George:

The recent flap over medical malpractice insurance rates needs to be seen for what it is -- the pigeons coming home to roost after years of insurance company deregulation and/or mismanagement.

First, a few facts:

1. Medical malpractice premiums are jumping.
2. On average, medical malpractice premiums are jumping higher, and faster, in state that have caps on recoveries than in states that don't have caps on recoveries.
3. Medical malpractice claim payouts have stayed the same, or have declined, in the last 10 years.
4. Over the past 10 years, insurance premiums of all sorts -- including but not limited to medical malpractice -- have been fairly stable, as insurance companies have been able to use gains on their investments to cover claims paid out.
5. Twenty years or so ago, insurance rates were fairly tightly regulated by state regulators, to make sure that they were running themselves in a way that would protect their insureds from future claims. The deregulation mentality that swept the 1980's led to a basic change in the regulatory climate, so that regulators for the most part stopped regulating rates (an act of regulation that looks to anticipate the future solvency of the company), and only monitored the financial health of the insurance companies (an act of regulation that evaluates the present solvency of the company).

In order to understand what is happening right now, you have to understand how insurance companies work.

If I pay my insurance company $100, they invest that money until they need to pay off claims from it. Let's say that on the last day of the year for which that premium was paid, I get in an accident. I cause damage of $110. But the insurance company doesn't settle the claim right away. They offer the injured person $85. If the plaintiff takes the low-ball figure, obviously the insurance company comes out ahead. If the person refuses the low-ball figure, the plaintiff has to sue. (Whose fault is that?) Then the timing is up to the courts and to the lawyers. Let's say it takes 18 months to get to trial, at which time the jury gives the plaintiff $110. This is now 30 months from the payment of the $100 premium. Operating costs at the insurance company are $5 a year, or $12.50 over 30 months. If the insurance company has been able to make a 10% return on their investment, that premium has now grown to $126, meaning that the insurance company has made enough money to pay the claim, cover its expenses of operation, and return a profit just by having successful investments.

Now, let's take the same set of facts, except that the insurance company, in the booming stock market of the 1990's, was making 20% on premiums invested. Other insurance companies jump in, anxious to receive premiums that they too can invest at 20%. So my company cuts my premium to $90, and then to $80, in an effort to retain my business. My $80 premium, invested at 20% for 30 months, still returns about $126 by the time of the payout, so the insurance company is still able to make its money, and I am happy because my premiums have been lowered.

In the 1970's regulators probably would have said, "We won't let you lower your rates to $80 -- maybe $90, but not $80. You need to be building up a cushion during these boom times." But consumer advocates (on the left) and free-market advocates (on the right) argued that this was just needless interference in the marketplace, and so companies were, increasingly, left free to set their own rates.

Jump ahead to 2003. The last 2 years (2001 and 2002) have been disastrous in the stock market. The insurance company had bet that they would be able to keep making 20%, but instead they LOST 10%. $80 invested at the end of 2000 is now worth $65. But there is still that claim that is worth $110. And the insurance company does not have the money to pay it. If they have been prudent, they have reserves, or they have investments that they can sell, to cover unexpected market losses. If they have not been prudent -- as the Reciprocal of Virginia (the largest insurer of doctors in Virginia) was not -- they have to go out of business. If they are able to stay in business, though, they will adjust their premiums so that they can make money under the new investment conditions. Prudent insurance companies would probably say, "I can't project more than a 5% return." To fund the hypothetical $110 payout 30 months after the premium was paid, the premium would have to be $98; to cover costs of running the company, the premium would have to be $110. If the company wants to rebuild its reserves, the premium has to be $120.

I start screaming! "You have jumped my premiums from $80 to $120? That's a 50% increase! I'm going to take my business to another company!" But whereas in the 1990's companies were clamoring to get into the business to be able to receive premium dollars to invest, now some of those companies are in bankruptcy, and others are raising their rates to cover their own losses.

We last heard these screams in 1985 -- about 3 years after the stock market tanked, and rates of return on investment dropped sharply. If we are going to live in a deregulated world (another topic for another day), booms and busts are inevitable. Bargain-shopping consumers who insist on a rate reduction when things are going well will have to live with a rate increase when things go poorly.

Who is at fault in this scenario? Is it the insured? Not really. Is it the insurance company? Maybe -- for cutting premiums to an unsustainable level during boom times. Is it the plaintiff? No, the claim hasn't changed. To hear the Bush White House talking, or to look at the posters in Richmond, it's the trial lawyers. But they miss the basic point -- the payouts for claims has not increased.

Lloyd Snook (electronic mail, February 6, 2004)

For related articles, see Justice Day at the Virginia General Assembly and Marching for Malpractice Reform.