Opinion ID: 1189013
Heading Depth: 1
Heading Rank: 8

Heading: The Validity of the Rate Regulations as to Rollbacks as Applied to 20th Century and the Effectiveness of the 20th Century Rate Rollback Order

Text: The superior court determined that the rate regulations as to rollbacks are invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is void, in the following six particulars: (1) the ratemaking formula itself; (2) 10 percent as the lower boundary of the range of reasonable rates of return; (3) the treatment of the line of earthquake insurance; (4) the variable expense factor; (5) the leverage factor; and (6) the preclusion of an individualized hearing on rate rollback liability. It appears that the foregoing determinations have constitutional bases relating to confiscation and arbitrariness, discrimination, and demonstrable irrelevance to legitimate policy and also statutory bases relating, of course, to Proposition 103. At the same time, the superior court determined that the rate regulations as to rollbacks are not invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is not void as to the requirement of 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. It appears that the foregoing determination was made on the constitutional and statutory bases identified above. Before proceeding further, let us state the governing rules. We derive them from the discussion set out above. (See pt. III.D., ante. ) (40a) When a regulation is challenged as violative of the due process clause as applied, the question is whether, in the particular case, it is arbitrary, discriminatory, or demonstrably irrelevant to legitimate policy. The same analysis is called for when a rate order itself is challenged as violative of the due process clause. (41a) When a regulation is challenged as violative of the takings clause as applied, the question is whether, in the particular case, its terms set a rate that is unjust and unreasonable and hence confiscatory. When a rate order itself is challenged as violative of the takings clause, the question is whether that order `viewed in its entirety' meets the [relevant] requirements.... Under the... standard of `just and reasonable' it is the result reached not the method employed which is controlling. [Citations.] It is not theory but the impact of the rate order which counts. ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at p. 345]; accord, Duquesne Light Co. v. Barasch, supra, 488 U.S. at p. 310 [102 L.Ed.2d at pp. 658-659].) The regulator is not bound to the service of any single formula or combination of formulas. ( Power Comm'n v. Pipeline Co., supra, 315 U.S. at p. 586 [88 L.Ed. at p. 1050]; accord, Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at pp. 344-345].) It is free ... to make the pragmatic adjustments which may be called for by particular circumstances. ( Power Comm'n v. Pipeline Co., supra, 315 U.S. at p. 586 [86 L.Ed. at p. 1050]; accord, Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at pp. 344-345].) (42a) Judicial inquiry as to whether or not a rate is just and reasonable is necessarily difficult. More than 25 years ago, in Permian Basin Area Rate Cases, supra, 390 U.S. 747, 790 [20 L.Ed.2d 312, 349], the court declared: [N]either law nor economics has yet devised generally accepted standards for the evaluation of rate-making orders.... The declaration was valid then. It remains valid now. (See Duquesne Light Co. v. Barasch, supra, 488 U.S. at p. 308 [102 L.Ed.2d at p. 657], citing and quoting Permian Basin Area Rate Cases, supra, 390 U.S. at p. 790 [20 L.Ed.2d at p. 349].) Judicial inquiry as to whether or not a rate is just and reasonable is also limited. Indeed, it is at an end [i]f the total effect of the rate order cannot be said to be unjust and unreasonable.... The fact that the method employed to reach that result may contain infirmities is not then important. ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at p. 345]; accord, Duquesne Light Co. v. Barasch, supra, 488 U.S. at p. 310 [102 L.Ed.2d at p. 659].) [H]e who would upset the rate order ... carries the heavy burden of making a convincing showing that it is invalid because it is unjust and unreasonable in its consequences. ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at p. 345].) The Hope court identified one situation in which he who would upset the rate order could not bear that heavy burden. Rates which enable the company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risks assumed certainly cannot be condemned as invalid, even though they might produce only a meager return.... ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 605 [88 L.Ed. at p. 346]; accord, Duquesne Light Co. v. Barasch, supra, 488 U.S. at p. 310 [102 L.Ed.2d at pp. 658-659].) More simply, a company [cannot] complain if the return which was allowed made it possible for the company to operate successfully. ( Market Street R. Co. v. Comm'n, supra, 324 U.S. at p. 566 [89 L.Ed. at p. 1184].) (40b), (41b), (42b) We believe principles substantially similar to the foregoing control when a regulation is challenged as violative of Proposition 103 as applied, and when a rate order itself is challenged as offensive to the initiative. Let us turn to the task at hand. (43) On one matter alone, the superior court accepted the position of the Insurance Commissioner. As stated, it determined that the rate regulations as to rollbacks are not invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is not void, as to the requirement of 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. This is sound. The analysis supporting our conclusion concerning the facial validity of the regulations in this regard is applicable here as well. (See pt. III.J., ante. ) 20th Century's situation does not require an exception. On the other matters, the superior court rejected the position of the Insurance Commissioner. We shall consider the points seriatim. (44) The superior court determined that the rate regulations as to rollbacks are invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is void, with respect to the ratemaking formula itself. This is error. The determination is based on the belief that confiscation does not require deep financial hardship within the meaning of Jersey Central. It does, at least in the general case, such as this. This erroneous belief fatally taints the conclusion in question  directly, insofar as it rests on the constitutional ground of confiscation; and indirectly, insofar as it rests on the constitutional ground of arbitrariness, discrimination, and demonstrable irrelevance to legitimate policy, and also on the statutory grounds. In addition, the determination depends on the facial invalidity of the rate regulations as to rollbacks with respect to the ratemaking formula. In this regard, however, the regulations in question are facially valid. (See pt. III.D., ante. ) 20th Century's situation does not require an exception. (45) The superior court also determined that the rate regulations as to rollbacks are invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is void, with respect to 10 percent as the lower boundary of the range of reasonable rates of return. This too is error. The determination is fatally tainted by the erroneous belief that confiscation does not require deep financial hardship within the meaning of Jersey Central, not even in the general case, such as this. Moreover, the determination is unsound in and of itself. The underlying reasoning appears to be that the lower boundary of the range of reasonable rates of return for a regulated firm is its cost of capital  which for 20th Century was found to be at least 20 percent. One assumption seems to be that a regulated firm is entitled to its cost of capital. Although such a firm has an interest in this matter, it has no right. (See Permian Basin Area Rate Cases, supra, 390 U.S. at p. 769 [20 L.Ed.2d at p. 337] [stating that [r]egulation may, consistently with the [United States] Constitution, limit stringently the return recovered on investment, for investors' interests provide only one of the variables in the constitutional calculus of reasonableness]; id. at p. 791 [20 L.Ed.2d at p. 350] [implying that, accordingly, the regulator cannot confine its inquiries ... to conjectures about the prospective responses of the capital market].) [27] The United States and California Constitutions make the point plain. As stated, a regulated firm has no constitutional right even against a loss. Manifestly, Proposition 103 is not to the contrary. Another assumption seems to be that cost of capital is dispositive as to the issue here, which concerns rate rollback liability. Although cost of capital, to quote the administrative law judge, may be 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.) It must be emphasized that the evidence of 20th Century's cost of capital appears to derive from a period during which 20th Century, like other insurers, was largely unregulated as to rates. To accord such evidence compelling weight would effectively exempt 20th Century from rate regulation. A result of this sort is barred by Proposition 103. It is not commanded by any other provision of law, including the United States and California Constitutions. (See FERC v. Pennzoil Producing Co., supra, 439 U.S. at p. 518 [58 L.Ed.2d at pp. 782-783] [declaring, with a quotation from Hope, that: The notion that [a regulator] is required to maintain, or even allowed to maintain to the exclusion of other considerations, the profit margin of any particular [regulated firm] is incompatible ... with a basic precept of rate regulation. `The fixing of prices, like other applications of the police power, may reduce the value of the property which is being regulated. But the fact that the value is reduced does not mean that the regulation is invalid.'].) The superior court was of the view that the rate regulations as to rollbacks as applied to 20th Century, and the 20th Century rate rollback order issued pursuant thereto, improperly preclude a rate covering 20th Century's cost of service plus 10 percent of its capital base, in spite of the definition of 10 percent as the lower boundary of the range of reasonable rates of return. Contrary to its evident assumption, any such preclusion is not improper in and of itself: the ratemaking formula does not purport to guarantee the 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. (See Fireman's Fund Ins. Co. v. Garamendi, supra, 790 F. Supp. at p. 948.) (46) The superior court determined as well that the rate regulations as to rollbacks are invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is void, with respect to the treatment of the line of earthquake insurance. This too is error. The determination is fatally tainted by the erroneous belief about confiscation. Moreover, the determination depends on the facial invalidity of the rate regulations as to rollbacks with respect to the treatment of the line of earthquake insurance. In this regard, however, the regulations in question are facially valid. (See pt. III.G., ante. ) 20th Century's situation does not require an exception. That applies to the fact that the regulations subject 20th Century to direct ratemaking. It also applies to the fact the regulations depend in substantial part on 20th Century's incurred losses for the rollback year, which were relatively small. To our mind, the regulations yield a generally supportable outcome for 20th Century, although treating it unfavorably because its incurred losses for the rollback year were relatively small. In any event, they do not themselves determine 20th Century'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 20th Century's five other lines, it functions only as an intermediate step in the refund calculation. Further, the determination falls insofar as it rests on the constitutional basis of confiscation. The assumption appears to be that confiscation can be effected within 20th Century's line of earthquake insurance in and of itself. Not so. As stated above, confiscation is judged with an eye toward the regulated firm as an enterprise. In this context, it depends on the condition of the insurer as a whole  and not on the fortunes of any one or more of its lines, including earthquake. That confiscation may perhaps turn on an insurer's earthquake line if the insurer writes that line alone is of purely theoretical interest. The fact is, 20th Century does not satisfy the condition, since it writes five lines in addition to earthquake. We recognize that calculations for 20th Century's earthquake line, since they are based on loss data from a single year with relatively small incurred losses, do indeed verge toward the low end. But that is not enough. The observation of the administrative law judge bears repeating: 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 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.) So far as the earthquake line is concerned, the final rollback amounts to 12.203 percent of $8.7 million or $1.06 million. [28] (47) The superior court also determined that the rate regulations as to rollbacks are invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is void, with respect to the variable expense factor. This too is error. The determination is fatally tainted by the erroneous belief about confiscation. Moreover, the determination is unsound in and of itself. The variable expense factor is the sum of the commission rate and the state premium tax rate. Within the ratemaking formula, it functions to recognize only such amount of commissions and state premium taxes as are attributable to the maximum rate for the rollback year set by Proposition 103 as construed in Calfarm. The superior court thought this objectionable. It is not. Otherwise, a rate above the maximum would tend to justify itself  surely an untenable result. It is not unreasonable to fail to recognize that amount of commissions and state premium taxes that would have been avoided had 20th Century charged a rate at or below the maximum for the rollback year. (48) The superior court determined as well that the rate regulations as to rollbacks are invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is void, with respect to the leverage factor. This too is error. The determination is fatally tainted by the erroneous belief about confiscation. Moreover, the determination depends on the facial invalidity of the rate regulations as to rollbacks with respect to the leverage factor. In this regard, however, the regulations are facially valid. (See pt. III.H., ante. ) 20th Century's situation, which appears to involve high leverage, does not require an exception. The leverage factor apparently excluded from recognition about $12 million of 20th Century's capital. It also apparently excluded from recognition about $1 million of the firm's investment income derived therefrom. It thereby apparently prevented that portion of the firm's investment income that would otherwise have reduced its maximum rate for the rollback year from doing so. (49) The superior court also determined that the rate regulations as to rollbacks are invalid as applied to 20th Century, and that the 20th Century rate rollback order issued pursuant thereto is void, with respect to the preclusion of an individualized hearing on the firm's rate rollback liability. This too is error. At the threshold, we observe that in making its determination the superior court concluded that the administrative law judge erred by holding that confiscation requires deep financial hardship within the meaning of Jersey Central. It is rather the superior court that erred. Confiscation does indeed so require, at least in the general case, such as this. In part, the determination depends on the facial invalidity of the rate regulations as to rollbacks with respect to the relitigation bar. In this regard, however, the regulations are facially valid. (See pt. III.I., ante. ) 20th Century's situation does not require an exception. All the same, what we stated previously bears repeating now: the administrative law judge effectively lifted the relitigation bar to allow 20th Century to introduce evidence to challenge the premises of the regulations in question. In other part, the determination depends on the facial invalidity of the rate regulations as to rollbacks with respect to the absence of a variance or variances sufficient for rate adjustments necessary to avoid confiscation. In this regard, too, the regulations are facially valid. (See pt. III.I., ante. ) As noted, included in the superior court's determination concerning the preclusion of an individualized hearing on 20th Century's rate rollback liability is a finding of fundamental unfairness in the conduct of the hearing. To the extent that this finding is based on the superior court's conclusion that the administrative law judge erred by holding that confiscation requires deep financial hardship within the meaning of Jersey Central  this seems the ultimate if not sole ground  it fails. Again, it is the superior court that erred and not the administrative law judge. To the extent that this finding is based on anything other than that conclusion, it fails as well. We have examined the conduct of the hearing, and have decided that it was fundamentally fair and otherwise in accordance with law. It is unclear whether and to what extent the superior court determined that the rate regulations as to rollbacks are invalid as applied to 20th Century as impermissibly retroactive. Insofar as it made any such determination, it erred. Our analysis above controls. (See pt. III.C., ante. ) `Primary' retroactivity does not obtain. `Secondary' retroactivity does, but it is an entirely lawful consequence of rulemaking and hence does not itself offend any law, including the United States and California Constitutions and their respective due process clauses. [29] (50a) Implicit in the superior court's decision is its ultimate determination that the 20th Century rate rollback order is unjust and unreasonable in its consequences and therefore confiscatory. This is the superior court's ultimate error. Indeed, it is this determination that is most fatally tainted by its erroneous belief that confiscation does not require deep financial hardship within the meaning of Jersey Central, not even in the general case, such as this. The analysis set out above establishes that the question whether the 20th Century rate rollback order is unjust and unreasonable in its consequences and therefore confiscatory depends on a balancing of the interests of 20th Century and its insureds. (See pt. III.D., ante. ) The interest of 20th Century's insureds, simply put, is in freedom from exploitation. By contrast, the interest of 20th Century itself is in having enough revenue for both operating expenses and the capital costs of the business, including service on the debt and dividends on the stock, of a magnitude that would allow a return to the equity owner that is commensurate with returns on investments in other enterprises having corresponding risks and sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital. ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 603 [88 L.Ed. at p. 345].) 20th Century's interest, however, is just that: it is an interest, not a right. It is only one of the variables in the constitutional calculus of reasonableness. ( Permian Basin Area Rate Cases, supra, 390 U.S. at p. 769 [20 L.Ed.2d at p. 337].) 20th Century has no constitutional right to a profit.... ( Jersey Cent. Power & Light Co. v. F.E.R.C., supra, 810 F.2d at pp. 1180-1181.) Indeed, it has no constitutional right even against a loss. It is apparently at this point that the superior court veered onto its path of error, mistaking what is an interest that 20th Century may pursue for a right that it can demand. To determine whether the 20th Century rate rollback order is unjust and unreasonable in its consequences and therefore confiscatory, the superior court should have asked whether that order `viewed in its entirety' meets the requirements of the balancing of interests identified above. ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at p. 345].) Under the ... standard of `just and reasonable' it is the result reached not the method employed which is controlling. [Citations.] It is not theory but the impact of the rate order which counts. If the total effect of the rate order cannot be said to be unjust and unreasonable, judicial inquiry ... is at an end. The fact that the method employed to reach that result may contain infirmities is not then important. ( Ibid. ) And in determining whether the 20th Century rate rollback order is unjust and unreasonable in its consequences and therefore confiscatory, the superior court should of course have focused on its consequences. They are these: 20th Century was ordered 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. 20th Century's maximum rate for the rollback year was effectively set 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, 20th Century's maximum rate for the rollback year was reduced to a point a mere 1.11 percent below its 1987 rate, rather than to a point 20 percent below that rate. [30] In view of the foregoing, it cannot be said that 20th Century carrie[d] [its] heavy burden of making a convincing showing that [its rate rollback order] is invalid because it is unjust and unreasonable in its consequences. ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at p. 345].) That is because such a showing is precluded when, as here, the return which was allowed made it possible for the company to operate successfully. ( Market Street R. Co. v. Comm'n, supra, 324 U.S. at p. 566 [89 L.Ed. at p. 1184]; accord, Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 605 [88 L.Ed. at p. 346].) 20th Century did indeed operate successfully during the rollback year. It practically admits as much. It asserts that its rate of growth throughout the years since it was founded in 1958  including the period extending from November 8, 1988, through November 7, 1989  has been phenomenal. From all that appears, 20th Century would have operated successfully during the rollback year under, and in spite of, the rate rollback. Its growth would surely have been slowed down. But as the administrative law judge stated, it has cited no case holding that a slowdown in growth is confiscatory. Put otherwise, its business would have been less prosperous as a result of the rate rollback. ( California Auto. Assn. v. Maloney, supra, 341 U.S. at p. 111 [95 L.Ed.2d at p. 793].) Such a diminution in value, however, has never mounted to the dignity of confiscation. ( Ibid. ) Since the total effect of the 20th Century rate rollback order cannot be said to be unjust and unreasonable, our inquiry ... is at an end. ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at p. 345].) To go further would lead us to micromanage the rate regulation process .... ( Jersey Cent. Power & Light Co. v. F.E.R.C., supra, 810 F.2d at p. 1191 (conc. opn. of Starr, J.).) That is not our function. ( Ibid. ) It is clear beyond peradventure that [w]e are not obliged to examine each detail of the [Insurance Commissioner's] decision.... ( Permian Basis Area Rate Cases, supra, 390 U.S. at p. 767 [20 L.Ed.2d at p. 336].) We will not do so. (51) To prove confiscation, 20th Century frames an argument that compares the amount of the refund of premiums required by its rate rollback order, which the superior court found to be about $78 million (plus interest), with the amount of its after-tax revenue for 1989, which the superior court found to be about $76 million. At first glance, the argument appears substantial. The comparison between about $76 million coming in and about $78 million going out seems to show a loss of about $2 million. On closer consideration, however, the argument turns out to be specious. With matching, an appropriate comparison would account for both the revenue forgone by 20th Century, i.e., the amount of the refund of premiums required by its rate rollback order, which the superior court found to be about $78 million, and the expenses avoided by 20th Century, including federal income tax, state premium tax, and commissions, which appear to be about $29 million. Under such a comparison, there is a profit of about $27 million  representing a rate of return of about 11 percent on what 20th Century declared to be a capital base of about $243 million (equaling its mean 1989 surplus calculated in accordance with statutory accounting principles). With a profit and rate of return of this magnitude, confiscation does not appear. In effect, 20th Century objects that it must really forgo revenue in the amount of $78 million but that it does not really avoid expenses in the amount of $29 million. This seems an effort to defeat matching by accepting accounting conventions that are favorable and rejecting those that are not. More fundamentally, it seems an effort to obtain a reward for having charged a rate for the rollback year higher than the Proposition 103's maximum rate of 80 percent of the 1987 rate. (See pt. III.D., ante. ) In any event, let us recall that 20th Century, in attempting to upset its rate rollback order, carries the heavy burden of making a convincing showing that it is invalid because it is unjust and unreasonable in its consequences. ( Power Comm'n v. Hope Gas Co., supra, 320 U.S. at p. 602 [88 L.Ed. at p. 345].) In the context of its objection, 20th Century would apparently have to prove that it could not recover the expenses in question, i.e., federal income tax, state premium tax, and commissions. It fails to do so. Indeed, all indications in the record are to the contrary. (50b) We may observe in passing that 20th Century does not make an argument for confiscation based solely on the fact that its rate rollback order requires it to refund premiums and to pay interest thereon. The reason is manifest. It is called equity. The refund puts 20th Century and its insureds into the situation they would each have occupied had the former not overcharged the latter and the latter not overpaid the former. (See pt. III.D., ante. ) Similarly with respect to the payment of interest. It follows from what has preceded that there is nothing in the 20th Century rate rollback order that is arbitrary, discriminatory, or demonstrably irrelevant to the legitimate policy of the protection of consumer welfare. [31]
For the reasons stated above, we conclude that we must reverse the judgment of the superior court and direct that court to render judgment in favor of the Insurance Commissioner and Voter Revolt and against 20th Century, Hartford, State Farm, et al. It is so ordered.