Underwriting Strategy and Underwriting Cycle in the Medical Malpractice Insurance Industry

Transcription

1 Underwriting Strategy and Underwriting Cycle in the Medical Malpractice Insurance Industry Yu Lei Barney School of Business University of Hartford 200 Bloomfield Ave. West Hartford, CT Phone: Mark J. Browne 975 University Avenue Madison, WI Phone: (608) Fax: (608) July 2012 To be Presented at the 2012 American Risk and Insurance Association Meeting Preliminary draft. Please do not quote without permission. 0

2 Underwriting Strategy and Underwriting Cycle in the Medical Malpractice Insurance Industry ABSTRACT Even though underwriting cycles have been extensively studied, one area seems to receive little attention. This article fills the gap by examining whether medical malpractice insurers underwriting strategy exhibits any cyclical behavior. Our analysis of the NAIC data indicates that some aspects of malpractice carriers underwriting strategy do show certain degrees of cyclical nature and they display trend that seem to be opposite that of the combined loss ratio in medical malpractice insurance, which we use in this study as a measure of the underwriting cycle. We find that when insurers underwriting performance worsens, there are fewer insurers offering medical malpractice, there are more exits than entries, insurers are less geographically concentrated in selling malpractice, and the significance of malpractice in terms of this line s premium share declines. Moreover, when we look at which states in which malpractice carriers do business, we see that the percentage of safer states (states that have caps on general damages or patient compensation funds) in which insurers write malpractice and the percentage of insurers that choose to do business only in safer states are both negatively associated with the combined loss ratio of the medical malpractice insurance industry. Taken all together, it seems that at the industry level, insurers underwriting performance has a negative association with their risk taking behavior in terms of how much to focus on malpractice line of business and where to write such business. Less focus on malpractice and wider distribution of malpractice products are seen to accompany worsened underwriting performance. We also test whether the capacity constraint theory can help explain the cyclical nature of medical malpractice insurers underwriting strategy. We find that when the total surplus of all single-line insurers (those only selling medical malpractice) shrinks, insurers are less likely to go single-line. We observe the same trend when we examine single-state insurers (those selling medical malpractice in just one state) and ONLY-CAP- State insurers (those selling medical malpractice only in states with caps on general damages). In other words, our results provide some support for the capacity constraint theory which predicts an inadequate capacity will shrink insurance supply. 1

3 INTRODUCTION It is well recognized that many property/liability insurance markets exhibit cyclical nature. Soft market periods, where prices are low and coverage is abundant, are followed by hard markets, where prices are high and coverage is scarce. Medical malpractice insurance, which provides coverage against professional liability for health-care providers, is a great example of the recurring soft and hard markets. Over the past several decades medical malpractice insurance has experienced periodic performance crises evidenced by rising premiums and decreasing supply of malpractice carriers. Even though underwriting cycles have been extensively studied, previous literature usually focuses on the cyclical behavior of prices, premium growth, underwriting performance (loss ratios or combined loss ratios) or insurance availability. On the other hand, most research on medical malpractice insurance crisis concentrates on the causes of price volatility during hard markets. This paper intends to examine one little-studied area of the medical malpractice insurance market. We will examine malpractice insurers underwriting strategy during the underwriting cycle and see if it exhibits any cyclical behavior. If so, we want to see whether the capacity constraint theory can help explain such phenomenon. This paper makes contribution to both the underwriting cycle study and the medical malpractice insurance literature by focusing on various aspects of insurers underwriting strategy. When the insurance industry swings from soft (or hard) to hard (or soft) markets, it is natural for insurers to re-evaluate and adjust their underwriting strategy to gain a competitive hold. It is likely the underwriting cycle causes changes in underwriting strategy, but it is also plausible for the modified underwriting strategy to have an impact on the depth and length of the underwriting cycle. It is not this paper s intention to discuss how the two-way feedback works. We ll instead try to identify if there is any cyclical pattern in insurers underwriting strategy during the medical malpractice insurance cycle, which we will measure using the malpractice industry s combined loss ratios. Insurers underwriting strategy could encompass many aspects. For instance, in response to medical malpractice crises, do insurers establish tighter claims frequency and severity standards for potential insured health care providers? Do they increase deductible amount and/or decrease the policy limit they re willing to insure? Do they choose to exclude certain high-risk specialties to cover? Ideally, we d like to explore how insurers adjust their underwriting strategy in reality. Unfortunately, we do not have such information available. 2

4 Instead, we ll utilize the National Association of Insurance Commissioners (NAIC) database and focus on the following things which we call underwriting strategy in our paper. First, do insurers choose to enter or exit the medical malpractice market? Lei and Browne (2008) study malpractice insurers entry and exit during the period of and find that exits are less frequent in states where there are caps on general (noneconomic) damages. We extend their study by looking at how insurers move in and out of the market in accordance with the underwriting cycle. Second, when insurers do choose to enter the malpractice market, how much do they want to focus on the malpractice line of business? Do they want to devote the entire business to malpractice or do they also write other lines of business? In other words, we want to examine how the significance of medical malpractice (which will be measured by malpractice line s premium share) changes in accordance with the underwriting cycle. Third, where do insurers sell medical malpractice? Do they write malpractice in just one state or multiple states? When they go multi-state, how do they allocate malpractice premiums across states? Fourth, do insurers choose to sell malpractice in safer states? In response to malpractice crises, many states enacted tort reforms (such as caps on awards for non-economic damages) and/or created alternative mechanisms (such as joint underwriting associations and patients compensation funds that provide coverage for substandard risks or limit an insurer s loss exposure on catastrophic claims). These efforts are intended to reduce the claims cost as well as the uncertainty associated with them. In this paper, we call states with either caps on general damages or patient compensation funds safer states. Viscusi and Born (2005) find that many tort reforms help reduce losses, lower premiums, and enhance insurer profitability, with limits on noneconomic damages being the most influential in affecting insurance market outcomes. Lastly, do insurers choose to insure more physicians or hospitals? Or do they choose to specialize in covering just one type of health care providers since different policyholders have different risk implications? It is not hard to imagine that these various aspects of insurers underwriting strategy, namely, entry and exit, geographic concentration of malpractice business, significance of malpractice line of business, distribution of malpractice business between safer states and less safe states (those without tort reform measures in place), and choice of prospective policyholders to cover, will have different implications on firms performance. Different strategies may have their own comparative advantages and will likely affect insurers differently. 1 We 1 There is not much study on the underwriting strategy mentioned here yet. The few available studies on geographic diversification and product diversification produce mixed results. Liebenberg and Sommer (2008) find that single-line property-liability insurers consistently outperform multiline insurers. Elango et al. (2008) discover that performance advantages associated with product diversification are contingent upon an insurer s degree of geographic diversification. Their results indicate that a highly diversified product profile with low geographic diversification is associated with the highest performance. Insurers that have relatively low 3

5 do not intend to evaluate the effectiveness of insurers underwriting strategy in this paper, but rather we will show how they change in the underwriting cycle. In the next section, we discuss our data and definitions of medical malpractice insurers. We generate two samples for our empirical study and we offer a brief overview of the samples in the same section. In the next five sections that follow, we show how the above-mentioned five aspects of insurers underwriting strategy, namely, entry and exit, geographic concentration, significance of malpractice line of business, distribution of malpractice business between safer states and less safe states, and choice of prospective policyholders to cover, evolve as the underwriting cycle unfolds. We then test the capacity constraint theory in the subsequent section. In the last section, we summarize our findings and conclude the paper. DATA AND DEFINITION OF MEDICAL MALPRACTICE INSURERS We utilize the NAIC property/casualty data to conduct our research. Since our focus is the underwriting strategy of medical malpractice insurers, we need to define such carriers in the first place. A natural response is to include all insurers that report positive direct premiums written in medical malpractice. We call the resulting sample Large Sample. This sample includes all possible medical malpractice insurers, yet some of them report to the NAIC even after they have stopped selling new policies. They continue to report positive premiums from existing relationships, but are not truly active in the market. To account for this issue, we also follow Nordman, Cermak and McDaniel (2004) and define a medical malpractice insurer as one that wrote at least 2 percent of the medical malpractice premium in at least one state in that year. We call the resulting sample Small Sample. Since we need to examine insurers geographic concentration, we make use of the state-level financial information in the NAIC database. The major financial statement we rely on is Exhibit of Premiums and Losses in different states, which we refer to as the Stage Page throughout the paper. The Stage Page provides information on premiums written/earned, losses incurred/unpaid/paid and loss adjustment and other expenses by line of business for each firm in all 50 states and Washington D.C. each year. With such information, we can analyze the underwriting performance of medical malpractice insurers both at the state-level and at the countrylevel. product and geography diversification have medium level performance. Lei and Schmit (2008) find no significant impact of geographic diversification on firm performance of malpractice insurers, but show that more product diversification is associated with stronger firm performance. 4

6 Using our two definitions of medical malpractice insurers and the Stage Page, we generate our Large Sample and Small Sample. Table 1 provides a snapshot of the two samples. Table 1: Comparison of Large Sample and Small Sample Large Sample Year N of MM Insurers Median Loss Median Expense Median Combined N of MM Insurers Countrylevel Premium Share in Large Sample Small Sample Statelevel Average Premium Share in Large Sample Median Loss Median Expense Median Combined Source: authors analysis of NAIC data. As we can see from Table 1, from 1992 to 2010, insurers that report positive premiums in medical malpractice business number from a low 243 in 2001 to an all time high of 345 in When we require that insurers must write at least 2% of medical malpractice in at least one state, the sample size drops significantly. Though the small sample is less than 45% of the large sample in terms of its size, its insurers are very active and meaningful malpractice writers, as evidenced by the premium shares they have when compared to the large sample. For instance, in year 2010, the small sample s total premiums account for 73.7% of the large sample s total premiums at the country level. At the state-level, we see that on average in each state, the small sample writes about 77.5% of the large sample s premiums. In other words, the small sample is very representative of the entire medical malpractice industry. For all the analyses we do, we use both samples as a robustness test to each other and we can also see how the entire industry and the major active writers differ or behave similarly in various aspects of their underwriting strategy. 5

7 In this paper we use the medical malpractice insurance industry s loss ratios as a proxy to the underwriting cycle. The State Page allows us to calculate three ratios for each malpractice carrier both at the state-level and at the country-level. Loss ratios are losses and loss adjustment expenses incurred divided by premiums earned. Expense ratios are commissions, taxes and fees divided by premiums written. Combined ratio is the sum of loss ratio and expense ratio. Since here we are not doing any other sample selection besides imposing definitions of medical malpractice insurers, we do have insurers that report negative premiums and losses. As a result, the mean values of loss ratios are not reliable. Instead, we use median values to show the trend of the underwriting cycle. Table 1 also shows the ratios for both samples over time. Figure 1 presents the same information in a more visual form. Figure 1: Comparison of Large and Small Samples Loss s As we can see, expense ratios are relatively stable over time for both samples, with the small sample enjoying lower expense ratios. Volatility in combined ratios is thus largely driven by changes in loss ratios. The small sample tends to have higher loss ratios and combined loss ratios (except for ). Both samples reached their peak in 2001 with the highest loss ratios during our study period. Overall, the two samples follow very similar pattern in terms of their loss ratios movement. In the analyses that follow, we use the combined ratio as a measure of the underwriting cycle. We next show how insurers underwriting strategy evolves in the underwriting cycle. 6

8 NUMBER OF TOTAL INSURERS, ENTRANTS AND EXITERS The first aspect of the underwriting strategy we study is whether or not an insurer chooses to enter or exit medical malpractice line of business. For this purpose, we study the movement both at the country-level and at the state-level. We define an insurer as entering the market in a state in a given year if its direct premiums written (DPW) for medical malpractice insurance in that state exceeded the 2% threshold for Small Sample (or 0% threshold for Large Sample) for the first time in that year. Similarly, we define a firm as exiting a state in a particular year if it wrote malpractice coverage in a particular state in a particular year, but in no subsequent years wrote 2% or more for Small Sample of the direct premiums in that state (or wrote no positive premium for Large Sample). Country-level entry and exit are similarly defined, with national entrant of a certain year being one that had positive premiums in medical malpractice for the first time in that year (for Large Sample), or that wrote at least 2% of premium in at least one state in that year (for Small Sample). Table 2 reports the total number of medical malpractice insurers, entrants or exiters at the country level. It also shows the mean values of total number of insurers, entrants and exiters at the state level. Table 2: Total Number of Medical Malpractice Insurers, Entrants and Exiters Country-level Mean Values at State-level Year Large Sample Small Sample Large Sample Small Sample Total Entry Exit Total Entry Exit Total Entry Exit Total Entry Exit Source: authors analysis of NAIC data. 7

9 Figures 2 and 3 provide a visual description of how the total number of insurers, entrants and exiters correspond to the combined loss ratios in the medical malpractice industry. State-level average values, though not graphed, show similar patterns. Figure 2: Large Sample: Total N. of Firms, Entrants and Exiters As we can see the combined ratio seems to be moving in opposite direction of the total number of insurers. Around the year of 2001 when the combined ratios worsened for both small and large samples, we see a dip in the total number of insurers. When loss ratios improved in recent years, we see gradual increase in the total number of malpractice insurers. During our study period, year 1993 saw the most exits in both large sample and small sample. In Large Sample, we notice more exits than entries leading up to the 2001 crisis period. In Small Sample, such phenomenon coincides with the worsened 2001 combined ratio. In general, we notice that when loss ratios are high, there tend to be more exits than entries (though there may be a time lag). When loss ratios improve, we see more entries than exits in both samples, contributing to the increased size of the malpractice market. 8

10 Figure 3: Small Sample: Total N. of Firms, Entrants and Exiters GEOGRAPHIC CONCENTRATION OF MALPRACTICE BUSINESS The second aspect of the underwriting strategy we examine is how insurers spread out their malpractice business across states. We first look at the number of states in which insurers sell medical malpractice. Table 3 reports the median values of this information for both samples over time. Though the number of states in which insurers write malpractice ranges from 1 to 51, the median values are pretty low in both samples. In Large Sample, half of the insurers write malpractice in less than 4 states. The small sample insurers write in even fewer states, with 1 or 2 being the median values. In order to see how insurers allocate their malpractice premiums across states, we also calculate a geographic Herfindahl-Hirschman Index (HHI) for each firm, which is defined as the sum of the squares of its premium share in each state 2. A higher HHI indicates more geographic concentration. Table 3 also reports the median values of geographic HHI over time for both samples. As we can see more clearly from Figure 4, the geographic HHI shows an opposite trend to that of the combined loss ratios. In other words, higher loss ratios are shown to be associated with lower geographic HHI. When loss ratios improve, we see higher geographic HHI. In other words, a worsening (improving) underwriting performance seems to be linked with less (more) geographic concentration of malpractice business. 2 Premium share is the firm s malpractice premium in each state divided by its country-level total malpractice premiums. 9

11 Table 3: Analysis of Geographic Concentration of Medical Malpractice Insurers Large Sample Small Sample Small Sample Large Sample N of N of Year States States Geographic Geographic N of SS % of SS % of SS N of SS % of SS % of SS Insurers Insurers HHI HHI Insurers Insurers Premium Insurers Insurers Premium Sell Sell MM MM Source: authors analysis of NAIC data. Figure 4: Dynamics of Geographic Concentration 10

12 We next look at an extreme case of geographic concentration, given that many medical malpractice insurers operate in just one state. Table 3 also shows how many (and what percentage of) insurers sell medical malpractice in just one state, and the premium share these single-state insurers have when compared to the entire malpractice industry. Figure 5 graphs the same information. Again, we notice similar pattern. When insurers underwriting performance worsens, we see fewer insurers that sell malpractice in just one state. Improved loss ratios are shown to be associated with more insurers selling malpractice in just one state. Figure 5: Analysis of Single-state MM Insurers Single-state (SS) and multi-state (MS) insurers each have their own competitive advantage. Operating in just one state may gain insurers superior knowledge in dealing with state legal and regulatory environments and thus enable them to have better loss control. On the other hand, multi-state insurers may enjoy the benefits of diversification should a certain state suddenly changes its legal or regulatory environments in a way that s detrimental to the firms. Table 4 shows that usually multi-state insurers have higher expense ratios than singlestate insurers (except in year 2001 when in large sample, MS insurers have a higher median value of expense ratio than SS insurers). Figure 6 presents the same information in a more straightforward way. We also notice that single-state insurers have lower combined ratio than multi-state insurers from 1995 to 2004, but in other times they underperform. We suspect it is the comparative advantage of different underwriting strategies that are at play. Figures 7-8 provide a better presentation of the loss ratio information. 11

13 Table 4: Median Loss s of Single-state vs Multi-state Insurers year Small Sample MS Insurers Small Sample SS Insurers Large Sample MS Insurers Large Sample SSInsurers Exp Loss Comb Exp Loss Comb Exp Loss Comb Exp Loss Comb Source: authors analysis of NAIC data. Figure 6: Expense : Single-state vs Multi-state Insurers 12

14 Figure 7: Loss : Single-state vs Multi-state Insurers Figure 8: Combined : Single-state vs Multi-state Insurers 13

15 SIGNIFICANCE OF MEDICAL MALPRACTICE IN INSURER S PORTFOLIO The third aspect of the underwriting strategy we examine is the significance of malpractice insurance in insurers entire portfolio. We first look at the percentage of insurers total premiums written in malpractice line of business. Table 5 reports both mean and median values of such percentages over time. We observe that since 2003 there s been increased significance of malpractice business. By 2010, on average medical malpractice accounts for about 68.7% of total property/liability insurance premiums in Large Sample, and 84.9% in Small Sample. When we turn to median values of such premium percentages, we notice that half of malpractice insurers write more than 98% of premiums in this particular line. When we graph such information in Figures 9 and 10, we see that overall the percentage of malpractice premiums shares a negative association with the combined loss ratios. When insurers underwriting performance worsens, there is less significance of malpractice insurance (meaning insurers are writing less malpractice). When performance improves, we see insurers focus more on malpractice. This makes intuitive sense since it s natural for profit-driven firms to move away from less profitable business. Table 5: Analysis of Significance of Medical Malpractice Business Large Sample Year N % of MM % of MM N % of % of SL of Premiums Premiums of SL Premiums SL (Mean) (Median) SL % of SL % of SL Premiums Small Sample % of MM Premiums (Mean) % of MM Premiums (Median) Source: authors analysis of NAIC data. 14

16 Figure 9: Significance of MM in Large Sample Figure 10: Significance of MM in Small Sample 15

17 We also examine an extreme case where insurers devote its entire business to medical malpractice. Table 5 also shows that the total number and percentage of single-line (SL) insurers that only sell medical malpractice, as well as the premium share these single-line insurers have among all medical malpractice insurers. From 1996 to 2002, we see fewer single-line insurers only selling medical malpractice. The number and percentage picked up since In Large Sample, 40.3% of insurers are single-line insurers in 2010, contributing 22.3% to total medical malpractice premiums. In Small Sample, we see a slightly lower percentage of single-line insurers representing 19.9% of the medical malpractice market. Figure 11 shows that for the most part the percentage of the number and premium share of single-line insurers move in opposite direction to that of the combined loss ratios. When loss ratios improve, we see more single-line insurers focusing on malpractice. Figure 11: Analysis of Single-line (SL) Insurers Table 6 shows how single-line (SL) insurers fare as opposed to multi-line (ML) insurers. Figure 12 indicates that SL insurers usually have lower expense ratios. The only exception is in year 2005 when ML insurers have lower expense ratios in Small Sample. 16

18 Table 6: Median Loss s of Single-line vs Multi-line Insurers Year Large Sample SL Insurers Large Sample ML Insurers Small Sample SL Insurers Small Sample ML Insurers Exp Loss Comb Exp Loss Comb Exp Loss Comb Exp Source: authors analysis of NAIC data. Loss Comb Figure 12: Expense : Single-line (SL) vs Multi-line (ML) Insurers 17

19 Figure 13: Loss : Single-line (SL) vs Multi-line (ML) Insurers Figure 14: Combined : Single-line (SL) vs Multi-line (ML) Insurers 18

20 Figures show that in terms of loss ratios and combined ratios, SL and ML insurers have their comparative advantage at different times of the underwriting cycle. From 1997 to 2004, single-line insurers perform better. Multi-line insurers have better results at other times. DISTRIBUTION OF MALPRACTICE INSURANCE BETWEEN SAFER AND LESS SAFE STATES The fourth aspect of the underwriting strategy we study is how insurers allocate their malpractice business between safer states (those that have caps on general damages and/or patient compensation funds) and less safe states (states that do not have tort reform measures in place). Table 7 counts how many firms sell malpractice in CAP- or PCF- states (those that have caps on general damages and/or patient compensation funds), and how many in less safe states. Since a firm may sell in both safer and less safe states, the number of firms selling in CAP states and the number of firms selling in NO-CAP states do not add up to the total number of firms. We see some sharp increase in the number of firms operating in PCF states in recent years. Table 7: Analysis of Number of Firms in States of Different Regulatory Environments Large Sample Small Sample Year N of N of N of N of N of N of Firms N of Firms N of Firms in Firms in Firms in Firms in N of Firms in in PCF in CAP Firms PCF CAP No-PCF No-CAP Firms No-PCF States states States states States States States N of Firms in No-CAP States Source: authors analysis of NAIC data. 19

21 Next we examine how many CAP- or PCF-states each firm sells malpractice in. Table 8 shows the average values across insurers. For instance, in 2010, insurers in Large Sample write malpractice in 4.27 PCF states, which represents 45.4% of the states in which firms sell malpractice. Similarly we find that insurers sell malpractice in an average number of 8.07 CAP states, which account for 66.8% of total states in which insurers have malpractice business. Table 8: Average Number of States of Different Regulatory Environments Insurers Sell Medical Malpractice Large Sample Small Sample Year N of PCF States % of PCF States N of CAP States % of CAP States N of PCF States % of PCF States N of CAP States % of CAP States Source: authors analysis of NAIC data. Figure 15 shows that the average percentage of CAP- or PCF- states in which firms sell medical malpractice insurance moves in opposite direction to the combined loss ratios. Overall, we notice that higher loss ratios are associated with fewer CAP- or PCF-states in which insurers write malpractice. In other words, underwriting performance worsens when insurers write in fewer safer states. It is likely that operating in riskier states lead to worsened loss ratios in the first place. Since it s hard to identify cause and effect, we can only conclude that less business in safer states is associated with higher loss ratios. 20

22 Figure 15: % of PCF/CAP States Insurers Sell MM In We now turn to an extreme case where insurers choose to write malpractice only in safer states (CAP- or PCF- states). For simplicity purpose, we call such firms Only-CAP firms or Only-PCF firms. Table 9 shows the number, percentage and premium share of Only-CAP and Only-PCF firms. We notice since 2003 there s been an increase in the number of insurers that choose to sell malpractice only in PCF-states, or CAP-states. When we graph such information in Figures 16 and 17, we observe that the percentage of Only-CAP firms and Only- PCF firms share a negative relationship between the loss ratios. Such firms premium shares also seem to move in opposite direction to the combined ratios, though not as closely as the percentage of the number of firms. In other words, when loss ratios are high, we have fewer insurers that choose to sell malpractice only in safer states. When loss ratios improve, we see more firms preferring to write malpractice only in CAP- or PCF- states. This is consistent with our earlier observation in that fewer firms operating in safer states may have caused the underwriting performance to decline in the first place. 21

23 Table 9: Number, Percentage and Premium Share of Insurers that Only Sell MM in Cap-/PCF- States Large Sample Small Sample Year Only-CAP Firms Only-PCF Firms Only-CAP Firms Only-PCF Firms N % of % of % of % of % of % of % of % of N N N N Premium N Premium N Premium N Premium Source: authors analysis of NAIC data. 22

24 Figure 16: Large Sample: % and P-Share of Only Cap- or PCF- Firms Figure 17: Small Sample: % and P-Share of Only Cap- or PCF- Firms 23

25 Table 10: Median Loss s: Only-CAP Firms vs. Others Large Sample Only-CAP Large Sample All Other Firms Firms Year Exp Loss Comb Exp Loss Comb Small Sample Only-CAP Firms Exp Loss Comb Small Sample All Other Firms Exp Loss Comb Source: authors analysis of NAIC data. To gain some basic understanding of potential comparative advantage insurers that choose to write malpractice only in safer states, we compare the underwriting performance of Only-Cap firms to that of their counterparts. Table 10 reports the median values over time. We notice that firms that only sell medical malpractice insurance in CAP-states have lower expense ratios for most years in Large Sample, but such advantage is not as evident in Small Sample. In terms of loss ratios, from 1995 to 2010, firms that operate in only CAP states have lower loss ratios than their counterparts. This is consistent with our observation when we compare CAP-states versus No-CAP states and find that states that impose limits on general damages on average have better underwriting performance in their jurisdictions than states with no such limits on awards. This shows that caps on general damages indeed have effects on mitigating the crisis. The same pattern regarding loss ratio and combined ratio is also observed in Small Sample, as evidenced in Figures 18 and

26 Figure 18: Large Sample Loss s: Only-CAP Firms vs Others Figure 19: Small Sample Loss s: Only-CAP Firms vs Others 25

27 CHOICE OF PROSPECTIVE POLICYHOLDERS TO COVER The last aspect of the underwriting strategy we study is the types of health care providers insurers choose to cover. Ideally, we want to find out what kind of high- or low-risk specialties carriers tend to cover less or more. However, we do not have such information. In this study we utilize the best available data to do some preliminary analysis. For this purpose we turn to Supplement A To Schedule T Exhibit Of Medical Malpractice Premiums Written Allocated By States And Territories, which is an exhibit the NAIC didn t start providing until This exhibit shows premiums and losses each insurer incurs in medical malpractice in each state each year for each of the following four policyholder types defined by NAIC: PH (= physicians); OP (= other health care professionals); HS (= hospitals); OF (= other health care facilities). In Table 11 we show the total number of malpractice insurers each year 3 and the percentage of premiums written to cover each type of health care providers. We also show the median loss ratios of these providers. For instance, in 2001, 64% of premiums are written to cover physicians who as a group have a median loss ratio of Note that the loss ratios discussed in this section are losses incurred divided by premiums earned since there is no information on loss adjustment expense and underwriting expense by types of providers. Table 11: Mean Premium Share and Median Loss s to Cover Each Type of Provider Small Sample Large Sample year % of Premiums Written to % of Premiums Written to Median Loss s of Cover Cover Median Loss s of N PH HS OP OF PH HS OP OF N PH HS OP OF PH HS OP OF Source: authors analysis of NAIC data. As we can see from both samples, the majority of premiums are written to cover physicians, followed by hospitals. Over the years, there is some fluctuation in physicians premium share, though hospitals premium 3 Note the total numbers somehow differ from our earlier analysis based on the State Page. The reason is that not every firm provides information on both the State Page and the Supplement A page. 26

28 share remains relatively stable. Also hospitals tend to have higher loss ratios which explain why insurers cover less of them. As a matter of fact, many hospitals formed self-insured entities and do not report to NAIC. Since there are no earlier years of premiums/losses breakdown by types of health care providers, we do not observe significant trend during the years by examining providers premium share and loss ratios. We next turn to specialists that cover only one type of health care providers. Table 12 shows the percentage of such specialist-insurers as well as their premium shares. We graph the same information in Figure 20. Table 12: Analysis of Specialists Covering Only One Type of Health Care Providers Large Sample Small Sample Year % of Number of Firms Premium Share of Firms % of Number of Firms Premium Share of Firms Covering Only Covering Only Covering Only Covering Only HS PH OP OF S HS PH OP OF S HS PH OP OF S HS PH OP OF S Note: S refers to specialists that cover only one type of health care providers. Source: authors analysis of NAIC data. Figure 20: Analysis of % of Specialist-insurers 27

29 In 2001, 4% of firms in Large Sample cover only hospitals (HS), representing 9% of the total premiums written in medical malpractice. Similarly, 36% of firms in Large Sample are specialists covering only one type of health care providers in 2001, yet on average their premium share is 16% among all medical malpractice insurers. In both samples, we see a largely increasing trend in the number of specialist-insurers over time, yet their premium shares do not go up that much. Overall, we re seeing more and more insurers covering only physicians in their malpractice business, close to 28% in the Large Sample and about 22% in Small Sample by 2010, though their premium shares are still relatively small and stable. Figure 20 shows that for most years (except 2010), the percentage of insurers only covering physicians and that of all specialist-insurers display an opposite trend to that of the combined loss ratios. When we see insurers underwriting performance improve in recent years, we also observe an increasing percentage of specilist insurers. Test of Capacity Constraint Theory Having discovered some aspects of insurers underwriting strategy display certain cyclical nature, we now test whether the capacity constraint theory can explain such phenomenon in the medical malpractice industry. The causes of insurance cycles have been extensively studied and in this section we want to focus on the capacity constraint theory, while keeping in mind that tests of other cycle theories could be future research topics. Weiss and Chung (2004) summarize the capacity constraint theory well, The capacity constraint hypothesis postulates that capital does not flow freely into and out of the insurance indutry due to market imperfections As a result, insurers will be inclined to hold on to seemingly excess capital in profitable years, so as to have capital available to pursue opportunities in lean years. The capacity constraint hypothessi assumes also that claims are uncetain and correlated across policies, and insurers (combined) equity determins industry supply. Because losses are correlated, all insurers will be affected similarly by a loss chock (e.g., adverse interpretation of tort law for general liability insurers in the 1980s leading to a general liability crisis). Thus industry-wide soft and hard markets will occur. In soft markets capital is plentiful, while in hard markets it is relatively scarce. As a result, in periods of excess capacity, insurance price is relatively low, and it is relatively high in periods with relatively low capitabization. Therefore prices are hypothesized to be sensitive to industrywide capital. (p442) In our study we do not intend to examine how malpractice prices change in response to capacity change. Instead, we will test the capacity constraint theory by examining whether an increase (or decrease) in capacity 28