Premiums, Profits, and Costs of Business in Alberta’s Automobile Insurance Industry, 1996-2006

Posted on December 1, 2008April 20, 2017 By economica

This article first appeared in the winter 2008 issue of the Expert Witness.

Introduction

In February, 2008, Economica Ltd. was retained by the Canadian Bar Association to prepare a series of reports on automobile insurance premiums in five provinces: Alberta, Ontario, New Brunswick, Prince Edward Island, and Nova Scotia. We have now completed this work, having prepared two reports on Alberta and one on each of the other four provinces.

In this article, we summarise the main findings of the first of these reports, Alberta’s Minor Injury Regulation: Automobile Insurance Profits, Premium Rates, and Costs, prepared by Christopher Bruce, of Economica, and Jason Strauss, a Ph.D. student in the department of Risk Management and Insurance at Georgia State University. (The full text of this report can be found at: www.cba-alberta.org)

Our Report had three purposes:

to provide a measure of the profitability of automobile insurance in Alberta in the period 1996-2006, (that is, immediately preceding and immediately following the introduction of Alberta’s Minor Injury Regulation, the MIR, in the Fall of 2004);
to determine whether the observed changes in profits and premiums in the years prior to the introduction of the MIR had been caused by changes in costs; and
to identify what the effects on profits and premiums would be if the MIR was removed.

We summarise the results of our analyses in the three following sections of this article.

1. Profitability of Basic Coverage

As the MIR applied primarily to Basic Coverage, we focus in this section on that line of insurance. The methodology we use to estimate profits is based on the approach developed by the Insurance Bureau’s actuary, Mr. Joe Cheng, for his testimony in the case of Morrow v. Zhang (2008). (It was in Morrow that the constitutionality of Alberta’s Minor Injury Regulation was challenged.)

The most common measure of industry profitability (and the measure used in the Cheng Report), is after-tax “return on equity” (ROE) – that is, the industry’s after-tax profits divided by the value of the investments made in the industry. In Table 1 and Figure 1 (taken from our Report), we show that, prior to 2003, Basic Coverage was not profitable in Alberta, with an ROE ranging from -5.6 to +2.1 percent. In 2003, however, the return on Basic Coverage increased dramatically, to 19.1 percent, and rose above 20 percent in each of 2004, 2005, and 2006.

Table 1

1.1 Claims costs relative to total costs

It is possible that the sudden increase in ROE in 2003 could have arisen from a dramatic change in the costs of claims. The data in Table 2, however, indicate that these costs remained a relatively constant portion of insurance companies’ total costs throughout the entire period 1996 to 2006. That is, the rate at which the costs of claims were rising was not appreciably different from the rate at which insurance companies’ other costs – primarily the costs of administration – were increasing.

Table 2

1.2 Claims costs relative to premiums

Alternatively, profits may have risen in the 2003/2004 period because claims costs fell relative to premiums. We investigate this possibility in Table 3, which reports changes in claims costs per motorist, relative to average premiums. What this table indicates is that, until 2002, premiums tracked claims costs fairly closely. That is, each increase in claims costs per motorist was matched by a similar increase in insurance premiums, resulting in a ratio of costs to premiums that varied only slightly. For example, while the average claim for Basic Coverage was 99.0 percent of the average premium in 1996, that ratio was 92.9 percent in 2002 – because premiums rose by 39.1 percent over that period, while average claims rose by a similar amount, 30.3 percent.

Table 3

In 2003 and 2004, however, premiums rose much more quickly than did claims costs, driving down the claims ratio. Between 2002 and 2004, for example, the average premium rose by 19.3 percent, while average claims actually fell by 21.9 percent. Thus, it appears that the dramatic increase in profit rates over the 2003-2004 period was driven, in large part, by a sudden change in the relationship between the costs of Basic Coverage and the premiums that were charged for that coverage. In the following section, we investigate a number of factors that might have led to this change.

2. Changes in Costs per Vehicle

The price of automobile insurance – the premium – is affected by four components. First, there are the average costs of claims (including adjustment expenses) per vehicle that were discussed in the preceding section. Second, allowance must be made for administration expenses (broker’s commissions, overhead, etc.). Third, insurers earn income from the investment of equity and reserves (premium revenue that will eventually be used to pay claims). Finally, a reasonable rate of profit must be added to net costs.

The question we address in this section is whether the increases in premiums between 1996 and 2004 can be attributed to changes in any of these components.

2.1 Average claims per vehicle

In Table 3, we showed that the cost of claims rose at approximately the same rate as the price of premiums over the period 1996 to 2002. Thus, if there was a need for increased premiums in 2003 and 2004, it was not because the ratio of claims costs to premiums had changed over the preceding six years.

Nevertheless, Basic Coverage is composed of a number of sub-categories, including Third-Party-Liability and Accident Benefits. In turn, Third-Party-Liability (TPL) is composed of TPL-Property Damage and TPL-Bodily Injury, of which only the latter was affected by the Minor Injury Regulation (MIR). Thus, it is possible that even though claims costs for Basic Coverage as a whole did not increase in 2003 and 2004, there may yet have been an increase in the component that was affected by the MIR. To investigate this possibility, we report the data in Table 4.

Table 4

In this Table, it is seen that the claims for TPL-Bodily Injury increased at roughly the same rate as the other components of Basic Coverage prior to the MIR. For example, whereas claims for Bodily Injury increased by 32.5 percent between 1996 and 2002, claims for Property Damage increased by a similar percentage, 27.8.

We are led to ask, therefore, whether a change in some other element of the cost of insurance can explain the sudden increase in premiums that was observed in 2003 and 2004. In sections 2.2, 2.3, and 2.4 we analyze administrative expenses, investment income, and return on equity.

2.2 Administrative expenses

Table 5 reports that the ratio of administrative expenses to premiums (the expense ratio) decreased from 25.5 percent in 1996 to 23.8 percent in 2001. As average premiums increased only slightly over this period, the dollar value of expenses must have been decreasing or relatively stable. Furthermore, in the time period immediately prior to the introduction of the Minor Injury Regulation, 2002 and 2003, expense ratios fell further while premiums increased dramatically. It can be concluded, therefore, that changes in administrative expenses were not the source of the premium increases that occurred in 2002 and 2003.

Table 5

2.3 Return on investment

Insurance premiums are placed in a reserve until claims have to be paid. Those reserves are invested and the investment income generated thereby is credited against the cost of premiums. Hence, an increase (reduction) in the rate of return on investment, ROI, may lead to a decrease (increase) in premiums.

It is seen in Table 6 that the ROI insurers earned on their equity and reserves declined almost continuously over the period 1996 to 2001. Nevertheless, this decrease placed only limited upward pressure on premium rates. Specifically, we estimate that to compensate for the decrease in ROI from 9.0 percent in 2000 to 6.2 percent in 2003, insurers would have needed a $44 increase in the 2003 premiums on Basic Coverage. In fact, those premiums increased by $213, from $537 to $750. (See Table 3.) This confirms that decreasing ROI was not the primary impetus for the premium increases in 2002 and 2003.

Table 6

2.4 Return on equity

Once the net costs of insurance have been calculated, the premium is determined by adding a profit margin, or return on equity, ROE, to those costs. Thus, as the necessary ROE increases, premiums will also increase. We surveyed seven sources of expert opinion concerning the appropriate ROE target for the automobile insurance industry. We found:

Dr. Norma Nielson and Dr. Mary Kelly, in a presentation to the Alberta AIRB October 20, 2006, recommended an ROE in the range of 14.31 to 18.26 percent
NERA Consulting Economists, in a report for the Newfoundland & Labrador Board of Public Utilities, October 13, 2004, recommended an ROE in the range of 11 to 14 percent.
Based on NERA’s report, Dr. Ronald R. Miller of Exactor Insurance Services Inc. recommended an ROE of 12.5 percent.
Dr. Basil A. Kalymon, on behalf of the consumer advocate, recommended to the Newfoundland & Labrador Board of Public Utilities that the target return on equity for the setting of automobile insurance rates should be 9 to 10 percent.
The consumer representative to the Alberta AIRB, Ms. Merle Taylor, CMA, recommended that the ROE be higher than the allowable rate for utilities (at that time, 8.9 percent). She also stated that a 19.6 percent ROE would be “excessive.”
In his testimony in Morrow v. Zhang (2008), actuary Joe S. Cheng, F.C.I.A. stated that a 12.5% ROE was considered by many insurers to be in the low end of a reasonable range; and that the high end of a reasonable range might be 20%.

The Alberta Automobile Insurance Rate Board (AIRB) currently employs a formula that implies that an after-tax ROE of 9.5 percent would be appropriate.

Excluding the report by Merle Taylor, which did not give an exact range or recommendation, the average of the six remaining experts’ opinions concerning a reasonable ROE for automobile insurance is 12.76 percent. This figure is well above the rates earned on Basic Coverage in Alberta between 1996 and 2002, (see Table 1), but is well below the rates earned since then. Most importantly, Alberta insurance companies earned an ROE of 19.1 percent in 2003, the year before the introduction of the MIR.

2.5 Summary and conclusions

As indicated in the preceding sections, claims did not dramatically increase in the time period leading up to the Minor Injury Regulation.
As also shown above, administrative expenses did not increase but, rather, decreased in the time leading up to the Minor Injury Regulation.
Although investment returns decreased in the time leading up to the Minor Injury Regulation, their effect on the increase in premiums was minor.
ROE for Basic Coverage averaged -1 percent per year in the period 1996 to 2002 (7.4 percent for All Coverages). During this same period, average premiums for Basic Coverage only increased by 6 percent per year on average (4.5 percent per year on average for All Coverages). This premium deficiency (the difference between premium charged and premium required to reach a reasonable rate of return) appears to have been the primary impetus for the sharp increase in premiums that occurred in 2002/2003, as the “soft” market ended and a “hard” market began.
We estimate that without the premium increases in 2002 and 2003, ROE on Basic Coverage would have been -3.8 percent (in 2003).

3. Projected Effect of Removing the Minor Injury Regulation

Using the AIRB’s methodology, and controlling for other reforms beside the Minor Injury Regulation (i.e. controlling for the gross to net income reform and the collateral income reform), we estimate that the required average premium increase for Basic Coverage, if the Minor Injury Regulation had been removed, would have been $111.76/year if industry profits were to be maintained at their 2006 level, of 21.8 percent.

Alternatively, using the AIRB’s methodology, we estimate that insurer ROE for Basic Coverage would have been 12.2 percent in 2006 if the Minor Injury Regulation had been removed and premiums held constant. (Furthermore, in this case, the ROE would have been 16 percent for All Coverages.)

Christopher Bruce is the President of Economica and a Professor of Economics at the University of Calgary.

Jason Strauss is a Ph.D. student in the department of Risk Management and Insurance at Georgia State University.

Examination of Expert Witnesses

Posted on December 1, 2008March 26, 2017 By economica

by Christopher Bruce and Derek Aldridge

This article first appeared in the winter 2008 issue of the Expert Witness.

On October 28 in Edmonton and October 29 in Calgary, Chris Bruce and Derek Aldridge were participants in a Legal Education Society of Alberta panel on examination of expert witnesses. In this note, we offer some recommendations regarding the examination of expert economists. These recommendations are based on our comments during the panel, and the feedback we received.

We divide our advice into pre-testimony and during-testimony periods.

Pre-Testimony

An effective examination is not created days, weeks, or even months before trial, but years. That is because an effective examination begins with a well-constructed expert’s report. In our experience, at least half of the judge’s impression of your expert’s opinion is going to be based on his or her reading of that expert’s report. Our advice, therefore, is that as soon as you receive the first report from your expert, you should try to read it from the perspective of the judge. If you cannot follow the report easily, despite having been immersed in the case, it is not likely that the judge will be able to follow it either.

This is not to say that you should attempt to influence what your expert is going to say. You do, however, have the right to ask your expert to improve how that opinion has been expressed. At this stage, you should particularly be looking for a clear, logical, methodical development of the expert’s argument. Are the facts and assumptions, upon which the opinion has been based, stated clearly? Is there a clear progression from the facts and assumptions to the conclusions? Does the expert employ clear, simple terminology and arguments? Does he or she “tell the reader what he/she is going to say, say it, then tell the reader what has been said?” Too often, we are sent opposing experts’ reports with a request that we please explain what that expert has said. If the lawyer we are working for cannot understand the opposing expert’s report, it is unlikely that the lawyer for whom the report was prepared could understand it either ? and it is also highly unlikely that the judge will understand it.

Be cautious when asking your economist to present scenarios that may not be supportable. For example, suppose your plaintiff had a well-established career and earned a steady income averaging $75,000 per year. Your economist will likely include a scenario in which it is assumed that the $75,000 annual income would have continued, but for the accident. However, your plaintiff might have advised you that earnings of $100,000 would have been available, due to a likely promotion, and you may decide to ask your economist to include such a scenario, with the understanding that supporting evidence (say, from the employer) will be forthcoming. If it turns out that no evidence will be offered in court to support the more-optimistic scenario, it will reflect badly on your expert (and your case) if the judge is unimpressed with scenarios that are presented as “illustrative only” or “at the request of counsel.”

We strongly recommend that you have a meeting with your expert some time in the two or three weeks preceding a trial: to clarify what the expert’s opinion is in detail and to prepare the most effective method of presenting that opinion in court. We feel that there are at least four major advantages to this pre-trial meeting. (i) As most experts are involved in hundreds of actions and may have written the report in this case months, if not years, ago, a pre-trial meeting can ensure that the expert is fully familiar with his/her own report. (ii) As it is common that new information becomes available in the last month or two before the trial, it is important that the expert is made aware of this information. (iii) You and the expert should discuss the most effective techniques for presenting his/her evidence. Are you, for example, going to follow the expert’s report page-by-page? At this stage, it is often useful to try some practice questions on the expert as experts can sometimes find the wording of questions to be confusing. If there are certain points that you especially want your expert to make during his/her testimony, make sure that your expert knows this, and knows what type of question you will ask in order to obtain the desired response. (iv) A review of the file with your expert may provide you with a clearer assessment of the strengths and weaknesses of both your expert’s report and that of the opposing experts, thereby creating a firmer basis on which to negotiate a settlement.

It is often also important to meet with your expert during the trial, a day or two before his/her testimony. As the lay witnesses appear before the experts, it is important that your expert be informed about any new information that has been presented during the lay testimony. Also, since the economist typically follows most (if not all) of the other experts, your economist can be advised of what evidence was ultimately offered by some of the other experts who prepared reports that were used as a foundation for the economist’s evidence. For example, if the vocational expert’s evidence has changed slightly from that offered in his 218 report (based on new information offered by lay witnesses during trial perhaps), it is important for your economist to know about this. Finally, the expert can be informed concerning the general approach that has been taken by both the opposing counsel and by the judge.

In the weeks or days before testimony, it is important to discuss with your expert the counter-arguments that you and he/she expect will be raised by the other side. While rebuttal reports may been prepared already, it is useful to try to identify what will be the most contentious economic issues, and what your expert’s response will be. Discuss any weaknesses in your expert’s report, and how they might be dealt with in court.

During-Testimony

Unless you have a particularly poorly-qualified expert, you should always begin the expert’s testimony by reviewing his/her qualifications, to impress the judge with the expertise of your witness. If you have a particularly well-qualified expert, opposing counsel may attempt to preclude you from introducing these qualifications by announcing that he/she will accept the expert’s qualifications without a review of the c.v. It is not advisable, of course, to succumb to this tactic.

Before beginning a review of the expert’s qualifications, it is advisable to inform the judge what that individual’s area of expertise is, so the judge can contrast the expert’s qualifications with the expertise that you are claiming.

Do not simply ask the expert to describe his/her c.v. Some experts will be too modest to provide a full description ? and some will be too boastful. Rather, ask them a series of questions about specific aspects of their expertise ? for example, about their most important educational attainments, their professional experience, their most important publications, and their experience testifying.

Enter the expert’s report and base your examination on the report. As the judge will not have expertise in the expert’s area, it will be useful for the judge to have the report before him/her as an aid to understanding the testimony. Also, as the judge will need to read the report later, when preparing a decision, it will be useful to be able to relate the recorded testimony to the report.

Follow the report page-by-page, if not paragraph-by-paragraph or line-by-line in your questioning of the expert. Our experience is that judges find it useful to follow the report during the testimony. If you start jumping around from page to page, the judge will become frustrated.

Ask questions that require only short answers. The court’s attention is held better that way than by allowing the expert to ramble on, perhaps becoming embroiled in the language of his/her discipline.

If you are representing the plaintiff and you think opposing counsel is going to introduce his/her own expert to counter yours, it may be advisable to ask your expert to comment on the opposing expert’s arguments. Your expert may be in a better position to expose the weaknesses of those arguments than you will be in cross-examination.

Similarly, you should also attempt to anticipate the tack that opposing counsel will use in cross-examination of your witness and ask your expert to comment on the anticipated arguments. Your expert will be much more comfortable “arguing” with you than with your opponent, both because cross-examiners will often severely curtail any attempt by experts to raise counter-arguments and because most experts will be reluctant to appear argumentative (with cross-examiners) as it makes them appear biased.

Sometimes during cross-examination, your expert may concede a weakness or error in his/her report. If the other lawyer does not allow your expert ample opportunity to discuss the significance of this weakness/error, then it may be helpful for you to raise the issue during redirect. This will provide your expert with additional time to think about the issue, and to provide a more in-depth response, if one is required.

Conclusion

In summary, a successful examination of your expert economist begins with a well-written report, containing scenarios and assumptions that match the evidence that will ultimately be offered in court. Regardless of your expert’s prior trial experience, it is always useful to meet with him or her before trial to discuss the economic evidence that will be offered, prepare for the other side’s arguments, and advise him/her of relevant testimony by other witnesses. With a suitable foundation and preparation before trial, your expert will have the best opportunity to perform well during trial.