Tort Liability, Insurance Rates, and the Insurance Cycle

Markets for many types of property and casualty insurance exhibit soft-market periods, where premium rates are stable or falling and coverage is readily available, and subsequent hard-market periods, where premium rates and insurers' reported profits significantly increase and less coverage is available. Conventional wisdom among practitioners and other observers is that soft and hard markets occur in a regular "underwriting cycle." Like price fluctuations in equity markets, fluctuations in insurance premium rates and coverage availability are difficult to explain fully by standard economic models that assume rational agents and few market frictions.

The mid-1980s "liability insurance crisis" remains the most infamous hard market in the United States. The dramatic increases in commercial liability insurance premiums and reductions in coverage availability for some sectors received enormous attention, motivating extensive research on those specific problems and on fluctuations in insurance prices and coverage availability more generally. Large losses from natural catastrophes in the United States during the late 1980s and early 1990s spurred further interest in and research on the dynamics of pricing in reinsurance and primary insurance markets following large, industry-wide losses. The hard market for commercial property and casualty insurance that began in late 2000 and accelerated following the destruction of the World Trade Center in September 2001 focused renewed attention on markets for commercial property, medical liability, general liability, and workers' compensation insurance. With respect to general liability and medical liability insurance, substantial debate has arisen concerning the causes of increases in rates and reductions in coverage availability and the attendant implications for policy, such as tort reform, to reduce the expected value and uncertain costs of liability insurance claims or additional regulation of insurers to control allegedly imprudent underwriting and investment.

This paper provides an overview of volatility in premiums, coverage availability, and insurers' reported profits in U.S. commercial general liability insurance and examines its broad relation to the U.S. tort liability system.¹ I begin with a synopsis of the perfect markets model of insurance prices (sometimes called the arbitrage model) and its implications for commercial liability insurance. I next describe fluctuations in U.S. general liability insurance premiums, coverage availability, and reported profits during the past two decades and examine whether the perfect markets model is consistent with that evidence. I then summarize other factors that may affect insurance market volatility and provide new evidence concerning one alternative: that aberrant pricing by some firms aggravates soft markets and, by implication, the severity of subsequent hard markets. I conclude with a brief summary of policy implications and areas for future research.

Competitive Insurance Premiums with Frictionless Capital Markets

With rational insurers and policyholders, competitive insurance markets, and frictionless capital markets, insurance premiums will equal the risk-adjusted discounted value of expected cash outflows for claims, sales expenses, income taxes, and any other costs, including the tax and agency costs of capital. The levels and changes in premium rates will coincide with the levels and changes in discounted expected costs. Because the timing of payouts for claims incurred in a given year, nonclaim expenses, and capital costs should be comparatively stable over time, rate changes will primarily reflect changes in expected (forecast) claim and claim settlement costs and changes in interest rates.

In this perfect markets framework, long-run levels and short-run changes in premium rates for general liability insurance will reflect levels and changes in the following:

• Expected claim costs (incurred losses) and claim settlement costs,
• The timing of future claim payments for incurred losses,
• Interest rates used to discount expected future claim and claim settlement costs,
• Underwriting expenses (commissions, wages to underwriters, policy issue costs, premium taxes, and so on),
• Uncertainty about the frequency and severity of claims, including uncertainty about the form and parameters of the relevant probability distributions, which in turn affects the amount of capital that insurers need to hold to protect themselves against...