Insurance Firm Market Response to California Proposition 103 and the Effects of Firm Size

Insurance Firm Market Response to California Proposition 103 and the Effects of Firm Size Introduction California voters, dissatisfied with high insurance rates, approved Proposition 103 on November 8, 1988. The key provision was an immediate 20 percent reduction of automobile, homeowner, commercial, and municipal liability insurance rates. Rates also were to be frozen for one year, unless the insurance commissioner of all rate increases, repeal of the insurance industry's state antitrust exemption, allowing banks to sell insurance, and limiting the determinants of automobile liability rates to the insured's accident record. A major result of Proposition 103 was the movement of the insurance regulatory system in California from one of open competition to prior approval of rates. Brostoff (1988) and Aschkenasy (1989), among others, recognize that consumer dissatisfaction with the insurance industry is spreading, and legislation similar to Proposition 103 is being considred in at least 14 other states. Some consumers believe insurance rates, especailly those for auto insurance, are unfairly high. The public interest theory of regulation (Needham, (1983)) assumes that regulation is a government response to public demands for the rectificatin of inequitable practices (primarly in price setting) by business organizations. Regulation in the insurance industry is an example of public interest regulation because its purpose is to enforce the requirement that rates remain adequate, reasonable, and fair. Various researchers have examined the methods used for property-liability insurance rate regulation. Biger and Kahane (1978), Fairley (1979), and Hill (1979) proposed CAPM type models to determine fair rates of return for the property-liability insurance industry. Joskow (1973), Samprone (1979), Harrington (1984, 1987), and Grabowski, Viscusi and Evans (1989) analyze accounting data to determine the impact of open competition versus regulated ratemaking on insurer profitability. The findings of these studies are inconsistent with regard to whether open competition or regulated ratemaking serve to maximize insurer profitability. Peltzman (1976) developed a general model dealing with the influence of regulation based on the premise that regulation creates a wealth transfer. Industry and special interest groups compete for the benefits of regulatory change. Under Peltzman's model, regulatory change often transfers wealth to insurers since their financial interests are greater than that of individual consumers. Consumers' financial interests or costs are directly related to their involvement in the regulatory policy change. Higher levels of consumer involvement are generally associated with fewer industry benefits from the regulatory change. Proposition 103 provided short-term benefits for consumers. The most immediate attraction was the 20 percent reductionand freezing of automobile and other insurance rates for one year. Since consumers had such a large financial advantage from the enactment of Proposition 103, it is likely that the insurance industry suffered. The purpose of this research is to examine the impact of the passage of California Proposition 103 on insurance stock values. It is hypothesized that the passage had a significant negative impact on property-liability insurers, especially those doing large volumes of business in California. Fields, Ghosh, Kidwell, and Klein (1990) have examined California's Proposition 103. They found that for several days surrounding the election, insurance firms' stock values reacted negatively. The decrease in value is directly related to the proportion of the firm's revenues that are affected by the referendum. Profitable companies were found to have less negative effect. Szewczyk and Varma (1990) also analyze Proposition 103. Their study examines the effect of Proposition 103 on the common stock values of property-liability insurers around both the passage of the measure and the court decision upholding the rate rollback and overturning the insolvency provision. …