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Economics of Insurance: The Case of New Jersey

Mises Daily: Tuesday, January 13, 2004 by

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The New Jersey legislature recently responded to calls for reforming state automobile laws. Some claim that these laws will increase competition. Given the track record of this legislature in regulating auto insurance, there are good reasons to be wary of this legislation. Does it really improve this situation overall, or is it just another payoff to special interests? The answering of this question requires some analysis of the New Jersey auto insurance system.

New Jersey has the dubious distinction of having the worst automobile insurance system in America. It is literally the most expensive, and provides poor service to its customers. Despite these high premiums, many automobile insurance companies have exited this market. In the past ten years, twenty insurers have left New Jersey.

The reasons for this exodus are clear. New Jersey regulations establish transfers that create perverse incentives. New Jersey law requires that insurance companies take all comers, even those with the worst driving records. This forces New Jersey insurers to subsidize bad drivers.

The New Jersey 'no fault' system increases insurance costs considerably. If you have an accident in New Jersey, you can move your case forward at the expense of the insurance industry. Your insurance company pays for medical expenses and lost wages. Lawyers collect fees on the basis of New Jersey's regressive contingency system—they take a percentage of the damages that declines with the size of the award.

However, the insured has no out of pocket expenses (other than past insurance premiums) and bears no legal risk in the courtroom, and there is a very low threshold for instigating litigation. The only thing one must worry about after an accident is an increase in their future insurance rates—if they are deemed responsible for the accident.

Under New Jersey law, there need not be any verifiable evidence of injury. New Jersey drivers can be paid for pain and suffering after accidents. While there is no doubt that many accident victims do endure pain and suffering, drivers can claim that they have an undetectable neck injury and receive considerable sums of money. The New Jersey system encourages frivolous and fraudulent lawsuits. Lawyers benefit much from this litigious system, but legal expenses are a significant part of the reason for New Jersey's high insurance rates.

The state has regulated insurance rates and profit levels. The excess profit law mandated that insurers never earn 'too much' profit in a year. This law ignores the fact that the fortunes of business rise and fall. Lean years offset years of high profits. By eliminating the peaks, this law makes the troughs in profits unbearable. It also ignores the fact that markets have their own excess profit law—competition. So long as free entry and exit exists in markets, incumbent businesses can earn only competitive rates of profit. This means that they will earn only enough to keep them interested in remaining in the market for selling insurance—the equivalent of what they would earn in their next best opportunity.

Rate control was supposed to prevent excessive rates, but it is clear that this effort failed. Rates in New Jersey are the highest in the nation, yet they are still not high enough to keep insurers from leaving the state.

The state also has withdrawal restrictions. Legal restrictions inhibit exit from the State's existing insurance providers. Insurance companies must exhibit extreme financial hardship or pay another insurer to take its place before it can leave the state.

This is a classic example of governmental regulation leading to appalling results. These results have propelled efforts to reform the auto insurance system in New Jersey. Recently, New Jersey governor McGreevy signed a law that reforms this system. This new law is supposed to improve automobile rates by introducing greater competition.

The New Jersey Automobile Insurance Competition and Choice Act of 2003 is supposed to introduce greater competition into the New Jersey automobile insurance market. It does this by reforming "a regulatory system that stifles competition and has resulted in fewer and fewer automobile insurers doing business in the State." This act declares "The reduction in the number of automobile insurers doing business in the State has resulted in fewer choices for consumers and reduced competition, and any further reduction in insurers will jeopardize the availability of automobile insurance for the public and will undermine the continued economic development of the State."

The New Jersey legislature has determined that "a modernized regulatory system that promotes robust competition among insurers will better serve the needs and interests of consumers". Changes in the current system will attend to the demands of New Jersey drivers by preventing the diminution of the number of current insurers and encouraging the entry of new insurers to the state.

This reasoning has a superficial appeal. When multiple sellers compete for customers, these customers get lower prices and higher quality. The more competitors there are, the more competition exists. So, larger numbers of competitors automatically translate into better outcomes for consumers. Economist Abba Lerner argues that markets should be judged by the standard of perfect competition. Without a large number of competitors, sellers held 'market power' and could exploit consumers with high prices. Increasing the number of actual sellers increases the welfare of consumers in a mechanical fashion. The absence of a large number of sellers supposedly warrants governmental intervention to reign in the use of market power.

The reality of the market process is somewhat different. The actual number of competitors in a market is not nearly as important as the conditions for market entry and exit. As economist Friedrich Hayek argued, competition is a dynamic and rivalrous process, where people discover the best prices and products. Competition disseminates information and allows people to form opinions about what is best for their interests. Market conditions change continually, so competitors must actively compete through time. Lerner's static conception of perfect competition fails to appreciate the dynamic nature of markets. It also sets an absurdly high standard of perfection for market performance.

Economists William Baumol and Harold Demsetz emphasize the importance of barriers to entry and exit in markets. So long as free entry and exit prevails, sellers will serve consumers well. Even a few competitors can compete intensely for market share. Even a monopolist will have to price his products competitively or face new competitors, when entry barriers are low. The lesson here is that potential competitors are just as good as actual competitors as far as consumers are concerned.

The idea that increasing the number of insurers in New Jersey will necessarily help consumers is false. This need not be true. To see if it is true, we must examine the content of this new legislation.

This law asserts that a competitive market "should provide timely and accurate information as to price, solvency and market conduct, so that consumers can enjoy the full benefits of the marketplace." It insists that "the State retain the necessary regulatory authority to protect consumers and insure that the competitive market fairly and adequately serves consumers." To do this, this law establishes a 13-member commission on insurance competition within the New Jersey Department of Banking and Insurance. This commission will implement a consumer information system and protect consumers from unfair and anticompetitive insurance practices.

The state will determine how competitive the insurance market is by examining the number of actual insurance sellers, the degree of industrial concentration, the dominance of any one insurer in terms of market share, financial or economic barriers to entry, consumer access to information, and the availability of coverage to consumers. In other words, this legislation substitutes one form of detailed regulation for another. The questions that this fact raises are will this form of regulation work better and why do legislators not simply pursue real deregulation.

Absent from the list of possible sources of monopoly pricing are political barriers to entry. This legislation accepts the view that private interests can use 'market power', the control of information, and practices like predatory pricing to establish monopoly control of insurance markets. It ignores even the possibility that high market share can result from superior efficiency rather than supposed market power. It also ignores even the possibility that political factors can stifle competition.

The control of information by regulators opens additional opportunities for abuse. Controls over practices like advertising tend to increase consumer prices[1]. There is a market for information on goods, as well as for goods themselves. As previously mentioned, the competitive process is a process of informing consumers. Control over information by the state can easily be abused. Politically influential businesses can restrict information on their competitors.

Worse still, economist George Stigler and Sam Peltzman have proven that private businesses can 'capture' regulators and use them to inhibit competition. Regulation can be abused to benefit the very businesses that it supposed to reign in. Existing insurers can use their political influence to harm entrants, provided that they have access to those who regulate the insurance market.

It is not necessarily the case that private insurers have such political influence. However, in this case they surely do. This law passed thanks to the lobbying efforts of a coalition that includes the National Association of Independent Insurers, Insurance Council of New Jersey, American Insurance Association, New Jersey Chamber of Commerce, Independent Insurance Agents of New Jersey, National Association of Mutual Insurance Companies, Professional Insurance Agents of New Jersey, and the Commerce and Industry Association of New Jersey. Why should we expect such a coalition to push for reforms that benefit consumers rather than themselves?

The details of this law indicate that it serves business, rather than consumer interests. It eliminates the 'take all comers' law. It also eliminates a 1$ a day medical policy for poor drivers. Such measures lower costs, but not necessarily prices. The regulations that this new law creates do open opportunities for abuse.

The notion that market concentration and financial or economic barriers implies monopolistic pricing depends upon faulty reasoning, but affords regulators the power to punish companies that act competitively. Insurers that have low rates and gain high market shares can be accused of predation, where they underprice their products to gain market share. Once having gained this mysterious commodity known as 'market power', they can raise their rates. This legislation could easily serve as cover for efforts by insurers to subvert competition and keep their rates above competitive levels. Insurance rates may stabilize or even fall due to this regulation, but they may still remain well above competitive levels.

All of this should come as little surprise.

Narrow special interests, like insurance companies, have an edge over broader interest in lobbying, like consumers. Smaller groups can organize for group action more easily, and therefore have undue influence on policy[2].

Thus, there are good reasons to expect that this legislation is merely an effort by the insurance industry to increase its profits by avoiding competition. It addresses some serious cost issues in New Jersey's present insurance system. Yet, it leaves other issues alone, and opens more opportunities for abuse. This new law may very well improve the market for auto insurance in New Jersey overall. However, this does not mean that it is the best possible type of reform.

As economists Ludwig von Mises and Friedrich Hayek taught us all, competition in markets provides the best basis for allocating scarce resources. Economists Mancur Olson and Gordon Tullock have shown how the politicization of markets by regulation favors special interests and leads to a wasteful competition over income transfers. The general principles of economic science indicate that the past failures of insurance regulation in New Jersey were not accidental, and will not be remedied by further state action. This new law in New Jersey seems to be just another such effort on behalf of special interests. Instead of focusing on serving its customers, New Jersey insurers are expending resources on lobbying the State Legislature for favorable legislation.

Proponents of this law have tried to make it sound like deregulation that aims towards establishing competitive free markets. This is really nothing but a change in the form of regulation. Hopefully, this new law will improve upon the current situation in N.J. There is certainly a great deal of room for positive change in this industry.

Given the failure of regulation in the past, we should view new forms of regulation with great skepticism. This bill will likely help the insurers who pushed for it. This may benefit consumers to some extent, by stemming the outflow of insurance companies. We should, however, remember that there is no real substitute for actual competition in truly free markets.


D.W. MacKenzie teaches economics at Ramapo College. Send him MAIL and see his Mises.org Daily Articles Archive.


[1] See Telser (1964) and Benham (1972).

[2] See Mancur Olson in The Logic of Collective Action (1965).