How Markets Work: Lessons for Workers Compensation

Transcription

1 2013 Annual Issues Symposium How Markets Work: Lessons for Workers Compensation Harry Shuford Practice Leader and Chief Economist May 17, 2013

2 How Markets Work: Lessons for Workers Compensation The Standard Economic Model of a Market Lessons for Workers Compensation (WC) The Balloon Theory of the WC Market 2

3 2013 Annual Issues Symposium The Standard Economic Model of a Market

4 How Markets Work: Lessons for Workers Compensation What Makes a Market a Market? An environment where a good or service is traded Typically: Multiple sellers the supply side Multiple buyers the demand side No set of either buyers or sellers is able to set prices or control the quantity either supplied (e.g., duopoly) or demanded (e.g., monopsony) 4

5 How Markets Work: Lessons for Workers Compensation What Makes a Market Competitive? Sellers and the Supply Curve The supply curve is derived from the cost function that underlies the production of the good or service The supply curve in a competitive market is upward sloping, reflecting the observation that: At least over short time periods, it costs more to produce more due to decreasing economies of scale Referred to as increasing marginal costs of production This means that the price must increase to get an increase in the amount supplied At low levels of production, the cost curve typically is downward sloping due to increasing returns to scale. This typically is not part of the supply curve because it is unstable; the average cost is declining; the marginal cost is negative. 5

6 How Markets Work: Lessons for Workers Compensation What Makes a Market Competitive? Sellers and the Supply Curve The supply curve is derived from the cost function that underlies the production of the good or service The supply curve in a competitive market is upward sloping, reflecting the observation that: At least over short time periods, it costs more to produce more due to decreasing economies of scale Referred to as increasing marginal costs of production This means that the price must increase to get an increase in the amount supplied At low levels of production, the cost curve typically is downward sloping due to increasing returns to scale. This typically is not part of the supply curve because it is unstable; the average cost is declining; the marginal cost is negative. 6

7 The Supply Curve Reflects the Increasing Costs of Producing More Supply (increasing costs) Price Quantity 7

8 How Markets Work: Lessons for Workers Compensation What Makes a Market Competitive? Buyers and the Demand Curve The demand curve is derived from the utility function and the relative value that buyers place on the good or service The demand curve in a competitive market is downward sloping, reflecting the observation that At least over short time periods, increased consumption of most goods and services is linked to declining marginal utility, or Some buyers place a higher value than others on the good or service This means that the price must decrease to get an increase in the amount bought 8

9 How Markets Work: Lessons for Workers Compensation What Makes a Market Competitive? Buyers and the Demand Curve The demand curve is derived from the utility function and the relative value that buyers place on the good or service The demand curve in a competitive market is downward sloping, reflecting the observation that At least over short time periods, increased consumption of most goods and services is linked to declining marginal utility, or Some buyers place a higher value than others on the good or service This means that the price must decrease to get an increase in the amount bought 9

10 The Demand Curve Reflects the Decreasing Value Placed on Consuming More Price Quantity Demand (decreasing value) 10

11 Market Equilibrium: Supply Equals Demand at Market Price Price Demand (decreasing value) Quantity 11

12 Market Equilibrium: Supply Equals Demand at Market Price Supply (increasing costs) Price Demand (decreasing value) Quantity 12

13 How Markets Work: Lessons for Workers Compensation What s to Like About Competitive Markets? In general competitive markets are efficient in the sense that resources are used where they create the most value The supply curve is derived from the cost function that underlies the creation and delivery of the good or service; the costs include a normal profit to cover the cost of capital The demand curve is derived from the utility function that reflects the relative value that each successive potential buyer places on the good or service When supply equals demand at the market price, the value of the resources (as reflected in production costs) required to produce the good or service is equal to the value that the buyers place on consuming the good or service For this reason economists argue that competitive markets typically allocate resources efficiently 13

14 How Markets Work: Lessons for Workers Compensation What s to Like About Competitive Markets? In general competitive markets are efficient in the sense that resources are used where they create the most value The supply curve is derived from the cost function that underlies the creation and delivery of the good or service; the costs include a normal profit to cover the cost of capital The demand curve is derived from the utility function that reflects the relative value that each successive potential buyer places on the good or service When supply equals demand at the market price, the value of the resources (as reflected in production costs) required to produce the good or service is equal to the value that the buyers place on consuming the good or service For this reason economists argue that competitive markets typically allocate resources efficiently 14

15 How Markets Work: Lessons for Workers Compensation What s to Like About Competitive Markets? In general competitive markets are efficient in the sense that resources are used where they create the most value The supply curve is derived from the cost function that underlies the creation and delivery of the good or service; the costs include a normal profit to cover the cost of capital The demand curve is derived from the utility function that reflects the relative value that each successive potential buyer places on the good or service When supply equals demand at the market price, the value of the resources (as reflected in production costs) required to produce the good or service is equal to the value that the buyers place on consuming the good or service For this reason economists argue that competitive markets typically allocate resources efficiently 15

16 Market Equilibrium: Supply Equals Demand at Market Price Supply Price Demand Quantity 16

17 How Markets Work: Lessons for Workers Compensation What s to Like about Competitive Markets? The market price is a critically important economic measure It is a single number that captures and equates the resource cost and the consumption value 17

18 How Markets Work: Lessons for Workers Compensation One Implication of the Competitive Market Equilibrium There is a single price for all buyers and for all sellers All but the last buyer would have paid more than the market price All but the last item produced cost less than the market price Most buyers get more value than they paid for a surplus Most goods sold cost less than what they sold for a profit This could be termed a favorable return because the underlying costs include a normal profit 18

19 How Markets Work: Lessons for Workers Compensation One Implication of the Competitive Market Equilibrium There is a single price for all buyers and for all sellers 19

20 How Markets Work: Lessons for Workers Compensation One Implication of the Competitive Market Equilibrium There is a single price for all buyers and for all sellers All but the last buyer would have paid more than the market price All but the last item produced cost less than the market price Most buyers get more value than they paid for a surplus Most goods sold cost less than what they sold for a profit This could be termed a favorable return because the underlying costs include a normal profit 20

21 Market Equilibrium: Supply Equals Demand at Market Price Consumer Surplus Supply Price Demand Quantity 21

22 Market Equilibrium: Supply Equals Demand at Market Price Supply Price Producer Surplus Demand Quantity 22

23 Market Equilibrium: Supply Equals Demand at Market Price Consumer Surplus Supply Price Producer Surplus Demand Quantity 23

24 How Markets Work: Lessons for Workers Compensation What s to Like about Competitive Markets? In general, in competitive markets the market will clear in the sense that the quantities supplied and purchased will be equal at the market price A key feature of perfect competition is full information That is, all buyers and sellers have the same information Generally there is no uncertainty Perfect information is not a feature of most real-world markets 24

25 2013 Annual Issues Symposium Deviations From the Standard Market Model

26 How Markets Work: Lessons for Workers Compensation Deviations from the Standard Market Model Supply Is Constrained Supply is less than demand at the prevailing price An indication of market inefficiency The value placed by potential buyers exceeds the costs of additional production Price Is Constrained Actual supply exceeds the amount that would be offered at the prevailing price An indication of market inefficiency The costs of the added production exceed the value indicated by the price 26

27 How Markets Work: Lessons for Workers Compensation When Markets Don t Clear Supply Is Constrained Quantity supplied at the market price is less than the quantity demanded In a competitive environment, the excess demand should cause the price to increase to bring the market into balance Why might markets not clear? lack of full information Asymmetric information Moral hazard and/or adverse selection Uncertainty 27

28 Market Equilibrium: Supply Equals Demand at Market Price Supply Price Demand Quantity 28

29 Market Fails to Clear: Demand Exceeds Supply at Market Price Supply Under Uncertain Costs Supply With Full Information Price Demand Excess Demand Quantity 29

30 How Markets Work: Lessons for Workers Compensation When Markets Don t Clear Examples: Credit rationing Stiglitz and Weiss Excess demand for bank loans at prevailing loan rates A willingness to pay high rates is a signal that borrower may be prepared to assume excessive risk Insurance contractual constraints on multiple policies for the same risk Stiglitz and Rothschild Results in an excess demand for insurance at prevailing premium rates A desire to purchase multiple coverages is a signal of adverse selection 30

31 How Markets Work: Lessons for Workers Compensation When There is Excess Supply at the Prevailing Price Examples: Regulation that limits the price and requires all production to be sold at that price; typically to the government Export controls on, e.g., rice 31

32 How Markets Work: Lessons for Workers Compensation When There is Excess Supply at the Prevailing Price Examples: Regulation that limits the price and requires all production to be sold at that price; typically to the government Export controls on, e.g., rice 32

33 Market Coercion: Quantity Supplied Exceeds Supply at Market Price Supply Price Demand Quantity 33

34 Market Coercion: Quantity Supplied Exceeds Supply at Market Price Supply Price Inadequate Profits/ Losses Demand Quantity 34

35 How Markets Work: Lessons for Workers Compensation Deviations From the Standard Market Model An Indication of Market Inefficiency Examples: Limited supply e.g., Rationing Incomplete information: bank lending to small business Market manipulation: diamonds Limited price e.g., a Taking Export controls on rice Market manipulation: Web browsers 35

36 2013 Annual Issues Symposium Lessons for the Workers Compensation Market

37 How Markets Work: Lessons for Workers Compensation Lessons for the Workers Compensation Market A Model for the Workers Compensation Market Using the Model to Understand Pricing Environments Some Initial Analysis to Test the Workers Compensation Model 37

38 How Markets Work: Lessons for Workers Compensation Supply in Workers Compensation Market ASOP 30 The total financial needs model is a standard concept used to develop the underwriting profit provision in actuarial ratemaking. Source: Treatment of Profit and Contingency Provisions and the Cost of Capital in Property/Casualty Insurance Ratemaking, Actuarial Standard of Practice No. 30, Actuarial Standards Board, July 1997, page 8. 38

39 How Markets Work: Lessons for Workers Compensation The total financial needs model : the sum of underwriting profit, miscellaneous (non-investment) income, investment income from insurance operations, and investment income on capital, after income taxes, will equal the cost of capital. Source: Treatment of Profit and Contingency Provisions and the Cost of Capital in Property/Casualty Insurance Ratemaking, Actuarial Standard of Practice No. 30, Actuarial Standards Board, July 1997, page 8. 39

40 How Markets Work: Lessons for Workers Compensation The total financial needs model : Underwriting Profit and Cash Flows Loss costs Investment Income From Insurance Operations Projected loss payouts and reserves Interest rates Surplus and the Cost of Capital Surplus to reserves Cost of capital 40

41 How Markets Work: Lessons for Workers Compensation The total financial needs model : Comparable to the Internal Rate of Return analysis that NCCI does for full rate situations: P =(X+L) + {[ ( * RES)*( R C - R T )] [(RES)* R T ]}/(1+ R T )} P/W ={(X+L) + {[ ( * RES)*( R C - R T )] [(RES)* R T ]}/(1+ R T )}}/W P/W the Price Component of the Supply Curve for WC Insurance 41

42 How Markets Work: Lessons for Workers Compensation At any point in time, most key supply factors will be determined: Cost of capital Interest rates Target reserve to surplus Expected cash flow patterns Therefore, at any point in time, the shape of the supply curve will be linked to the expected losses of individual employers 42

43 The Supply Curve in WC Reflects the Increasing Loss Costs of Potential Insureds Supply Rate Quantity 43

44 How Markets Work: Lessons for Workers Compensation A Model for the Workers Compensation Market Demand is different from most other markets Because having workers compensation insurance is mandatory, the demand will be largely insensitive to price Demand is inelastic over most prices 44

45 The Demand Curve in WC Likely Reflects the Mandatory Nature of the Coverage Demand Rate Quantity 45

46 Regulation Plays a Key Role in the Workers Compensation Market Supply Rate Demand Quantity 46

47 How Markets Work: Lessons for Workers Compensation Using the Model to Understand Workers Compensation Market Environments Administered pricing Competitive markets 47

48 How Markets Work: Lessons for Workers Compensation Implications of the Financial Needs Model of Supply in an Administered Pricing Environment Insurers have little pricing flexibility Insurers are required to charge the same standard premium rate Insurers may be required to satisfy excess demand at that rate indirectly Collectively via a residual market pool A state fund may be an alternative arrangement 48

49 How Markets Work: Lessons for Workers Compensation Implications of the Financial Needs Model of Supply in an Administered Pricing Environment Insurers have little pricing flexibility Insurers are required to charge the same standard premium rate Insurers may be required to satisfy excess demand at that rate indirectly Collectively via a residual market pool A state fund may be an alternative arrangement 49

50 The Impact of Administered Pricing in the Workers Compensation Market A Hypothetical Example Supply Rate The Workers Compensation Market Demand Quantity 50

51 The Impact of Administered Pricing in the Workers Compensation Market A Hypothetical Example Supply Rate Demand Quantity 51

52 If All Policies Are Priced at the Market Clearing Price, WC Insurers Would Earn Significant Favorable Returns as Measured by Financial Needs Demand Supply Rate Favorable Returns Quantity 52

53 If All Policies Are Priced at the Market Clearing Price, WC Insurers Would Earn Significant Favorable Returns as Measured by Financial Needs Demand Supply Rate Quantity 53

54 If All Policies Are Priced at the Market Clearing Price, WC Insurers Would Earn Significant Favorable Returns as Measured by Financial Needs Demand Supply Rate Quantity 54

55 If Excess Demand Is Placed in a Residual Market (RM) and All Policies Are Priced at the Administratively Determined Price WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Excess Demand Voluntary Market Quantity 55

56 If Excess Demand Is Placed in a Residual Market (RM) and All Policies Are Priced at the Administratively Determined Price WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Excess Demand Favorable Returns Voluntary Market Quantity 56

57 If Excess Demand Is Placed in a Residual Market (RM) and All Policies Are Priced at the Administratively Determined Price WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Inadequate Profits/ Losses in the RM Excess Demand Voluntary Market Quantity 57

58 If Excess Demand Is Placed in a Residual Market (RM) and All Policies Are Priced at the Administratively Determined Price WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Inadequate Profits/ Losses in the RM Excess Demand Favorable Returns Voluntary Market Quantity 58

59 If Excess Demand Is Placed in a Residual Market And All Policies Are Priced at the Administratively Determined Price, WC Insurers Could Face Substantial Losses as Measured by Financial Needs Inadequate Profits/ Losses in the RM Rate Dominate Favorable Returns in the Voluntary Mkt. Quantity 59

60 If Excess Demand Is Placed in a Residual Market And All Policies Are Priced at the Administratively Determined Price, WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Quantity 60

61 If Excess Demand Is Placed in a Residual Market And All Policies Are Priced at the Administratively Determined Price, WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Quantity 61

62 If Excess Demand Is Placed in a Residual Market And All Policies Are Priced at the Administratively Determined Price, WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Quantity 62

63 If Excess Demand Is Placed in a Residual Market And All Policies Are Priced at the Administratively Determined Price, WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Inadequate Profits/ Losses in the RM Excess Demand Favorable Returns Voluntary Market Quantity 63

64 If Excess Demand Is Placed in a Residual Market And All Policies Are Priced at the Administratively Determined Price, WC Insurers Could Face Substantial Losses as Measured by Financial Needs Demand Supply Rate Inadequate Profits/ Losses in the RM Excess Demand Favorable Returns Voluntary Market Quantity 64

65 If Excess Demand Is Placed in a Residual Market And All Policies Are Priced at the Administratively Determined Price, WC Insurers Could Face Substantial Losses as Measured by Financial Needs Rate Favorable Returns Are Sufficient to Cover Inadequate Profits/ Losses in the RM Quantity 65

66 How Markets Work: Lessons for Workers Compensation Implications of the Financial Needs Model of Supply in an Administered Pricing Environment For stability in the workers compensation market the residual market burden can not dominate the profitability of the voluntary segment of the WC market This is a testable hypothesis 66

67 How Markets Work: Lessons for Workers Compensation Financial Needs, the Residual Market, and Equilibrium in Insurance Markets Competitive Market Environment 67

68 How Markets Work: Lessons for Workers Compensation Implications of the Financial Needs Model of Supply in a Competitive Market Environment Insurers have considerable but not complete flexibility in setting premium rates on individual policies Insurers may be unwilling to voluntarily write some applications even at high premium rates ( rationing ) In addition, regulators may want to insulate businesses from high premium rates at the upper portion of the supply curve Insurers typically are required to satisfy excess demand at least indirectly Collectively via a residual market pool A state fund may be an alternative arrangement 68

69 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 69

70 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 70

71 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Residual Market Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 71

72 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Inadequate Profits/Losses in RM Rate Favorable Returns in the RM Residual Market No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 72

73 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Inadequate Profits/Losses in RM Favorable Returns in the RM Rate Quantity 73

74 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Residual Market Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 74

75 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Residual Market Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 75

76 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Inadequate Profits/Losses in RM Favorable Returns in the RM Residual Market Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 76

77 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Inadequate Profits/Losses in RM Favorable Returns in the RM Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity 77

78 How Markets Work: Lessons for Workers Compensation Competitive Market Implications for Ratemaking 78

79 How Markets Work: Lessons for Workers Compensation Implications for Ratemaking The primary effect is to lower the approved loss cost for the voluntary market To the extent that this loss cost is used as a benchmark to set premiums for individual policies, it will shift the supply curve down from the true supply curve That is, the benchmark is lower than it should be 79

80 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Inadequate Profits/Losses in RM Favorable Returns in the RM Residual Market Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 80

81 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Residual Market Rate No Favorable Returns in the Voluntary Market With Competitive Pricing Quantity Voluntary Market 81

82 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Residual Market Rate Shortfall in Breakeven Profits Voluntary Market Quantity 82

83 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Inadequate Profits/Losses in RM Rate Favorable Returns in the RM Residual Market Shortfall in Breakeven Profits Voluntary Market Quantity 83

84 In Competitive Markets Where Excess Demand Is Placed in a Residual Market, the Administratively Determined Price Is Critical Demand Supply Inadequate Profits/Losses in RM Rate Favorable Returns in the RM Residual Market Shortfall in Breakeven Profits Voluntary Market Quantity 84

85 How Markets Work: Lessons for Workers Compensation Implications for Ratemaking Lowering the filed loss cost creates risk of inadequate total market return from competitive pricing Inadequate total market return causes market tightening Higher premium rate policies incur underwriting losses and are shifted from the competitive market to the residual market Resulting increase in residual market share produces a decrease in the subsequent filed loss cost, shifting supply curve even further from the true values Creating a potential downward spiral 85

86 How Markets Work: Lessons for Workers Compensation Preliminary Observations The Balloon Theory of the WC Market 86

87 How Markets Work: Lessons for Workers Compensation The Balloon Theory of the WC Market The financial needs model offers an effective description of the factors that underlie the supply curve for workers compensation insurance The analysis shows that there is a single market for workers compensation insurance This market often will not clear at prevailing premium rates Residual markets exist to serve the employers who would otherwise be rationed out In administered pricing environments, the premium rates must be such that favorable returns cover the losses in the residual market In competitive market environments, the premium rates in the residual market must be sufficient for the favorable returns to cover the losses in that market 87

88 How Markets Work: Lessons for Workers Compensation The Balloon Theory of the WC Market In other words when the rating environment squeezes the voluntary market The pressure merely shifts to the residual market end of the balloon And if the pressure is too great, the balloon will burst 88

89 How Markets Work: Lessons for Workers Compensation The Voluntary and Residual Markets Are Two Ends of a Single Workers Compensation Market 89

90 Residual Market Share of the WC Market Grew Following the Most Recent Recessions U/W Gain Market Share '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12p Calendar Year (UW Gain Private Carriers (pvt) and RM Share), Policy Year (UW Gain RM) U/W Gain - pvt U/W Gain - RM RM Share 0 p Preliminary Source: NCCI 90

91 Residual Market Share of the WC Market Grew Following the Most Recent Recessions U/W Gain Market Share '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12p Calendar Year (UW Gain Private Carriers (pvt) and RM Share), Policy Year (UW Gain RM) U/W Gain - pvt U/W Gain - RM RM Share 0 p Preliminary Source: NCCI 91

92 How Markets Work: Lessons for Workers Compensation The Business Cycle and Workers Compensation Economic factors and the residual market: Grew following recessions Shrank during recovery The residual market tracks the underwriting cycle The underwriting cycle tracks the business cycle 92