Opinion ID: 1189013
Heading Depth: 3
Heading Rank: 2

Heading: The Insurance Commissioner's Determination of 20th Century's Rate Rollback Liability

Text: Let us now turn from the Insurance Commissioner's rate regulations to his determination of 20th Century's rate rollback liability. It appears that a week after we handed down Calfarm, the Insurance Commissioner's predecessor gave public notice that insurers who wished to do so could file applications for approval of rates for the rollback year higher than the maximum rate of 80 percent of the 1987 rate (hereafter rollback-exemption applications), and could charge such higher rates pending approval. It further appears that 20th Century filed seven rollback-exemption applications and proceeded to charge the indicated higher rates  which seem to have been about 12.63 percent greater than the 1987 rate  pending approval. The firm writes six lines of insurance. Subsequently, in File No. REB-5173 the Insurance Commissioner issued an order to show cause and notice of hearing in the matter of 20th Century's rate rollback liability. The commissioner indicated that 20th Century should refund to each insured an amount equal to the premiums paid for the rollback year multiplied by a refund percentage of 13.34 percent, with simple interest calculated at 10 percent per annum from May 8, 1989, to the date of payment. A hearing on the Insurance Commissioner's order to show cause was held before an administrative law judge. The hearing was extensive. In her own words, the administrative law judge considered hundreds of pages of prefiled testimony and detailed exhibits as well as several weeks of live testimony, posthearing briefs and oral argument.... The administrative law judge issued a proposed decision that fills 185 pages. Evidently for the purpose of subsequent judicial review, she effectively lifted the relitigation bar to allow 20th Century to introduce evidence to challenge the premises of the rate regulations, accord[ing] it the opportunity to present evidence ... on every issue that it contended was material. She also recognized a constitutionally mandated variance  separate and independent from those established in the regulations in question  which would be available to 20th Century on proof of confiscation, for which she allowed evidence and argument on whether the rollback formula ... yielded unconstitutional and confiscatory results as applied to 20th Century and thereby justif[ied] or requir[ed] departure from the regulations.... As pertinent here, her determinations were to the following effect. During 20th Century's rollback liability hearing, the rate regulations were in effect, notwithstanding the OAL's disapproval at various times. Proposition 103 authorizes the Insurance Commissioner to adopt rate regulations to implement the rate rollback requirement provision. The regulations, explained the administrative law judge, avoid the administrative gridlock that would result from readjudicating over and over hundreds of issues that affect multiple insurers in lengthy hearings that would yield inconsistent results  if they ever yielded any result at all. (Italics added in place of underscoring in original.) The regulations employ generic determinations and a detailed formula designed to ensure manageability and consistent treatment of insurers and insureds. At the same time, the regulations incorporate multiple company-specific factors into the rollback formula, and then are applied in individual adjudicatory hearings. The company-specific hearings allow further tailoring to a company's situation.... Specifically, Proposition 103 authorizes the Insurance Commissioner to adopt rate regulations to implement the rate rollback requirement provision with a view toward factors including the individual insurer's profits and not  as 20th Century claims he must  through the imposition of general price caps on the rates of insurers generally. 20th Century's rates for the rollback year might survive the imposition of such price caps because they were relatively low  reflecting its relatively low costs: it is a direct writer of insurance, and therefore does not employ or utilize captive or independent agents; and it is very selective as to its insureds, choosing preferred risks. But, observed the administrative law judge, 20th Century's argument for regulation by price caps rather than factors including profits is bottomed on policy rather than law  specifically, a policy that would have us ignore Calfarm's emphasis on such factors as profits and Proposition 103's call for reduction of rates industry-wide, regardless of whether the rates were low or high by industry standards.... (Italics added in place of underscoring in original.) Confiscation requires at least deep financial hardship  albeit deep financial hardship short of bankruptcy  within the meaning of Jersey Central. ( Jersey Cent. Power & Light Co. v. F.E.R.C., supra, 810 F.2d at p. 1181, fn. 3.) Moreover, it is an enterprise-wide issue, not one to be parsed on a line-by-line basis. Under the rate rollback requirement provision  to use the terms appearing in Insurance Code section 1861.05, subdivision (a)  a rate is inadequate if confiscatory and excessive if more than minimally nonconfiscatory and above 80 percent of the 1987 rate. Proposition 103 authorizes the Insurance Commissioner to adopt a ratemaking formula to implement the rate rollback requirement provision. Specifically, it empowers him to frame a ratemaking formula to determine whether, for an individual insurer, a maximum rate for the rollback year higher than 80 percent of the 1987 rate is required to avoid confiscation and, if so, what such higher maximum rate is. Substantively, the rate regulations are valid on their face as necessary and proper for the implementation of Proposition 103's rate rollback requirement provision. Specifically, the rate regulations are sound insofar as they define 10 percent as the lower boundary of the range of reasonable rates of return in the ratemaking formula. The administrative law judge stated that the 10 percent rate of return was based on the average historical rates of return actually achieved by the industry between 1980 and 1989, rather than theoretical investor expectations determined by econometric models. She noted that the industry earned an average 9.1% return ... in 1989 under statutory accounting principles, and that over the 10 years from 1980 to 1989 averaged a 10% return under both statutory accounting principles and generally accepted accounting principles. (Internal quotation marks omitted.) She concluded that [u]se of actual historical rates of return rather than inherently speculative hypothetical projections of investor expectations is ... reasonable ..., particularly for a time period now already past. The ratemaking formula, it must be noted, does not purport to guarantee any individual insurer a rate covering its cost of service plus 10 percent of its capital base independent of the various adjustments, exclusions, etc., incorporated therein. There is no constitutional or other requirement that all reasonable expenses and prudent investments must be allowed. The rate regulations are also sound insofar as they recognize investment income in the ratemaking formula. [U]nlike other businesses such as public utilities, observed the administrative law judge, insurers need not transform their capital into physical assets like a power plant, but may keep them instead in liquid assets like stocks and bonds. Surplus may simultaneously support the insurance business and earn investment income. The rate regulations are sound as well insofar as they concern the line of earthquake insurance, which is of particular interest because the Loma Prieta earthquake struck Northern California during the rollback year. They subject all insurers to consistent treatment, including direct ratemaking  which is used to avoid a possible loophole since reinsurance is generally not regulated (Ins. Code, § 1851, subd. (a)). They yield generally supportable outcomes for individual insurers, although they disfavor those whose incurred losses are small and favor those whose incurred losses are large. In any event, they do not themselves determine the insurer's rate rollback liability. The minimum permitted earned premium for the earthquake line must not be viewed in isolation as an end result. Together with the minimum permitted earned premium for each of the insurer's other lines, it functions only as an intermediate step in the refund calculation. With specific regard to direct ratemaking, the administrative law judge observed: The Insurance Commissioner's adoption of direct ratemaking as a consistent basis for determining rollback obligations is a reasonable policy choice.... One of 20th Century's witnesses admitted that 20th Century, like the industry generally, uses direct ratemaking. He also agreed that as a matter of policy the Commissioner should adopt a consistent basis for all insurers and that direct ratemaking would greatly benefit companies with large reinsured losses like those who paid claims due to the Loma Prieta earthquake. He acknowledged that most insurers benefit from use of the direct basis since they had large losses ceded to reinsurers in 1989 due to the Loma Prieta earthquake ..., and those recoveries from reinsurers are not recognized on a direct basis. Therefore, the uniform use of direct rather than net ratemaking was more favorable to the industry as a whole, while placing the higher rollback obligation on those with low losses and thus better able to pay it. Further, while 20th Century's argument that direct ratemaking is unfair because it ignores money actually paid to purchase reinsurance in 1989 has some appeal at first blush, it ignores the fact that any set of accounting rules necessarily includes conventions which in a sense deviate from actual expenditures. Indeed, 20th Century benefits from the regulations' recognition of 1989 reserves as if those amounts were actually paid, when in fact the claims covered by reserves were actually paid after 1989. Surely, losses are a major component in the rate regulations  both generally and specifically as to rollbacks. But that is simply because the nature of the insurance business is to indemnify losses. The rate regulations are also sound insofar as they require a uniform, maximum rate for the rollback year, and a uniform percentage refund of premiums overcharged and overpaid therein, without regard to claimed excessiveness or inadequacy in individual lines. Further, the rate regulations are not impermissibly retroactive. Procedurally, the rate regulations are valid on their face as necessary and proper for the implementation of Proposition 103's rate rollback requirement provision. Specifically, they are sound insofar as they provide for a hearing on an individual insurer's rate rollback liability. They do not preclude an individualized hearing by reason of the nature or number of the potentially available variances, viz., the one-line, entering-the-market, and insurer-insolvency variances. Neither do they preclude an individualized hearing by reason of the relitigation bar. Moreover, substantively and procedurally, the rate regulations are valid as necessary and proper for the implementation of Proposition 103's rate rollback requirement provision as applied to 20th Century. The operation of the ratemaking formula with its variables deriving their values from firm-specific data necessarily afforded 20th Century whatever rate adjustment was necessary to avoid confiscation. The hearing thereon was individualized and altogether full and fair. Further, 10 percent as the lower boundary of the range of reasonable rates of return is not confiscatory as to 20th Century. 20th Century introduced evidence in an attempt to establish its entitlement to a rate of return of at least 20 percent and perhaps as high as 99 percent. The evidence related to 20th Century's cost of capital. [5] Cost of capital may be defined as the rate of return available in the marketplace on investments comparable in terms of risk and otherwise or, more practically, as the expected rate of return a hypothetical investor would require to take a position in the firm in question. Specifically, the evidence looked to 20th Century's cost of capital derived from various econometric models directed toward the optimal prospective rate of return based on hypothetical investor expectations. 20th Century's cost-of-capital evidence was deemed immaterial by the administrative law judge. The adjective optimal is inapt: Under Proposition 103 as construed in Calfarm, for the rollback year the Insurance Commissioner must select a rate at or near the bottom of the range of rates which are constitutional. Yet [20th Century] has ignored the lower end of the range, instead focusing exclusively on the highest rate of return that might conceivably be expected by investors in 1989. Also inapt is the adjective prospective: While estimated returns are pertinent for prospective ratemaking [under the prior approval system], implementation of the rollback does not require prospective ratemaking but rather the determination of a minimum nonconfiscatory return for a period now past. (Internal quotation marks omitted.) 20th Century's cost-of-capital evidence was also deemed unpersuasive by the administrative law judge. One of 20th Century's main expert witnesses testified to a constitutionally required rate of return (ultimately 33 percent, earlier 41.5 percent, and even higher when he initially advocated more than doubling his figures) that exceeds 20th Century's actual rate of return of about 31.51 percent under statutory accounting principles and 32.52 percent under generally accepted accounting principles. Neither is any of the following confiscatory as to 20th Century: the treatment of the line of earthquake insurance, including direct ratemaking; the variable expense factor; the leverage factor; or the requirement of a uniform, maximum rate for covered insurance for the rollback year, and a uniform percentage refund of premiums overcharged and overpaid therein, without regard to claimed excessiveness or inadequacy in individual lines. As to the treatment of the line of earthquake insurance, including direct ratemaking, the administrative law judge observed: The component of the rollback calculation related to 20th Century's Earthquake line may appear somewhat harsh when it is viewed in isolation ..., as if it were the final result rather than only an intermediate step in the calculation. However, 20th Century's rollback must be judged on the issue of confiscation based on the overall result. [Citation.] From that perspective, the impact is not confiscatory. [Citation.] 20th Century is a multi-line insurer whose Earthquake line accounted for only 1.35 percent of its business ($8.7 million of $641.7 million) in the rollback year, and its unrecognized reinsurance premiums on Earthquake only accounted for 0.7 percent of its business ($4.5 million of $641.7 million). [Citation.] It admittedly suffered very low losses in its Earthquake line that year [because of its concentration in southern California, which did not experience the Loma Prieta earthquake] and its cost of writing that coverage was small (estimated ... to be as low as five dollars per policy, [citation]), so it enjoyed a high profit in that line. In any case, calculation of the Earthquake component of the rollback is merely one of the many intermediate steps to the final rollback. (Fn. omitted.) As to the leverage factor, the administrative law judge observed: For rollback, the regulations use whichever is higher, the actual leverage ratio that the insurer had in the rollback year or a specified ratio. (For the prior approval system, by contrast, they use a specified leverage ratio, even if the actual ratio is higher.) 20th Century contends that for the rollback year it should be permitted to earn a profit on a higher level of surplus (i.e., lower leverage or premium-to-surplus ratio) than it actually had that year, because as a more highly leveraged company, it was riskier and therefore entitled to a higher rate of return. This contention boils down to an unjustifiable request to earn a profit on capital that it did not have. In addition, 20th Century omits the corollary to its argument that its stockholders deserve a higher return because of the greater risk entailed by [its] high leverage ratio: that policyholders who purchased its insurance for security and peace of mind shared in this higher risk, and probably did so involuntarily. Implicit in the administrative law judge's observation is a recognition that the leverage factor is crucial to the determination of rates. As stated, the ratemaking formula is designed to yield a premium that the insurer should receive from its insureds in order to earn a sum amounting to (1) the reasonable cost of providing insurance and (2) the capital used and useful for providing insurance multiplied by a fair rate of return. The leverage factor directly contributes to the definition of the capital that is deemed used and useful for providing insurance by inverse relationship: the higher the leverage ratio, the smaller the used-and-useful capital; the lower the leverage ratio, the greater the used-and-useful capital. It follows that the leverage factor indirectly contributes to the setting of the rate itself by inverse relationship: the higher the leverage ratio, the smaller the used-and-useful capital and hence the smaller the rate; the lower the leverage ratio, the greater the used-and-useful capital and hence the greater the rate. Thus, so far as the determination of rates is concerned, the insurer generally favors a lower leverage ratio and its insureds generally favor a higher leverage ratio. The nonrecognition of capital that turn[s] out not to be used and useful is not confiscatory, observed the administrative law judge, no matter the prudence of the underlying investment. The administrative law judge concluded: Nowhere in the hundreds of pages of testimony, exhibits and argument that 20th Century has proffered in support of its argument of confiscation has it claimed that its rollback would pose the type of deep financial hardship ... that rises to the level of confiscation. At most, it has argued that it would not be able to expand as rapidly as it has in the past because its reduced surplus after a rollback would not support as large a growth in premiums written. [Citations.] Even assuming that this were true, 20th Century has cited no case holding that a slowdown in growth is confiscatory. The clear evidence that 20th Century has been able to expand rapidly largely through use of retained earnings, selling stock only once in the last six years while growing from a $500 million to a $1 billion company [citation], undercuts 20th Century's claim that it will not be able to raise new surplus if forced to rollback. Moreover, to the extent that 20th Century has already set aside reserves against its rollback liability, with a corresponding reduction in surplus, the impact of that reduction has already occurred. [Citation.] Yet 20th Century has continued to grow by more than 10 percent each year from 1989 through 1991. (Fn. omitted.) The Insurance Commissioner adopted the administrative law judge's proposed decision as his own. In accordance therewith, he ordered 20th Century to refund to each insured an amount equal to the premiums paid for the rollback year multiplied by a refund percentage of 12.203 percent, with simple interest calculated at 10 percent per annum from May 8, 1989, to the date of payment. In so doing, he effectively set 20th Century's maximum rate for the rollback year at about 98.89 percent of the 1987 rate to avoid confiscation, rather than at 80 percent of that rate, as required by Proposition 103 in the rate rollback requirement provision. Put differently, he reduced 20th Century's maximum rate for the rollback year to a point a mere 1.11 percent below the 1987 rate, rather than to a point 20 percent below that rate. The Insurance Commissioner's decision on the rate rollback liability of 20th Century is the first and only final determination of this sort. The commissioner chose the 20th Century matter as a test case, in part because of its relative simplicity. It appears that more determinations of rate rollback liability will follow: The commissioner represents that about 460 insurers have filed over 4,000 rollback-exemption applications, and have proceeded to charge the indicated higher rates. [6]