insurance companies on the reserves for un earned premium and loss reserve over the ten-year period 1956-1965 is $8,125,511,360.” This amount accounted for 45 percent of the increase in net worth from all activities of the companies. The other 55 percent, according to Charles K. Leslie, an insurance consultant, was made up of gains from underwriting insurance ($3.2 billion— 19 percent) and from investing capital ($5.9 billion—36 percent).
In another estimate, Senator Philip A. Hart, chairman of the Senate Antitrust and Monopoly Subcommittee, which investigated the auto insurance industry, stated in a speech to an insurance group in Chicago in October, 1968, that the net investment income of auto insurance companies from 1958 to 1967 was more than $7 billion. Senator Hart remarked, “When someone turns one pocket inside out to show you how empty it is, but has $7 billion in the other pocket, it is difficult to take their claim of poverty too seriously.” He concluded that the automobile insurance system needs a “rather basic overhaul.”
To take just one year, in 1967, auto premiums totaling over $10 billion were sold. If all this had been invested in municipal bonds, the investment income in one year at 4 percent would have been $400 million and there would, moreover, be no federal taxes on that sum.
How to Make Money While Seeming to Lose Your Shirt
Ignoring the profit from reserve funds when making public their financial picture is not the only way in which the insurance companies let it appear that they are losing money. They have an accounting procedure straight out of Alice in Wonderland, an ingenious system that makes it seem that they are losing the most money at the very time they are enjoying the greatest increase in business.
There are, in general, two accepted ways to show income and expenses. One method is called the cash method; the other is the accrual method. The cash method is quite straightforward: when cash income comes into a company, it is declared income when received, and expenses are declared when money is spent by the company. This is true even when the income may impose some future obligations on the company or when the expenses of the company may give it some privilege in the future.
A much more widely used method of accounting is the accrual method. Under the accrual method, income is regarded as income only when earned, not when received; expenses are apportioned in the same way. The cash method gives a more accurate picture of when money was actually received and spent by a company; the accrual method gives a truer picture of when a company’s income is actually earned, and for this reason the majority of companies use it. But both methods used properly give the same results.
The casualty insurance industry is unique; It uses a “combination method” of the two. The insurance companies accrue one twelfth of the premium you pay for insurance, and put the remainder in the unearned premium fund, while at the same time they charge all their expenses on a cash basis against their income. Naturally, they will show a loss. For example, if on December 1, 1968, an insurance company wrote a twelve-month policy, with an annual premium of $120, and paid an agent’s commission of 20 percent and 15 percent for other expenses in connection with writing the policy, the company’s books would look as follows if it closed its books on December 31, 1968:
December 31, 1968 Profit Computation
Income (1/12 of $120) $10.00
Sales Commission 20% $24.00
Additional Expenses 15% 18.00
Total Expenditures in Writing Policy $42.00
Underwriting profit or loss ($32.00) loss
Although the company wrote a new policy on December 1, 1968, and took in $120, by its unique accounting method, it shows a $32 loss. And as long as it keeps increasing its business each year, it will show a loss. The beauty of the system is this: the more that business increases year by year, the more money the company would seem to be losing. The defense that the insurance companies might make is that they are merely following state law, which specifies that premiums are earned by the company proportionately as each day passes. That portion of the premium which is not earned is required to be set aside in the unearned premium reserve.
The key point is, however, that the insurance industry is not making the losses it claims on auto insurance. In fact, many companies are making a profit. The only way they show a loss is by failure to make an adjustment on their annual statement which would reflect the 35 percent profit that their unearned premium reserve contains. This results in an understatement of profit from their total operations of approximately 6 percent. Some companies do make this adjustment on the annual statement to their stockholders, but the adjustment is rarely the full amount. As Senator Philip A. Hart stated in a speech in October, 1968, stock property and casualty companies reported an underwriting loss of $713 million from 1958 to 1967 under one accounting system, while under another, profits of $413 million were indicated.
Furthermore, it is of interest to note that Section 832(b) of the Internal Revenue Code allows a stock casualty company to report and tax its income on the combined accrual basis for income and cash basis for expenses. In addition, only 15 percent of dividends are taxed, and long-term capital gains are taxed at 25 percent. Considering the huge amounts of money in the reserves which are not currently taxed, the effective federal tax rate for such companies is only 4 percent. This results in a tax windfall of hundreds of millions of dollars annually.
Determining Insurance Rates
The fact that the automobile insurance industry uses a misleading method of accounting and ignores profit from the investment of their various reserve funds has some very important consequences for the insurance buyer.
Insurance companies, like public utilities, operate under supervision of state commissions. In order to raise their rates within a state, they must apply for, and in most states justify, the increase before the state’s insurance commissioner. Most of the insurance companies feed their individual statistics to organizations known as rating bureaus, which then compile the overall statistics and appear on behalf of the insurance industry in the various states whenever from their computations a raise in rates seems justifiable. They are the insurance industry’s agents for getting higher insurance rates, and they have served their principal exceedingly well. In Michigan, for example, from 1964 through 1968, the rating bureaus were successful in obtaining five increases in liability premiums, raising rates more than 58 percent. In fact, the average price of auto insurance rose from December, 1963, through December, 1968, by 30.3 percent, while the overall consumer price index rose less than half that amount—that is, 15 percent. In many parts of the country, insurance premiums have risen by more titan 50 percent. A 1967 congressional investigation found that the premium on liability coverage for a family car (driven occasionally by an eighteen-year-old son) increased between i960 and 1966 by 90 percent in Sacramento, 107 percent in Indianapolis, 128 percent in Lansing, and 134 percent in Des Moines. And one minor accident can up these increases substantially. Of course the insurance industry could argue that these increases in the cost of auto insurance are merely the reflection of the skyrocketing medical costs, auto repair costs, and average weekly earnings. But as Senator Philip A. Hart stated in a 1968 speech, “Since 1957, insurance premiums have risen nearly one third more than medical costs, average weekly earnings, and automobile repair costs.”
Let us picture the scene of an auto insurance rate hearing. We enter a small hearing room in a state office building. Behind a table sits the Commissioner of Insurance or one of his deputies who will decide the matter. The representatives, often attorneys of the rating bureaus, argue for the increased premiums. To substantiate their claims, they have brought with them documents which run into hundreds and sometimes thousands of pages, containing numerous charts, diagrams, statistical tables, and so on. But there is no attorney there to represent the public, cross-examine the people who prepared the documents, and ask on what basis they were prepared. The consumer is completely left out. Is it any surprise that the rating bureaus always obtain rate increases? From October, 1965, to October, 1966, insurance rates were increased in approximately forty-five states, usually without an open hearing. For example, prior to December, 1965, the Maryland Insurance Commissioner had no reason to hold an open hearing on a rate increase matter. No one had ever demanded an open hearing. The same was true in Maine until July, 1966.
The rating bureaus use a very complicated rate formula to justify their requests for rate increases. Simplified, the formula demands that earned premiums exceed all expenses by 5 percent, including claims paid, an estimate of unsettled claims, underwriting expenses, and claims expenses. In other words, the rating bureau on behalf of the insurance companies demands of the state commissioner that he take their own often exaggerated estimate of unsettled claims, ignore the income derived from the investment of reserve funds, and raise rates to the point where the companies will receive a 5 percent additional profit.
Here is an example of the way premium dollars are budgeted for rate purposes:
Sales, General, and Administrative
Profit and Contingencies 5%
Losses and loss expenses
(including estimates of future losses and claim expenses) 65%
If losses exceed 65 percent, the excess reduces stockholders’ surplus. Therefore, whenever losses exceed 65 percent, the rating bureau files for additional rate increases. The insurance companies are allowed a constant 30 percent for expenses regardless of the total premiums they write. This would seem not to encourage efficiency but on the contrary would be an open invitation to keep expenses at the allowed level even where they could be easily reduced. Another way to look at this is that with costs allowed at a constant 30 percent whenever losses exceed 65 percent, t lie insurance company’s 5 percent pure underwriting profit is reduced. Therefore, the rating bureaus seek an increase to keep their underwriting profit at the 5 percent level.
The Investment-Income Squabble
The battle over investment income from portions of the unearned premium reserve and loss reserve has been going on for a long time. It stems from a 1921 ruling by the National Association of Insurance Commissioners, known as the 1921 Profit Formula. The formula, which was specifically concerned with fire insurance, included the following statement: “No part of the so-called banking profit (or loss) should be considered in arriving at the underwriting profit or loss.” This principle has been applied to all lines of insurance. The typical approach of the industry is presented in a paper entitled “Investment income in Rate Making,” written by Fred H. Merrill, president of Firemen’s Fund American Insurance Companies. Mr. Merrill sets the tone of his argument at the outset:
In recent months, an old and well-settled question has been raised repeatedly by a group of self-appointed protectors of the public interest:
“Should investment income be included in insurance rate making?”
The occasional resurrection of this complex question-each time as if it were a new concept—can have but one purpose, to confuse public thinking about the overall and profound subject of the true reasons behind the industry’s struggle to obtain adequate rates.
Time and time again over the last half-century, the industry has demonstrated to practically everyone’s satisfaction that investment earnings have no place in insurance rate making.
It is difficult to comment on such a statement. Just who is practically everybody?
Recently, as the pressure has grown greater for the inclusion of investment income in the rate formula, the insurance industry has looked for more sophisticated support of their position. In 1967 the American Insurance Association paid $150,000 to Arthur D. Little, Incorporated, for a study on whether investment income should be used in the rate formula. The study used a great many “scientific” statistics to come to the “surprising” conclusion that investment income should not be used in the rate-making process, and that 99 percent of corporate profits were higher than those in the insurance industry. The “Little Study” supported all the claims of the insurance industry.
Meanwhile, an independent study of the insurance industry was commissioned for $1200 by the Senate Antitrust and Monopoly Subcommittee which held hearings in July, 1968. The subcommittee hired two statistics professors, Richard Norgaard and George Schick of the University of Southern California Graduate School of Business Administration. Their study concludes that the insurance companies are making “exceptional profits” despite their claims to the contrary. They found that the insurance companies have greater riskadjusted profit rates than 90 percent of the 641 major American corporations sampled. Professor Norgaard said these findings “are diametrically opposed to those recently reported by the American Insurance Association”—in the “Little Report” —although the same basic data were used. As Professor Norgaard explained while testifying before the Senate subcommittee hearing in July, 1968, “The difference in results came about because of the techniques to measure and interpret the data. . . . Insurance companies are sufficiently different from other companies that the traditional methods of determining profits do not apply.” The study concluded:
It is [our] unqualified opinion that major property and liability insurance companies have earned a high rate of profits over the last 15 years. . , . Tbe large, multiple-line underwriters and the companies which specialize in automobile insurance are making exceptional profits.
The New Jersey Battleground
New Jersey best illustrates how clearly the battle lines are drawn and to what lengths the insurance industry will go to fight any change.
In a landmark ruling in February, 1968, New Jersey’s former Commissioner of Banking and Insurance, Charles Howell, denied application for a 20.6 percent rate increase filed by two rating agencies. Mr. Howell had approved six auto insurance rate increases in the last ten years. This denial came after the first full public bearings in New Jersey’s history, with the public’s interest being represented by an attorney, a public defender, appointed by the state.
The commissioner ruled that investment income and unearned premium and loss reserves should be included in determining profits. In addition, profits on “excess limits” coverage beyond New Jersey’s basic coverage limits of $10,000/$20,000 bodily injury liability and $5000 property damage liability were required to be included. On the basis of data submitted by the public defender, Commissioner Howell found that the companies were not entitled to the 20.6 percent increase requested and granted them only a slight increase.
The casualty industry has declared war on the commissioner and the citizens of the state of New Jersey. Horace J. Bryant, New Jersey’s Deputy Insurance Commissioner, has stated:
The insurance companies are determined to teach New Jersey a lesson so that no other state insurance department will ever dare to do what New Jersey has done. Commissioner Howell has opened up a challenge to the whole theory of rate-making, and they want to close it fast before somebody else gets the same idea. The whole retaliating campaign by the industry is that simple.
The industry has been using two main weapons in its campaign:
1. Restrictive and arbitrary underwriting. It is estimated that since Commissioner Howell’s denial of the auto premium increase, over 50,000 cancellation notices have been sent to motorists, business people, and homeowners. This figure is based on almost 2500 complaints which have come into the commissioner’s office since the rate decision. Officials estimate that they receive only 5 percent of the total complaints.
2. The consent to rate procedure. New Jersey’s unique “consent to rate" procedure is permitted under a 1962 New Jersey law which allows motorists with poor driving records to obtain adequate coverage, rather than being forced into the Assigned Risk Pool, where only the minimum of liability coverage, 10/20/5, can be purchased. Under this law, a motorist can obtain the coverage he desires but must first sign that he is willing to pay a higher premium. The insurance industry has used this procedure to get around Commissioner Howell’s decision. During 1967 there were 25,051 consents; in 1968, 50,995, approximately 85 percent of them for auto insurance policies. The motives of the insurance industry are clearly seen in the words of a memo one company sent to its agent:
These [consent rates] represent rates which in our opinion are actually commensurate with present day exposures. Most rates will be higher by about 20% than those found in manuals.
This, of course, is almost the exact amount of the premium increase denied by Commissioner Howell.
New Jersey Representative William T. Cahill summarized his views of the conduct ol the insurance industry before the Senate Antitrust and Monopoly Subcommittee in July, 1968, as follows:
What is in my judgment so sinister about this de facto withdrawal of property and casualty insurance in New Jersey is the united front presented by the industry members. With thousands of apparently acceptable motorists being turned down, not one company has breached the line drawn by the industry. Again, I am persuaded by the situation that such concerted retaliatory effects present a tacit conspiracy in restraint of trade.
A second, greater, victory came on April 28, 1969, when the Virginia Supreme Court of Appeals unanimously overturned an auto liability insurance rate increase granted in 1967 by the State Corporation Commission. The court directed the commission to hold new hearings in the case. It held that the commission erred on two or three major points appealed by the opponents, the Virginia AFL-CIO and a group of Virginia legislators who intervened on behalf of motorists, led by Norfolk Senator Henry E. Howell, Jr., now a Democratic candidate for governor. The court held “that the Commission should consider income from investment of the loss reserve, as well as from investment of the unearned premium reserve, as a ‘relevant factor’ in fixing a ‘reasonable margin for underwriting profit and contingencies.’ ”
The main credit for stemming the battle thus far goes to T. Grayson Maddrea, a C.P.A. from Richmond, Virginia. Mr. Maddrea has personally testified at hearings in Virginia, Maryland, Maine, Arkansas, Ohio, Oklahoma, and other states to stop the unjustified rate increases. Members of the American Trial Lawyers Association who often represent plaintiffs in personal injury cases have filed briefs to oppose rate increases in some states. The AFL-CIO has appeared in numerous states, including Ohio and Texas, to stop the rate increases. But the important, point is this: though stopping the rate increases in itsell is an important step, only four states as of this writing have set any new printiples for the determination of auto insurance rates. Maryland, Virginia, Pennsylvania, and New Jersey now require investment income from the portion of the unearned premium reserve that represents polityholders’ advance payments to be used in the rate formula. New Jersey and Virginia are the only states to include earnings on the loss reserve. (New York also takes investment income into account, but New York’s law is unique because it omits the word “underwriting" us a definition of “profit” in its rate regulatory act.)
In the meantime, the insurance industry has been conducting a nationwide campaign to have states adopt “file and use” laws to control rate regulation. Under these, the insurance companies just file with the state their proposed rate increases, and they automatically go into effect. Theoretically, the state reviews them and can disapprove of the increase and require the companies to refund the increase to their policyholders. This, however, rarely happens. Under these laws the entire question of investment income would become moot, since companies would be free to use whatever criteria they thought justifiable in setting their own rates. Instead of the insurance companies having to justify their increase, the burden is placed on the public to show that the increases aren’t justified. Fourteen states presently have some form of “file and use” statute, and the industry is quietly working to have these laws adopted nationwide.
To summarize: investment income from the “loss reserve" and a portion of the “unearned premium reserve” should be incorporated in rate-making because it is money earned on funds placed with the companies by their policyholders for future liabilities. The only practical way this investment income can be returned to policyholders is by using it in the determination of future rates. I am not talking a about the investment of any company’s past profits or about the appreciation of the stocks which may rise and fall as a result of market conditions. If the investment income were used in determining rates, there would be no need to have rates rise again. But nothing will be clone about rising insurance rates until an informed and insistent public demands it.