Insurance Price Deregulation: The Illinois ExperienceStephen P. D'ArcyProfessor of FinanceUniversity of Illinois at Urbana-ChampaignPresented at theInsurance Rate Regulation ConferenceBrookings InstitutionJanuary 2001Revised: May 14, 2001This paper analyses the effect of the absence of an automobile insurance rate regulatory law in Illinois. The author is grateful for the support of the Brookings Institution and the American Enterprise Institute on this project. The author wishes to thank Robert Litan and David Cummins for their support and guidance on this project. Other individuals who have provided assistance with this project include Rep. Shirley Bowler, Martin Grace, Anne Gron, Scott Harrington, Robert Heisel, Roger Kenney, Rodger Lawson, Phil O'Connor, Judy Pool, Gary Ransom, Dick Rogers, Sharon Tennyson and attendees at the AEI - Brookings Conference on Insurance Regulation. Any comments or suggestions on this paper would be greatly appreciated. Please do not quote from this paper without the written permission of the author.Contact information: Stephen D'Arcy, 1206 S. Sixth St., Champaign, IL 61820 Telephone: 217-333-0772 E-mail: [email protected] insurance market represents a valuable laboratory for analyzing the effect of regulation since the states have primary responsibility for insurance regulation and a variety of different approaches are taken by the various states. Illinois is the only state that does not have a law regulating auto insurance rates. Thus, Illinois represents a unique model of rate regulation for automobile insurance. This chapter reviews the history of insurance regulation to document how this situation developed, explains the role of insurance regulation in Illinois and then tests a variety of competing theories of regulation to determine what can be learned from this state. In summary, the insurance market functions quite effectively and economically in Illinois, indicating that rate regulation is not necessary to ensure the availability of automobile insurance at reasonable prices. 1I. IntroductionOne of the primary advantages of state regulation of insurance is the opportunity this presents for experimentation with different forms of regulation. Most of these experiments are planned, in which a state adopts aspecific form of regulation in order to accomplish certain specified goals. Others are more serendipitous, where the exact form of regulation was not specifically intended. This is the case in Illinois, where there is currently no specific rating law applicable to auto insurance. How this situation arose, how the current system operates and the effectiveness of allowing competition to determine auto insurance rates will be covered in this chapter. However, first, a brief review of the history of insurance regulation is necessary to provide an understanding of the circumstances that led to theIllinois experience.II. History of Insurance RegulationInsurance regulation arose in this country long before the Federal government became actively involved in regulatory activities, and even before the United States was formed. An early example of regulation was the charter granted to Ben Franklin's Philadelphia Contributorship for the Insurance of Houses from Loss by Fire in 1752 by the Commonwealth of Pennsylvania. This charter provided specific requirements that the company had to meet and served as a form of regulation by legislation.1 The lag between the payment of a premium and the receipt of services, combined 2with the contingent nature of the services, created a situation in which regulation was felt necessary for the consumer to be at all assured that the promised benefits would, in fact, be paid. In most cases, the regulation simply required the insurer to publish financial information to allow policyholders to ascertain the company's financial condition. In addition to being a benefit to consumers, regulation also helped insurers. By providing some assurance that the insurers were able to stand behind their promise to pay benefits, insurance became a more valuable, and salable, product.In colonial days, the formation of stock companies was restricted to limit competition with Crown corporations. For this reason, the early charterswere issued only to mutual insurers. This restriction ended upon independence. In 1794, Pennsylvania issued a charter to the first stock insurance company, the Insurance Company of North America, which was another example of regulation by legislation. More general statutory reporting requirements that applied to insurance companies, as well as otherfinancial institutions, were enacted in Massachusetts in 1807 and New York in1827. These regulations, though, were aimed at promulgating information, not regulating rates.2Insurance regulation provided the opportunity to tax the industry, both to cover the cost of regulation as well as to support other governmental functions. The first tax on insurance in the United States was levied by Massachusetts in 1785, in the form of a stamp tax.3 The first premium tax, which is the common current form of taxation, was enacted by New York in 31824.4 In addition to raising revenue, taxation was used to protect local insurance companies. Massachusetts again instigated this activity in 1827 with a 10 percent premium tax on insurers not domiciled in the state. Eight states, including New York, responded with similar legislation.5 The New Yorkpremium tax rates were 10 percent on insurers not domiciled in the state, but zero for domestic insurers.6 Illinois enacted a law in 1844 that taxed the total premiums of out of state insurers.7 By 1996, premium taxes paid by insurance companies in all states totaled $9.1 billion, a figure well in excess of the cost of regulation.8 The dominant form of property-liability insurance prior to the early twentieth century was fire insurance. One notable feature about this risk during this period was the propensity for fires to become catastrophes, with devastating losses occurring in New York (1835), Chicago (1871), Boston (1872) and San Francisco (1906). Due to the regional nature of many early insurers, in part fostered by protectionist regulations, the catastrophic losses led to significant insolvencies among insurers and fire insurance was generally unprofitable over the period 1791 to 1850.9 The New York fire of 1835 demonstrated the problem of New York's protectionist tax laws, as 23