Opinion ID: 1189013
Heading Depth: 3
Heading Rank: 8

Heading: The Validity of the Rate Regulations as to Rollbacks With Respect to the Leverage Factor

Text: (35) The superior court determined that the rate regulations as to rollbacks are invalid on their face insofar as they incorporate the leverage factor. As stated, the leverage factor is crucial to the determination of rates. 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. Expressly and in major part, the superior court's determination of invalidity rests on a finding that the leverage factor is confiscatory. Confiscation, however, does not appear. The leverage factor functions as an application of the used and useful rule. That rule is a permissible tool[] of ratemaking under the takings clause. ( Jersey Cent. Power & Light Co. v. F.E.R.C., supra, 810 F.2d at p. 1175.) The superior court itself acknowledged explicitly that insureds need not provide a return on capital which is not required for insurance business. It further acknowledged implicitly that insureds need not provide a return on capital that is not actually employed for that purpose. As explained, to the extent that the leverage factor excludes from recognition capital not used and useful, it also excludes from recognition investment income derived therefrom. (See pt. III.D., ante. ) The former exclusion is to the insurer's detriment. The latter is to its benefit: it prevents a portion of investment income that would otherwise reduce its maximum rate for the rollback year from doing so. Nevertheless, in finding the leverage factor confiscatory, the superior court reasoned to this effect: Under the prior approval system, the rate regulations allow[] more highly leveraged insurers to use [a lower] `normative leverage factor' rather than [their] actual [higher] leverage [factor] in order to obtain a higher ... rate of return [ sic : read, higher return] to compensate such insurer[s] for [their] greater risk. They should have done the same under the rate rollback. Because they did not, they disallow[] or disregard[] a significant amount of actual `proper' 1989 surplus.... The Insurance Commissioner's response is sufficient: In prior approval the regulations impute to the insurer the amount of surplus the leverage factors specified in the regulations imply. [Citation.] To the extent that the insurer is more highly leveraged, it will be able to retain extra profit. This provides the insurer with the salutary incentive to write more insurance than it otherwise might, albeit at the cost of somewhat higher risk of insolvency. The Commissioner's decision to use the specified, rather than the actual, leverage ratio in prior approval reflects his judgment that the risk is small, particularly when coupled with effective solvency regulation.... However, neither the incentive to write more insurance nor the risk of insolvency [is] any longer relevant to 1988-1989 policies, so, for the rollback period, the regulations provide for the use of the insurer's actual leverage ratio, as long as the insurer's actual leverage ratio is no less than the leverage ratio adopted in the regulations. If the actual leverage ratio is less, that means that the insurer had more capital than was reasonably necessary to support the insurance, and the insurer is not permitted to extract a profit on the extra surplus from its California policyholders. (Fn. omitted.) Therefore, what the superior court found to be actual `proper' 1989 surplus that is disallow[ed] or disregard[ed] is not in fact actual `proper' 1989 surplus. It was not useful as well as used. In any event, the rate regulations as to rollbacks expressly provide for variances as the final mechanism for rate adjustments necessary to avoid confiscation. If confiscation nonetheless results, it is properly charged against the variances. (See pt. III.I., post. ) Impliedly and in minor part, the superior court's determination of invalidity rests on a finding that the leverage factor is arbitrary, discriminatory, or demonstrably irrelevant to the legitimate policy of the protection of consumer welfare. Such does not appear. The leverage factor functions as an application of the used and useful rule. That rule is permissible under the takings clause. In our view, it is permissible generally. To be sure, the leverage factor may be said to favor the insured over the insurer. But not unreasonably so.