Opinion ID: 1189013
Heading Depth: 3
Heading Rank: 1

Heading: The Rate Regulations

Text: The rate regulations are codified as title 10, chapter 5, subchapter 4.8, articles 1 through 7, sections 2641.1 through 2647.1, of the California Code of Regulations. Insofar as they directly bear on rollbacks, they are included therein as title 10, chapter 5, subchapter 4.8, article 5, sections 2645.1 through 2645.9, and article 6, sections 2646.1 through 2646.5. At the outset, three general comments are called for. First, insurance premiums and losses may be accounted for on a cash or accrual basis. Cash accounting speaks of premiums written and losses paid: premiums written refers to dollars received; losses paid refers to dollars paid out. Accrual accounting, by contrast, speaks of premiums earned and losses incurred: premiums earned refers to dollars distributed pro rata over the term of the policy; losses incurred refers to both actual pay-outs and reserves set aside for future payouts. The rate regulations generally require insurance premiums and losses to be accounted for on an accrual basis, as premiums earned and losses incurred. (See Cal. Code Regs., tit. 10, §§ 2643.3, 2644.4, 2644.5, 2644.6, 2644.7, 2645.4, 2645.9.) Second, an insurer's capital may be measured in accordance with generally accepted accounting principles (hereafter sometimes GAAP) or statutory accounting principles (hereafter sometimes SAP). Statutory accounting principles are more conservative than generally accepted accounting principles. Statutory accounting principles ... are rules that state insurance departments have developed to regulate ... insurance companies; SAP mandate that conservative methods be employed in valuing the assets of such companies to guarantee their continuing solvency. [Citations.] This routine conservatism as reflected through use of SAP requires only that [ sic : read, requires that only] certain types of assets be considered in calculating a company's financial condition, and that the value of such ... assets be determined according to quite restrictive rules. ( Meyers v. Moody (5th Cir.1982) 693 F.2d 1196, 1218.) The rate regulations generally require an insurer's capital to be measured in accordance with statutory accounting principles rather than generally accepted accounting principles. (Cal. Code Regs., tit. 10, § 2643.5.) Third, insurance transactions may be subjected to direct or net ratemaking. To quote the Insurance Commissioner: `Direct ratemaking' measures the insurer's operations at the `retail' level, counting all premiums the insurer receives from its policyholders and all losses paid to them. `Net ratemaking' measures the same operations `net' of reinsurance  subtracting from premiums the insurer receives from policyholders that portion it passes on (`cedes') to reinsurers and subtracting from losses those amounts covered by (`ceded to') reinsurers. The rate regulations generally require insurance transactions to be subjected to direct ratemaking. (See Cal. Code Regs., tit. 10, § 2645.9.) Central to this matter is what is commonly referred to as the ratemaking formula. (Cal. Code Regs., tit. 10, §§ 2644.2, 2644.3.) Permitted EP = losses + ALAE + fixed expenses - ancil income 1 - var exp factor - profit factor + invest inc factor Permitted EP stands for permitted earned premium. (Cal. Code Regs., tit. 10, §§ 2644.2, 2644.3.) Losses means incurred losses that are adjusted as specified. (Cal. Code Regs., tit. 10, §§ 2644.4, 2644.5, 2644.6, 2644.7, 2645.4.) ALAE stands for allocated loss adjustment expenses, which means the costs associated with the adjustment of specific claims. (Cal. Code Regs., tit. 10, § 2644.8, subd. (a).) Fixed expenses means expenses for acquisition (other than commission and brokerage), field supervision, and collection; plus general expenses; plus state and local taxes, licenses, and fees; minus state premium taxes; plus unallocated loss adjustment expenses  all adjusted as specified. (Cal. Code Regs., tit. 10, § 2644.9.) Fixed expenses are subject to an efficiency standard  a test of reasonableness  for each covered line of insurance, as established from time to time by the Insurance Commissioner in a generic determination. (Cal. Code Regs., tit. 10, § 2644.12.) The generic determination applicable to rollbacks is incorporated. ( Id., tit. 10, § 2645.5, subds. (b) & (c).) Fixed expenses do not include: (a) political contributions and lobbying; (b) executive compensation exceeding a reasonable amount, as found from time to time by the Insurance Commissioner in a generic determination  the generic determination for rollbacks is incorporated (Cal. Code Regs., tit. 10, § 2645.5, subd. (a)); (c) bad faith judgments and associated allocated loss adjustment expenses; (d) costs attendant to the unsuccessful defense of discrimination claims; (e) fines and penalties; (f) institutional advertising expenses; and (g) payments to affiliates for goods or services exceeding their fair market value. ( Id., tit. 10, § 2644.10.) Ancil income stands for ancillary income, which means net income not derived from operations directly related to covered insurance. (Cal. Code Regs., tit. 10, § 2644.13.) Var exp factor stands for variable expense factor, which means the sum of the commission rate and the state premium tax rate. (Cal. Code Regs., tit. 10, § 2644.14.) Profit factor means the permitted after-tax rate of return divided by the product of the leverage factor for each line of covered insurance multiplied by the federal income tax factor. (Cal. Code Regs., tit. 10, § 2644.15.) Permitted after-tax rate of return is the yield on investment as established from time to time by the Insurance Commissioner in a generic determination. ( Id., tit. 10, § 2644.16.) The generic determination applicable to rollbacks is incorporated as 10 percent, corresponding to the lower boundary of the range of reasonable [rates of] return[] .... ( Id., tit. 10, § 2645.6, subd. (a).) Leverage factor means the ratio of net written premiums to surplus for each line of covered insurance, as established from time to time by the commissioner in a generic determination. ( Id., tit. 10, § 2644.17.) The generic determination of leverage ratios applicable to rollbacks is incorporated. ( Id., tit. 10, § 2645.6, subd. (b).) If an insurer's actual leverage ratio or ratios for the rollback year under 1989 calendar year data is higher than the specified leverage ratio or ratios, it is used instead. ( Id., tit. 10, § 2645.6, subd. (c).) Federal income tax factor means 1 minus the insurer's effective federal income tax rate. ( Id., tit. 10, 2644.18.) Invest inc factor stands for investment income factor, which means the insurer's yield multiplied by the sum of the reserves ratio plus the surplus ratio. (Cal. Code Regs., tit. 10, § 2644.19.) Reserves ratio means (a) the average of the last two years' loss reserves, plus loss adjustment expenses reserves, plus unearned premium reserves, (b) divided by the earned premium for the most recent year for which data are available. ( Id., tit. 10, § 2644.21.) Surplus ratio means the reciprocal of the leverage factor. ( Id., tit. 10, § 2644.22.) (2) 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. This is consistent with the general rule that the rate set for a regulated firm is the sum of (1) its cost of service and (2) its capital base multiplied by a rate of return. (See, e.g., Jersey Cent. Power & Light Co. v. F.E.R.C. (D.C. Cir.1987) 810 F.2d 1168, 1172 [28 App.D.C. 189] (en banc) [hereafter sometimes Jersey Central ].) [4] The ratemaking formula incorporates the accounting principle of matching. Matching involves, inter alia, the consistent treatment of related items of revenue and expense. Thus, for any given period, one must recognize, for example, an increase in taxes with an increase in premiums and a decrease in taxes with a decrease in premiums. So far as review of rates subject to the rate rollback is concerned, matching operates to take account of the expenses that would have been avoided had the insurer charged a rate no higher than the maximum rate set by Proposition 103 as construed in Calfarm  i.e., the rate that is 80 percent of the 1987 rate or such rate greater than 80 percent of the 1987 rate as is minimally nonconfiscatory  as well as the revenue that would have been forgone. The ratemaking formula defines the values of many of its variables differently for the review of rates subject to the rate rollback and for the review of rates subject to the prior approval system. Because the prior approval system concerns rates for the future, its orientation is necessarily prospective. Hence, for review of rates thereunder, the ratemaking formula relies much on projections. (See, e.g., Cal. Code Regs., tit. 10, §§ 2644.2, 2644.3, 2644.4, 2644.8, 2644.9, 2644.13, 2644.20.) By contrast, because the rate rollback concerns rates for a period that has passed, its orientation is retrospective. Hence, for review of rates thereunder, the ratemaking formula relies much on actual historical data. (See, e.g., Cal. Code Regs., tit. 10, §§ 2645.2, subd. (d), 2645.4, 2645.8.) For convenience, such data is taken largely from the 1989 calendar year instead of the rollback year, which as noted extended from November 8, 1988, through November 7, 1989. (See, e.g., id., tit. 10, §§ 2645.4, 2645.6, subd. (c).) Further, the ratemaking formula is used differently for the review of rates subject to the rate rollback and for the review of rates subject to the prior approval system. Under the prior approval system, the insurer is effectively free to set for itself whatever rate it chooses, provided that (as relevant here) its rate is neither excessive nor inadequate. The rate regulations define as excessive a rate that is expected to yield the reasonably efficient insurer a profit that exceeds a fair return on the investment used to provide the insurance in light of the competing interests of consumers in lower prices and of investors in prices that yield high returns and the fact that insurance is imbued with the public interest and is sometimes legally required. (Cal. Code Regs., tit. 10, § 2642.1.) They define as inadequate a rate under which a reasonably efficient insurer is not expected to have the opportunity to earn a fair return on the investment that is used to provide the insurance in light of the considerations identified above. ( Id., tit. 10, § 2642.3.) Lastly, they define a fair return as the profit that an investor can reasonably expect to earn from an investment in a business other than insurance subject to regulation [thereunder] presenting investment risks comparable to the risks presented by insurance subject thereto. ( Id., tit. 10, § 2642.2.) By contrast, under the rate rollback, the insurer is not free to set for itself whatever rate it chooses between the excessive and the inadequate. Rather, it is required to charge a rate no higher than the maximum rate set by Proposition 103 as construed in Calfarm  i.e., the rate that is 80 percent of the 1987 rate or such rate greater than 80 percent of the 1987 rate as is minimally nonconfiscatory, whichever is higher. In this regard, the rate regulations set out, among others, the following findings by the Insurance Commissioner: Proposition 103 requires that all rates charged during the rollback period be reduced by 20% from their November 8, 1987, levels. Consumers are entitled to receive, and insurers are obligated to give, this reduction, except to the extent that it violates the insurers' constitutional rights. (Cal. Code Regs., tit. 10, § 2645.2, subd. (a).) Insurers are entitled to rates during the rollback period that are not confiscatory. Rates are confiscatory if and only if all the rates charged by the individual insurer are, taken as a whole, confiscatory. (Cal. Code Regs., tit. 10, § 2645.2, subd. (b).) To the extent that the rates specified by Proposition 103 for the rollback period are confiscatory, insurers are entitled to a rate above the level prescribed by the initiative, but not higher than necessary for the rates not to be confiscatory. (Cal. Code Regs., tit. 10, § 2645.2, subd. (c).) To cover both the rate rollback and prior approval system, the ratemaking formula may be used to yield both a maximum permitted earned premium (when the profit factor variable takes as its value a maximum profit factor based on a maximum permitted after-tax rate of return [see Cal. Code Regs., tit. 10, § 2644.2, 2644.15]) and a minimum permitted earned premium (when the profit factor variable takes as its value a minimum profit factor based on a minimum permitted after-tax rate of return [see id., tit. 10, §§ 2644.3, 2644.15]). For review of rates under the prior approval system, the Insurance Commissioner determines both the maximum and minimum permitted earned premium. That is because, as stated, the insurer is effectively free to set for itself whatever rate it chooses between the excessive and the inadequate. A rate is excessive if it is higher than the maximum permitted earned premium. (See Cal. Code Regs., tit. 10, 2644.1.) It is inadequate if it is lower than the minimum permitted earned premium. (See ibid. ) The commissioner must approve a rate that (as relevant here) falls between the excessive and the inadequate. (See ibid. ) By contrast, for review of rates under the rate rollback, the Insurance Commissioner proceeds otherwise. As stated, the insurer is not free during the rollback year to set for itself whatever rate it chooses between the excessive and the inadequate, but rather must charge a rate no higher than the maximum rate set by Proposition 103 as construed in Calfarm, i.e., the rate that is 80 percent of the 1987 rate or such rate greater than 80 percent of the 1987 rate as is minimally nonconfiscatory. For the rollback year, the commissioner determines only the minimum permitted earned premium, and does so only to define what is minimally above inadequate or minimally nonconfiscatory. The insurer must refund to each of its insureds, with simple interest calculated at 10 percent per annum computed from May 8, 1989, the midpoint of the rollback year, through the date of payment, an amount equal to the premiums paid for the rollback year multiplied by the refund percentage, which means the lesser of (1) the statutory percentage (i.e., the larger of (a) total 1989 direct earned premium [excluding surety, credit, and financial guaranty insurance] minus total 1989 direct earned premium [excluding surety, credit, and financial guaranty insurance] adjusted to the rate that is 80 percent of the 1987 rate divided by total 1989 direct earned premium [excluding surety, credit, and financial guaranty insurance], or (b) zero), and (2) the constitutional percentage (i.e., the larger of (a) total 1989 direct earned premium [including surety, credit, and financial guaranty insurance] minus the total minimum permitted earned premium [including surety, credit, and financial guaranty insurance] divided by total 1989 direct earned premium [excluding surety, credit, and financial guaranty insurance], or (b) zero). (Cal. Code Regs., tit. 10, § 2645.9.) In the refund calculation, the total minimum permitted earned premium is the sum of the minimum permitted earned premium for each of the covered lines of insurance written by the insurer  the latter functioning only as an intermediate step in the calculation. Central to this proceeding is not only the ratemaking formula itself, but also the nature and scope of the hearing at which the individual insurer's rates are reviewed. Concerning the nature of a hearing for review of rates: such a hearing has two purposes. (Cal. Code Regs., tit. 10, § 2646.4, subd. (b).) One is to determine whether the insurer has properly applied the relevant statutory and regulatory provisions, including generic determinations, in calculating the maximum or minimum permitted earned premium. (Cal. Code Regs., tit. 10, § 2646.4, subd. (b)(1).) The other is to determine whether the resulting maximum or minimum permitted earned premium should be adjusted. (Cal. Code Regs., tit. 10, § 2646.4, subd. (b)(2).) A request for such an adjustment is referred to as a variance request. ( Ibid. ) There are eight valid bases for a variance request. (Cal. Code Regs., tit. 10, § 2646.4, subd. (c).) Only three are applicable to rates under the rate rollback. (Cal. Code Regs., tit. 10, § 2646.4, subd. (d).) They are: First, the one-line variance: [T]he insurer should be authorized a rate of return other than 10 percent on the ground that the insurer writes in only one line and its mix of business presents investment risks different from the risks that are typical of the line as a whole. (Cal. Code Regs., tit. 10, § 2646.4, subd. (c)(4).) Second, the entering-the-market variance: [T]he insurer should be granted relief from operation of the efficiency standard for a line of insurance in which the insurer has never previously written over $1 million in earned premiums annually and in which the insurer has made or is making a substantial investment in order to enter the market.... (Cal. Code Regs., tit. 10, § 2646.4, subd. (c)(5).) And third, the insurer-insolvency variance: [T]he insurer's financial condition is such that its maximum permitted earned premium should be increased in order to protect the insurer's solvency.... (Cal. Code Regs., tit. 10, § 2646.4, subd. (c)(8).) Concerning the scope of a hearing for review of rates: Relitigation in a hearing on an individual insurer's rates of a matter already determined either by these regulations or by a generic determination is out of order and shall not be permitted. However, the administrative law judge shall admit evidence he or she finds relevant to the determination of whether the rate is excessive or inadequate (or, in the case of a proceeding [concerning a rate for the rollback year], relevant to the determination of the minimum nonconfiscatory rate), whether or not such evidence is expressly contemplated by these regulations, provided the evidence is not offered for the purpose of relitigating a matter already determined by these regulations or by a generic determination. (Cal. Code Regs., tit. 10, § 2646.4, subd. (e).) This is commonly referred to as the relitigation bar.