The Regulation of Automobile Insurance in California
In this paper, we evaluate the effects of regulation in California’s automobile insurance market. Auto insurance is a critical consumer service, so regulation in this market has an important direct impact on consumer welfare. 1 In addition, because regulation in this industry takes place at the level of the state, auto insurance provides a particularly useful laboratory for evaluating the more general effects of regulation and deregulation.
The study of the effects of regulation is frequently contentio us, so we note immediately that our conclusions differ substantially from the other papers in this volume. These studies systematically conclude that regulation has created serious damage and/or that deregulation has been highly successful. In contrast, we conclude that although auto insurance has been highly
regulated in California since 1988, the effects of this regulation have been benign, our study finding none of the traditional negative effects of regulation.
Our analysis is based on the passage of California referendum Proposition 103. This ballot initiative was passed on November 7, 1988, dramatically altering the regulatory environment of the property and casualty insurance industry in the state. Prior to that, California was ranked among the states with the least degree of auto insurance regulation. The passage of Proposition 103 transformed California to a state among those with the greatest degree of auto insurance regulation in the US.
Although Proposition 103 has components directed at all lines of property casualty insurance in California, by far its major impact has been on auto insurance. Proposition 103 thus represents a benchmark for state auto insurance regulation in much the same way that the state’s earlier Proposition 13 (which limited local government expenditures to a fixed amount of
property tax revenue), represents a benchmark for local funding of public expenditures.
In this paper, we use the passage of Proposition 103 to carry out an “event study,” which allows us to contrast the performance of the state’s auto insurance market in low and high regulatory regimes. On the surface, Proposition 103 seems ideal for this purpose. More than a decade has passed since the passage of the Proposition, allowing us to observe both the transitory
and continuing effects of the introduction of the new regulatory environment. On closer inspection, however, unraveling the effects of this change is complicated by the presence of a number of confounding factors. For one thing, at about the same time the regulatory regime changed, a major California Supreme Court decision, Moradi-Shalal v. Fireman’s Fund (henceforth “Moradi”), substantially limited the conditions under which insurance companies could be sued. For another thing, changes occurred in California’s auto safety regulations over
the post Proposition 103 period, the most important being the strict enforcement of seat belt and driving under the influence laws. Our analysis in this paper therefore attempts to separate the influence of the se factors from the effects of Proposition 103 itself.
The paper can be summarized as follows.
In Section 2, we describe the regulatory regime that Proposition 103 introduced. The description covers not only the actual Proposition, but also (a) the operating regulations created by the state’s Department of Insurance under the new elected office of Commissioner, (b) additional legislation passed by the State legislature, and (c) the stream of legal challenges and decisions, still ongoing in the state’s courts.
In Section 3, we discuss the established economic theory concerning the expected impact of regulations such as those created by Proposition 103. Using the excellent recent study by Harrington  as our benchmark, we enumerate various costs and market failures that are expected to occur as a result of such regulation. From this we derive a number of predictions of
the likely effects of Proposition 103. Following Section 3, the remainder of the paper evaluates the actual impact of the Proposition.
In Section 4, we look at the first prediction, that firms would exit the market for auto insurance in California. We show that there has been no significant exit from California’s auto insurance market since Proposition 103.
In section 5, we look at the second prediction, that the assigned risk pool in California would expand as a result of Proposition 103. We demonstrate, however, that California’s assigned risk pool has dramatically declined, reflecting the adoption of a policy of market-based pricing for the pool. Nothing in Proposition 103 precluded the adoption of this price adjustment.
In Section 6, we examine the third prediction, that the premium freeze, and prior approval more generally, would lower profitability in California, and thereby lower the supply of auto insurance, in this way harming consumers. To the contrary, we conclude that Proposition 103 has been highly beneficial for consumers and insurance firms alike The basis for this finding is that at the same time that California consumers benefited from the sharpest decline in auto insurance premiums in the country, profit rates for auto insurance firms in California ran significantly above the national average. Falling premiums and rising profit rates can coincide only if incurred losses or underwriting expenses also fall. We will show this is exactly what did occur in California.
In Section 7, we examine the factors that explain the decline in auto insurance premiums in California. Some of these factors are directly linked to Proposition 103, whereas others are independent of the Proposition. As a roadmap to our analysis, Figure 1 illustrates the various factors we will be examining and indicates how they are connected to auto insurance premiums. Factors related to Proposition 103 are so noted, whereas all other factors are independent of the
Proposition. A detailed discussion of all these factors is provided in Section 7. In addition, in Section 7, we examine the hypothesis that regulation inhibited the willingness of firms to pass through the benefit of lower costs to consumers as lower premiums.
<<All Figures will be found at end of paper>>
Section 8 provides our conclusion, namely that none of the negative effects of auto insurance regulation, as predicted by economic theory, occurred in California following the passage of Proposition 103. In this sense, the California data and experience are sufficiently unique to suggest that even if most regulation is harmful, benign or good regulation is not an oxymoron.