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The Reserves Game

A malpractice insurance company's profits are not simply the premium income minus the administrative costs and the costs of paying and defending claims. The malpractice insurance business is not in equilibrium. There is uncertainty in evaluating claims, a long delay in closing claims, and the potential for political change during the interval between the presentation of a claim and the resolution of it. Claims-made policies were introduced to lower rates by reducing the uncertainty of future payouts. Unlike occurance policies which cover any injuries that occur during the term of the policy, claims-made policies cover claims filed during the term of the policy.

Insurance companies manage the uncertainty of future payouts through reinsurance and the accumulation of reserves. Reinsurance is the process of spreading the risk of loss to another insurance company. The primary insurer pays a premium to the secondary insurer that is determined by the level of risk shifted and the potential losses that are being reinsured. Reserves are premiums that are invested to cover future losses. They are treated as losses, and the income from reserves is not categorized as profit. The controversy over malpractice insurance profitability arises from the accounting practices for reserves.

When an insurance company wants to justify a rate increase to a state regulatory commission, it can increase its reserves, which reduces its cash on hand and its investment income. If enough capital is shifted to reserves, a prosperous company can appear to be on the edge of insolvency. The rate commission must then approve higher rates or face political blackmail as the company threatens to leave the state.

The most troubling aspect of the reserves game occurs when a company with excess reserves does leave the market because excess premiums that these reserves represent are never returned to the insureds. They eventually revert to the company as claims are paid. If the company can successfully argue that it still has outstanding claims against these reserves, it can keep them off the books for years. Malpractice insurers can enter and leave state markets so that they can continually recapture excess reserves.

The return on invested reserves depends on the world business cycle. Precipitous changes in interest rates, bond yields, and the stock market can drastically reduce the value of a poorly hedged reserve investment portfolio. These losses must be offset by increasing premium income. Since it is financially costly for a company to be underreserved, investment shortfalls must be offset very quickly. This is easiest to do in lines of insurance in which current increases in claims may be projected into huge future losses, thus justifying sudden premium increases. Shortfalls in reserve investment income have been a primary cause of the volatility of malpractice insurance rates since the early 1980s.


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