Opinion ID: 1189013
Heading Depth: 3
Heading Rank: 6

Heading: The Validity of the Rate Regulations as to Rollbacks With Respect to 10 Percent as a Reasonable Rate of Return

Text: The superior court determined that the rate regulations as to rollbacks are not invalid on their face insofar as they define 10 percent as the lower boundary of the range of reasonable rates of return. At this point, it may be profitable to call to mind the pertinent findings and conclusions of the administrative law judge: 10 percent as the lower boundary of the range of reasonable rates 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; the industry earned an average 9.1% return ... in 1989 under statutory accounting principles, and 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); [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. In making its determination, the superior court applied the appropriate standard of review and proceeded to arrive at the proper conclusion thereunder. Its discussion deserves to be quoted at length. [T]he scope of review of the [generic] determinations  one of which is 10 percent as the lower boundary of the range of reasonable rates of return  is the arbitrary/capricious standard. Determining rates of return is not an exact science, and indeed requires exercise of judgment. The different rates of return found to be reasonable by Commissioner Gillespie and Commissioner Garamendi for the rollback year are an example of how reasonable minds can arrive at different results and how evidence is available to serve as [a] basis for varying conclusions. ... Commissioner Garamendi, after `considering all the evidence presented,' found that [a] ... rate of return of 10% ... corresponds to the lower boundary of the range of reasonable returns, and that such a `rate of return is nonconfiscatory.' [Citation.] Evidence supporting the Commissioner's determinations included the testimony of Dr. Andrew Safir, ... that, in his opinion, 10.3% rate of return ... was the lower boundary reasonable rate of return. This opinion was based on the individual performance between 1985 and 1989 of a sample of insurers doing business in California and on a view that investors' expectations are shaped largely by historic profit levels of the companies making up the industry. The validity of Dr. Safir's 10.3% rate of return as at the lower boundary reasonable rate of return was confirmed by other evidence. Thus, his figure was above the level characterized as `accepted norm' for profitability by A.M. Best Co. [Citation.][ [22] ] Furthermore, during the ten years when the industry average had been 10% return on equity, the surplus grew substantially, and even at that low level the industry had been able to meet debt obligations and pay dividends. [Citations.] Dr. Safir looked at a number of companies that earned up to one percent less than his recommended rate of return (between 9.3% and 10.3% ...), and found that out of 48 such companies, 45 had surplus growth, adding a net $1 billion during the year in which they fell below 10.3%. [Citation.] Some of the above was confirmed by 20th Century witness, Dr. Timothy Crichfield. For example, Dr. Crichfield confirmed that most of the surplus growth was from retention of earnings, not attraction of new capital [citations] and that a number of low-earning companies were able not only to retain earnings, but attract capital. [Citations.] Further, evidence in the record showed that in 1989 the insurance industry earned an average return of 9.1% on statutory equity or 9.6% on GAAP [citations]. Over the ten years 1980-1989, the industry averaged 10% return on both SAP and GAAP. Nevertheless, the industry's accumulated capital grew significantly. (Underscoring omitted.) The insurers criticize the whole approach of relying on [the] industry's historical average and industry average for 1989 to determine cost of capital for the rollback year.... There are indeed limitations to the historic average approach. As the insurers point out, the fact that an industry or firm has had low profits for five years or ten years does not necessarily mean that it is a low-risk enterprise or can attract capital even with low rates of return. Similarly, the number of years chosen to include in the average affects the result considerably. Thus,... the five-year average is 10.4%, the four-year average 12.4%, and the three-year average 11.8%. Commissioner Garamendi chose a ten-year average in his conclusion. (Commissioner Gillespie previously had used a 15-year average.) Certainly, a rate of return determined on this basis has to be viewed with caution and in the context of other evidence.... The insurers presented testimony of economists, Dr. [David] Appel and Dr. [James H.] Vander Weide, regarding two theoretical models for estimating investor profit expectations and determination of the return necessary to attract capital: the discounted cash flow model (`DCF') and capital assets pricing model (`CAPM'). These models produced 16.98% and 16.6% rates of return. [Citations.] Depending on assumptions, these rates, too, could vary substantially. [Citation.] Dr. Vander Weide also estimated capital cost based on the risk premium method, arriving at a similar (15.5%) result. Dr. Vander Weide's range of reasonable returns, based on the DCF model, was between 13.8% and 20.3% [citation]. It is really rather obvious from the record herein that all models can be manipulated/applied to produce a great range of rates of return. The insurers also argued that although utilities are less risky, Pacific Gas and Electric and Southern California Edison were allowed a 13% rate of return in 1989 by the Public Utilities Commission. The Commissioner responds that the utilities, unlike insurance companies, hold depreciating assets, and the Public Utilities Commission, unlike the Commissioner, was not looking for a rate at the lower boundary of reasonable rates of return for purposes of determining a one-time rollback. In coming to his determination, the Commissioner considered that unlike utilities, insurers do not generally raise capital by attracting investors or borrowing, but primarily by internal growth [citations], and that therefore, such capital acquisition is free of the transactional costs associated with securities markets. In evaluating all of the evidence presented, the Commissioner considered also that unlike utilities, where heavy stock and bond issuances provide market data on cost of capital, only poor market data was available as to insurer cost of capital and, therefore, less credence could be placed on such data by the regulator. In concluding that unrealized capital gains must be taken into account in the ratemaking process to `avoid setting rates higher than appropriate,' the Commissioner again considered the distinction between utilities and insurers. Thus, the Commissioner found that the insurers have been able to attract capital despite returns that lag behind other industries because, unlike other industries, much of their investment value is in appreciating investments. [Citations.] Thus, in 1989, while the property-casualty insurance industry reported a return of 9.6%, its surplus grew 13.1%; while reporting income of $11.2 billion, the insurance companies were increasing in value by $15.5 billion. [Citation.] The Commissioner also stressed that the rollback is a one-time event, unlike utilities where the rate of return applies for the indefinite future. A one-year rate of return at the lower end of reasonable rates, he reasoned, is not likely to affect investor expectation so that attracting capital plays a diminished role in the fair rate of return calculus. According to the Commissioner, while utility ratemaking is prospective, Proposition 103 rollbacks `present a rare instance where the financial conditions for the relevant period are known....' [Citation.] His determination to rely on available annual historical industry-wide data, and not rely exclusively on analysts' hypothetical projections on what rates should have been, is not arbitrary and capricious.... Use of past data, along with other factors, in determining a reasonable rate of return for a past limited period (one year in the case of the rollbacks) is not improper.... The insurers have pointed to serious flaws in the evidence supporting the Commissioner's determination of 10% as the lower boundary reasonable rate of return.... Under the arbitrary/capricious standard, however, this court cannot reweigh the evidence and substitute its own judgment for that of the Commissioner. The Commissioner considered not only Dr. Safir's opinion testimony, but other evidence in the record as well. He further considered a number of factors which distinguish the insurance business from other businesses, and utilities in particular. The court considers all of the factors relied on by the Commissioner  both evidence in the record of File No. RCD-2 and matters not included therein under the rubric of `legislative fact[s]'  relevant and proper considerations in setting the lower boundary reasonable rate of return on the range of reasonable rates of return in determining rollbacks. Of particular significance is the fact that the rollback is a one-time event, applicable to a past period and is, thus, less likely to affect future expectations of investors than if all future rates were to be limited by the same 10% lower boundary rate of return. Constrained by the narrow scope of its review, this court concludes that there is substantial evidence in the record to support the 10% lower boundary reasonable rate determination for the rollback year, and such determination is not arbitrary or capricious. (33) The insurers contend that the superior court erred by determining that the rate regulations as to rollbacks are not invalid on their face insofar as they define 10 percent as the lower boundary of the range of reasonable rates of return. They also contend that the superior court erred at the threshold by applying the arbitrary-or-capricious standard of review instead of the independent-judgment-on-the-evidence test. We reject the latter claim. Our analysis above demonstrates that the arbitrary-or-capricious standard of review is indeed applicable. (See pt. III.B., ante . ) We reject the former claim as well. To our mind, the superior court's discussion is persuasive. It establishes that the Insurance Commissioner could properly have defined 10 percent as the lower boundary of the range of reasonable rates of return. The insurers mount an attack based on both the law and the facts. But they simply cannot show that the commissioner acted unreasonably. We note, for example, their strenuous objection to what the superior court called the commissioner's historic average approach. They maintain in substance that this approach cannot determine a reasonable rate of return but only an actual rate of return. The historic averages in question, however, derive from a period during which the insurance industry was largely unregulated as to rates. Because they do, they reflect a rate of return that the market, at least, would apparently have considered reasonable. It is true that the 10% return that the industry ... averaged over the 10 years from 1980 to 1989 (internal quotation marks omitted) was apparently calculated on its entire capital during that period. Evidently, the insurers would assert, and the commissioner would deny, that all that capital was used and useful for providing insurance. To the extent that the insurers may be understood to complain of the defined rate of return because it is applied to a capital base comprising not their entire capital during the rollback year but only that part that the leverage factor operates to define as used and useful for providing insurance, their complaint is not with the rate of return but actually with the leverage factor. That will be addressed in due course. (See pt. III.H., post. ) There is certainly nothing confiscatory in the definition of 10 percent as the lower boundary of the range of reasonable rates of return. (See also Fireman's Fund Ins. Co. v. Garamendi, supra, 790 F. Supp. at p. 948 [implying that a regulation is not properly subject to a facial takings challenge either in whole or in part].) Neither is there anything arbitrary, discriminatory, or demonstrably irrelevant to the legitimate policy of the protection of consumer welfare.