A legislative initiative called Fair, Affordable Insurance Rates (FAIR) is poised to begin gathering signatures throughout Michigan.

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1 Michigan s Flawed FAIR Legislation By Eli Lehrer A legislative initiative called Fair, Affordable Insurance Rates (FAIR) is poised to begin gathering signatures throughout Michigan. This article aims to educate citizens and policymakers about the nature of Michigan s auto insurance system and the likely consequences of the initiative. The article provides a short introduction to the way auto insurance works in Michigan, and it outlines the initiative s key provisions. It then introduces five fundamental realities Michigan citizens, policymakers, and businesses should be aware of. After the introduction, one section of the paper is devoted to each of the following five points: 1. Auto insurance in Michigan is required by the state to provide more benefits than auto insurance anywhere else in the country. These greater benefits explain why premiums are higher in Michigan than elsewhere. 2. Michigan auto insurance premiums are generally not excessive. 3. The across-the-board premium cuts promised under the FAIR proposal will not come to pass. 4. In the medium term, it s likely that auto insurance rates will go down in the city of Detroit proper and up almost everywhere else in the state if the FAIR initiative becomes law. 5. The FAIR initiative will impose massive new administrative overhead costs that insurance consumers ultimately will have to pay. Auto Insurance in Michigan and the FAIR Proposal Michigan s auto insurance system does things typical of systems elsewhere in the country and is regulated under a system that s also typical of the country as a whole. In Michigan and elsewhere, auto insurance exists to provide financial protection from injuries to drivers bodies and damage to their automobiles and to protect other drivers from financial consequences of damage caused by insured drivers. Like nine other states, Michigan settles bodily injury auto accident claims under a no fault system that typically keeps those claims out of court. (All other states use tort systems that involve more time in court.) When Michigan drivers get into accidents even when they are not at fault they almost always make claims against their own insurance company rather than the insurance company of the at-fault driver. Michigan drivers can sue another driver only if an accident causes death, serious impairment of body function, or permanent serious disfigurement one of the most restrictive standards in the country. 1 1 MCL (1) 1

2 Almost all auto policies in Michigan consist of multiple parts. The no fault portion of the policy required by law in Michigan is called Personal Injury Protection, or PIP. Other elements of a typical Michigan policy can cover damage to a driver s car caused by another driver (collision), accidents involving uninsured motorists, and car damage caused by trees, weather, or other factors besides other drivers (comprehensive). Although auto lenders almost always require collision coverage, these other coverages are not required by law and typically are not as closely regulated or subject to as much political oversight. Michigan requires all licensed motorists to carry auto insurance, and it regulates the rates drivers pay; both of these requirements are typical of the country as a whole. 2 The major laws that govern Michigan auto insurance are the Essential Insurance Act and No Fault Acts. Originally passed in 1979 (and taking effect in 1981), the laws (contained mostly in MCL ) set up a system for Michigan auto insurance that provides more extensive medical coverage than the auto insurance system anywhere else in the United States. The FAIR Initiative The FAIR proposal backed by a group that currently does not have either a Web page or a working telephone number would change Michigan s automobile insurance system significantly. It proposes two fundamental things: first, it orders a 20 percent cut in auto insurance premiums; and second, it sets up a vastly larger and more complex bureaucracy to oversee automobile insurance rates. Although large sections of the initiative largely restate current law, several points deserve particular attention. In addition to the supposed 20 percent cut in rates, major changes to current law include provisions that would: Place enormous new restrictions on insurers ability to decide which risk factors to use and ban most distinctions between geographical areas. 3 Ban discounts given on the basis of credit scores. 4 Ban discounts for people with modest incomes. 5 Bar the insurance regulators from considering competition among insurers when reviewing rates, even when doing so might result in more consumer choice. 6 Increase public access to insurance company information and decrease trade secret protections afforded to insurers. 7 2 The insurance services office, however, estimates that 17 percent of Michigan motorists go without insurance. 3 FAIR Sec 1960 (10); (11) 4 FAIR Sec 1960 (3) 5 Ibid. 6 FAIR Sec 1961 (1) 7 FAIR Sec

3 Require public hearings on many types of insurance rates. 8 Require taxpayer subsidies for special-interest groups that wish to testify at insurance hearings and impose a 100 percent tax on all insurance company advocacy activities to fund private-sector advocacy activities that find favor with the commissioner Auto insurance in Michigan is required by the state to provide more benefits than auto insurance anywhere else in the country. These benefits explain why Michigan premiums are higher than elsewhere. Although Michigan regulates auto insurance in much the same way as most states, the system has one feature that makes it more expensive than most: Uncapped personal injury protection to anyone who has auto insurance. 10 In Michigan, a driver paralyzed for life as a result of an auto accident can receive round-the-clock medical care worth millions of dollars over the course of a lifetime through his or her auto insurance policy. Needless to say, this costs a lot of money. To shield insurers own assets from the highest claims, the state requires all of them to participate in an automobile insurance catastrophe fund the Michigan Catastrophe Claims Association (MCCA). Currently, when a claim exceeds $460,000 the amount will rise in set increments until 2011 the MCCA reimburses the insurer for the claim. (Legally, the insurer remains liable.) To pay its own bills, the MCCA collects a fee of $ per vehicle (in 2009) to pay for these high-end claims. 11 For a typical Michigan resident, this represents a little more than 10 percent of the total auto insurance premium. 12 High medical claim costs outside of the MCCA force premiums even higher. In the country as a whole, the average loss cost per policy for injuries was $116; in Michigan in 2009, the average cost per policy was $311, a difference of $ Were medical benefits limited under the system, there would be no need to pay an MCCA fee, and injury-related loss costs would presumably drop to somewhere near the national average. (Although MCCA provides a reinsurance capacity for the highest automobile insurance claims, its existence alone does not cover the full difference in costs.) These benefits which people buying auto insurance in Michigan cannot refuse make policies more expensive than those in neighboring states. (See table 1.) Were the benefits reduced, premiums would drop significantly. 8 FAIR Sec 1961 and 1964, FAIR Sec 1964 (6) 10 People in the insurance industry often refer to the system as one of unlimited benefits, and insofar as no cap exists on the potential benefits, this is correct. But of course, benefits are limited to the actual costs of dealing with an injury. 11 MCCA, Purpose, 12 See insurance information Institute. Average Expenditures for Auto Insurance By State, 2006, 13 Insurance Services Office via American Insurance Association Fasttrack. Likewise, the average paid claim in Michigan stood at $32,733 compared to $8,557 in the country as a whole. 3

4 Table 1 Average Per-Vehicle Auto Insurance Expenditure Michigan and Nearby States Michigan $925 (Current) Illinois $704 Ohio $654 Indiana $631 Michigan (estimate without uncapped medical benefits) $605 Wisconsin $ Michigan auto insurance premiums are generally not excessive. Although it provides extremely plush benefits, Michigan s system is not terribly expensive for most state residents. Even though Michigan s automobile insurance rates are higher than those for other states in the region, they are not among the 10 highest in the country. (See table 2.) Table 2 Twenty States with Highest Average Per-Vehicle Auto Insurance Expenditures 1. District of Columbia $1, New Jersey 1, Louisiana 1, New York 1, Florida 1, Massachusetts 1, Rhode Island 1, Delaware 1, Nevada 1, Connecticut Alaska Maryland Michigan Arizona Hawaii California Washington Pennsylvania West Virginia Texas 820 Source: Insurance Information Institute. These statistics aren t directly comparable. 4

5 Academic research has shown no evidence that Michigan residents get overcharged for insurance. (Of course, consumers who pay for benefits they don t want may consider premiums excessive even if academics don t.) In general, academics determine excessiveness by looking for profit margins that are too high. The one comprehensive study on the topic in Michigan a 2004 Wayne State University report found the state s automobile insurance market was generally competitive and provided a reasonable number of choices. 14 With a few potentially significant exceptions relating to a small part of individuals auto policies (see footnote for a list), the study found that excessive rates were not common in Michigan. 15 While excessiveness of rates may become a problem in a market with few carriers, the reasonably large number of carriers operating throughout Michigan makes it difficult for a company to acquire very large profits over the long term. Michigan s auto insurance costs more because it provides more and, except in a few areas (see footnote 15 for a list), does not produce enormous profits for auto insurers. For the most part, Michigan auto insurers make about the same profits (in good years) and show about the same losses in (in bad ones) as carriers elsewhere. 3. The across-the-board premium cuts promised under the FAIR proposal will not come to pass. The centerpiece provision of the FAIR initiative is a 20 percent reduction in automobile insurance costs for all consumers. Although this sort of price cut may seem attractive, it simply won t work as advertised. In fact, rates may go up after FAIR passes. To cut premiums by 20 percent, Michigan auto insurers would have to be making an average return on capital of roughly 20 percent a year. Quite simply, they don t make profits of this magnitude. 16 When California passed similar legislation Proposition 103 in 1988, it ordered similar rate cuts and simultaneously instituted a similarly rigid, red-tape-filled regulatory system. After legal wrangling, courts determined that rate cuts of this size would render half of the state s largest insurers insolvent and require taxpayers to bail them out. If ordered to cut rates, insurers would simply stop selling policies in Michigan or, more likely, seek court decisions allowing them to charge higher rates. And insurers would likely prevail: It s illegal in Michigan, and everywhere else in the country, for an insurer to sell a policy at an inadequate rate that will not leave it with sufficient resources to pay likely claims. (Insurers also could raise a variety of constitutional challenges.) A 20 percent across-the-board rate cut 14 George Galster et al., The Competitiveness and Premium Excessiveness of the Home and Auto Insurance Industries in the State of Michigan, Center for Urban Studies, Wayne State University, and the Michigan Office of Financial and Insurance Services, September 30, Galster et al. do find that seven rating territories Flint Inner, Lansing Inner, Monroe, Jackson Inner, Detroit Suburban, Ann Arbor Outer, and Benton Harbor outer did have excessive rates for state-mandated coverage although not other coverages as the researchers define them. Since it relates to only part of the total auto policy, this finding may not have significant public policy implications. Nonetheless, under existing state law it appears that scrutiny might be justified in these areas. 16 Ibid. 5

6 would certainly leave at least some policies with inadequate rates. Thus courts might well order premium increases. In addition, although rates generally fell in California after the passage of Proposition 103, the one comprehensive study done on the topic (performed by a leading, independent actuarial firm and paid for by several insurance industry trade groups) concludes that a number of other factors not the regulations caused the rate reductions. 17 In most lines of insurance, rates in California changed at the same rate as rates elsewhere in the country. 18 Quite simply, the prices people pay for insurance represent the costs of selling it. While insurance companies need to make a return on their investment capital it s the only way they can attract new investments the cost consumers pay for insurance will reflect the cost of providing it. Additional competition can squeeze returns on investments, and minimal competition may sometimes allow companies to earn greater-than-normal profits. In the long term, however, competition and costs, not regulation, determine auto insurance rates. 4. In the medium term the proposal will decrease rates in Detroit and increase them almost everywhere else. For the most part, the FAIR proposal would represent a massive transfer of wealth from the state of Michigan as a whole to the residents of Detroit. Detroit residents have every reason to be concerned about automobile insurance rates. Michigan s current system of auto insurance simply does not work in the city of Detroit. A single auto policy in that city costs on average $5,072 a year more than a third of the city s average per-capita income of about $15, A house in many areas of Detroit costs less than a typical automobile insurance policy. The FAIR proposal s provisions probably will cut rates in Detroit. By making it very difficult for insurers to use geography in determining auto rates, factors such as high crime, vandalism, and fraud rates that result in high rates in Detroit will be excluded from rate calculations, and rates will fall in Detroit while rising almost everywhere else in the state. Michigan has experimented with prohibitions on territorial rating previously. The original language of the Essential Insurance Act provided the lowest base rate in the state could not be less than 45 percent of the highest, and a base rate could not be less than 90 percent of the base rate in an adjacent territory. In California under Proposition 103, urban areas saw the largest premium decreases, while most of the state saw little or no change in rates. 20 In California, however, the differences between areas were nowhere near as severe as they are in Michigan. Residents of major cities paid twice 17 David Appel, Analysis of the Consumer Federation of America Report Why Not the Best, Milliman Inc., For a user-friendly summary of the report see David Appel, Revisiting Lingering Myths about Proposition 103: A Follow-up Report, 18 American Insurance Association, Response to Commissioner Garamendi 19 Runzheimer International. via Insurance Information Institute, The Five Most Expensive and Least Expensive Cities for Auto Insurance, Philadelphia, Pennsylvania, is a distant second at $\3, Appel, op. cit. 6

7 the rates elsewhere in the state, not rates five times higher as in Michigan. The system didn t work and eventually was repealed by the legislature. Thus it s quite likely that any company delivering rate cuts in Detroit will have to raise rates elsewhere in the state. If the initiative becomes law, it will do so with an overwhelming vote in favor from Detroit and, as a result, it s quite likely auto insurers will face pressure to do exactly that. 5. The FAIR initiative will impose massive new administrative overhead costs that insurance consumers will ultimately have to pay. If it becomes law, FAIR will undermine the efficiency of Michigan s auto insurance system. It will end many types of discounts, enormously increasing the amount of paperwork, and it will funnel significant amounts of money to special-interest groups that want to testify at insurance hearings. Consumers will end up picking up the tab for these new costs through higher rates. Through its bans on many types of discounts, the FAIR initiative will undermine insurance companies rate-making methods and require them to hike prices across the board. This will happen because of the way insurance rates get made. Essentially, insurance rates are based on insurers calculations of risk factors driving record, location, credit history, age, and car type rank amongst the most commonly used and then adding a risk premium. This risk premium, ideally, provides both a return on capital for the company s owners and a fudge factor that covers uncertainty of the calculations about many risk factors. The more accurately a firm can forecast the risk factors, the more it can reduce the risk premium while earning the same (or even higher) profits. By banning the use of credit scoring which lets insurers offer discounts for people who show themselves reliable and trustworthy in financial matters the FAIR initiative will remove a tool that the Federal Trade Commission and others have found extremely useful in setting insurance rates. 21 Similar bans on the use of data about location, some traffic violations, and certain types of damage to cars may have similar negative consequences. To make up for their loss of data, insurers will almost certainly have to make across-the-board rate increases. Many consumers will lose auto insurance discounts they have received for years. The massive increase in paperwork and public hearings on insurance rates also will increase consumer costs, in two ways. First, at least at the margins, the actuaries and clerks that insurance companies have to hire to prepare the filings will produce an increase in costs that will likely end up in consumers bills. Just as importantly, the vast increases in the complexity of any rate change will make insurers far less likely to change rates either up or down. 22 When costs rise as they did during the 1980s consumers may welcome this news. However, when costs and 21 Federal Trade Commission. Credit-Based Insurance Scores: Impacts on Consumers of Automobile Insurance, Federal Trade Commission, July, 2007, Based_Insurance_Scores.pdf 22 Sharon Tenyson et al. Automobile Insurance Regulation: The Massachusetts Experience, in David J. Cummins (ed.) Deregulating Property-Liability Insurance. AEI-Brookings Joint Center for Regulatory Studies, 2002,

8 rates fall, as they have for two straight years in Michigan, insurers will be extremely reluctant to cut rates. Finally, the FAIR proposal promises major subsidies to any special-interest group that wins favor with the insurance commissioner. One particular section should raise eyebrows and is worth quoting in full: (6) The Commissioner shall award reasonable advocacy and witness fees and expenses to any person who demonstrates that the person represents the interests of consumers and makes a substantial contribution to the adoption of any order, rule, or decision by the commissioner or a court. When such advocacy occurs in response to a rate application, the award shall be assessed against and paid by the applicant. 23 (7) The Commissioner shall provide that insurers pay fees or assessments sufficient to cover administrative and operational costs arising from this chapter and kept in a restricted fund. The commissioner shall create an entity to receive and disburse funds to any group as described in subsection (6). The commissioner shall assess the industry based upon an amount equal to the prior years lobbying expenses and campaign finance donations. The insurance industry shall be required to pay the assessment imposed by the commissioner. Taken together, these provisions create a massive fund for the insurance commissioner that he or she can distribute to just about anyone. Presumably, any groups of citizens that buy insurance can be taken to represent the interests of the consumers and, under this law, would be able to get any amount of money the insurance commissioner chooses to hand out. To stock this fund, the legislation places a 100 percent tax on any advocacy activities insurers engage in for the sake of their stockholders, employees, and policyholders. By definition, this provision will double the amount of money spent on the politics of insurance and, quite possibly, make the insurance commissioners position a very politically powerful job. Most likely, of course, politically favored groups will get the great bulk of the consumer advocacy money. Right-of-center think tanks and business groups might receive these subsidies when a Republican controls the insurance commissioner s office, whereas left-of-center groups such as ACORN and labor unions might get such subsidies under Democratic administrations. All of these groups have a potentially useful role to play in debates over insurance policy, but there s no reason that the insurance industry (and ultimately all consumers) should be required to pay massive new taxes into the pockets of the insurance commissioner s friends. Conclusion Michigan residents, particularly those who live in Detroit, have many reasons to want changes in Michigan s automobile insurance system. The Fair, Affordable, Insurance Rates initiative, however, does not appear to live up to its name. 23 FAIR 1964 (6)(7) 8

9 Although provisions in FAIR that increase the openness of certain aspects of insurance company ratemaking and clarify certain types of good driver discounts may deserve consideration by the legislature, the overall proposal ought to raise serious questions in the minds of Michigan residents. Although it promises lower rates, FAIR would very likely increase consumer costs everywhere in the state except Detroit. While full of language that may appear consumer-friendly at first blush, the initiative as written would eliminate many discounts and greatly increase the political sway of the insurance commissioner. Although it has a certain political appeal, FAIR would hurt Michigan. Anyone thinking of lending support to FAIR should think long and hard about the proposal s numerous and irremediable flaws. Eli Lehrer (elehrer@heartland.org) is a senior fellow of The Heartland Institute and director of its Center on Risk, Regulation, and Markets. 9