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Mr. Kevin Thompson
June 20, 2006
UNITED STATES SENATE COMMITTEE ON THE JUDICIARY
Good morning Mr. Chairman, I am Kevin B. Thompson, Senior Vice President- Insurance Services of Insurance Services Office, Inc. (ISO). I am a Fellow of the Casualty Actuarial
In the course of my remarks, I briefly cover ISO's role as an advisory organization and as a statistical agent of state insurance regulators, how its activities, products and services are regulated by government and how it has evolved over the years into a for-profit corporation that
In a highly competitive industry characterized by tight profit margins, where an insurer often must use the aggregated data of many others as an aid in estimating the average cost of its own products, it is vital to have a relatively low-cost source of those estimates. Developing
ISO's role as a state-licensed advisory organization and statistical agent and how it is regulated by the states
ISO is licensed as an advisory organization1 in all fifty states, Puerto Rico and the District of Columbia. As an advisory organization, our company provides statistical, actuarial, policy form development and related products and services to property/casualty insurers, including advisory prospective loss costs2, other prospective cost information,3 manual rules and policy forms. ISO also serves as an officially designated statistical agent of state insurance regulators to collect policy-writing and loss statistics of individual insurers and compile that information into reports used by the regulators.
How ISO has evolved over the years
From its beginning in 1971, ISO differed from its historical predecessors. In the early to middle twentieth century, there were insurance cartels that had mandatory membership criteria, offered indivisible services, and ran "stamping offices" that enforced adherence to the cartels' rates, rules and forms. But from the outset, ISO had a non-adherence policy and encouraged insurers to make their own decisions on the rates they would charge and the forms and rules they would use. Over the decades that followed its creation, ISO made a series of changes in its operations and structure: stopping the development of rates (1989); eliminating decision-making by insurers
ISO's corporate structure assures independence from insurer control; insurers may only own stock in the corporation that has very restricted voting rights, primarily limited to the election of three of the eleven members of the Board of Directors, alteration of its certificate of incorporation, or substantial changes to the corporate structure (i.e., merger or dissolution). As is common in other businesses, ISO hosts user meetings and panels to help improve its services, but those attending have no decision-making powers and are prohibited from discussing the corporate policies or intentions of any insurer. Meeting participants may not discuss insurer rate
ISO encourages and facilitates insurers' independent decisions about whether and how to use its material. Its Certificate of Incorporation and By-Laws contain a non-adherence provision, which states that no insurer may be required as a condition of its participation to use any loss costs, rules, forms or anything else that ISO produces. When it distributes advisory prospective cost
ISO also makes its material available in ways that permit insurer analysis, modification and adaptation in pursuit of independent business objectives. This includes distributing detailed statistics that underlie prospective loss cost information, providing ancillary services structured to facilitate insurers' analyses of risk and granting insurers the right to use policy form text in
ISO's staff of more than 150 actuaries includes approximately 50 Fellows and Associates of the CAS. Its staff of insurance experts includes more than 120 professionals who have received the Chartered Property Casualty Underwriter (CPCU) designation, as well as members of the Insurance Data Management Association (IDMA) and many other professional societies and
ISO's actuaries develop cost-based projections of prospective cost information at various levels of detail--state, territory and class. This information is submitted to state regulators and is made available for insurer use, but they may elect to accept, adjust, or not use any of it. ISO's actuarial analyses are produced entirely by its professional actuarial staff in accordance with the
ISO's products and services help reduce consumer prices; give them greater choice of insurers; help them to more easily compare prices and coverages; and speed the claims handling process ISO reduces an insurer's operating costs by providing information and services that the insurer
Also, by enabling insurers to more reliably predict expected losses, the availability of ISO's information permits them to be more confident in making pricing decisions. This increased confidence means less margin for error can be built into rates, leading to lower premiums. Many insurers, especially smaller ones, do not generate enough of their own loss information to predict expected costs reliably. They need this information because, unlike other industries, insurers do not know the ultimate cost of the product that they sell - the insurance policy - at the time of sale. It may take months or possibly years after the policy expires before an insurer knows the policy's costs because, at the time of sale, losses under the insurance policy have not yet occurred. However, by using ISO's products and services small insurers can compete with large ones and large insurers can do business in places in which they have low premium volume or no business at all. Insurance consumers are the beneficiaries when there are many insurers competing to gain market share.
ISO's common policy form language confers several benefits; one of the most important is the facilitation of comparison shopping by policyholders and their representatives. By comparing different insurer coverage forms to common policy language developed by ISO, insurance
ISO's policy forms enhance variety by providing language from which coverage can be tailored by insurers for the purpose of insuring unique risks and targeting specific submarkets. Insurers can and do compete in providing coverage enhancements and developing entirely unique,
The availability of prospective cost information based on the independently performed analyses of the combined data of many insurers is essential to the functioning of the highly competitive property/casualty insurance industry market.
There are fundamental differences between the insurance business and other industries. One of the most important differences is the lack of actual cost information about the insurance product at the time that it is offered for sale.
In exchange for a pre-determined premium, insurers provide coverage to their customers, but at the time a policy is sold, an insurer does not know to any significant degree the actual losses it will incur over a policy term. Consequently, the price charged for a policy is based on the insurer's best estimate of what those costs could turn out to be - on average. In most industries, companies are able to develop a greater proportion of the actual cost per production unit from more knowable, predictable, or controllable costs. For example, in the manufacturing sector, most businesses incur the majority of their costs before their products reach the market. As a result, a manufacturer has a great deal of the information it needs to determine a price for a product (i.e., to cover costs of acquiring raw material, manufacturing the product, and delivering it to the retail environment), as well as the profit it hopes to realize in a competitive market. Thus, at the time of sale or shortly thereafter, the manufacturer will know virtually all of its costs, both fixed and variable. In contrast, property/casualty insurers cannot know the ultimate cost or even the majority of the costs of their production units - insurance policies - at the time of sale.
The insurer is able to accept this risk of loss transferred from the insured if it can rely on the "Law of Large Numbers." The problem is that, for most lines of property/casualty insurance, few insurers have enough information of their own to allow the Law of Large Numbers to work for the purpose of evaluating the risk of loss associated with the types and classes of property/casualty insurance policies that they underwrite in every state.
If an insurer has been writing a given type of policy - a particular coverage grant, sets of exclusions/conditions, etc. - for a specific classification in a particular location for a given period of time, the insurer may have accumulated enough premium and loss data to be of some use. But if the insurer is small, has been in business for only a short time, or is large but is not a major writer for a particular line, class, or state it may not have enough reliable or credible information of its own to enter or remain in a market. It is this problem, unique to insurance, which drives such an insurer to seek from ISO advisory prospective cost information based on the aggregated data of many insurers.
The amount of information that any one insurer has for each of the thousands of individual classes and categories in a line of insurance is more limited than the data for the whole line. For example, commercial general liability insurance can be provided for more than 1,100 classes, ranging from hardware stores to coal mines. Accordingly, having a large aggregate data base available to insurers for each of these subgroups is even more crucial for reliably determining prospective loss costs for each of these classes. Depending on the line of insurance, several years of data often are needed to determine average statewide loss cost levels. But, even with a large pooled database provided by ISO, a larger volume of data is needed to provide reliable estimates of expected
Although large quantities of data are a prerequisite to a credible database, data collection is only the first step in the process of obtaining information about the future costs of insurance coverage. Historical data can provide a good picture of past costs, but it may provide little insight into the future costs current policies are expected to cover. Additional adjustments to this historical data - loss development, trend, and others- are necessary. These adjustments--including trend-- are
Collecting raw data from insurers and turning it into prospective cost information is a complex and costly process
The production of prospective cost information from a large aggregated database of statistics reported by many insurers is a complex and demanding process, as are many of the processes inherent in the production of ISO advisory information. That is why the process is so expensive. As I noted above, ISO employs a large staff of highly qualified data management and actuarial
Critics might say that it would not be difficult or costly for an insurer or consultant to perform the trend analyses that ISO uses to develop advisory prospective cost information. While the concept of trend is relatively simple, providing a false sense of comfort that the application of trend in the analytical process is also simple, it is not. Trend analysis is not simply a matter of
The use of trending in the analysis of data is what makes prospective loss costs prospective, but that is not its sole function. The trending process does not merely involve a projection; it also involves a complex process under which various sets of data are brought to common point in time (past, present or future) for evaluation purposes. 5 Actuaries use trend techniques to combine and analyze multiple sets of data (for example, losses, premiums and exposures) arising from different periods of time and to estimate what experience will be generated by policies written in the future. Actuaries rely on the observed rate of change over time (trend) in the frequency and size of insured losses, and in the number of insured exposures, viewed in the context of current and future events that might affect whether that trend can be expected to continue. This enables them to estimate from the most currently available data what experience was or can be expected for that set of policies written at any different point in time. These estimations are especially dependent on a thorough knowledge of the characteristics underlying the data.
Trend is embedded in many analyses that are used to derive prospective cost information from reported losses, and therefore is calculated and/or applied thousands of times annually by ISO actuaries to analyze costs for the various states, coverages, deductibles and amounts of insurance
The expense of the process needed to produce prospective cost information from the data of many insurers is significant because a small increase in marginal insurer expenses can have a big impact on an insurer's ability to enter or remain in markets
In 2004, average insurer profits were 9.1% of written premium (preliminary data indicate that the 2005 profit margin will be a bit higher). But, profit margins have been variable over the years. From 2000 through 2004, average insurer profit margins ranged from a high of the 9.1% earned in 2004 to a low of a net loss of 2.2% in 2001.
Since ISO provides information to many insurers, the relative cost to any individual insurer is low. Using commercial general liability insurance as an example, for each premium dollar written by insurers that purchase ISO's advisory prospective loss costs, rules and forms, insurers pay less than two tenths of one cent to ISO.
If every insurer had to incur even a fraction of the total ISO cost for providing these services, it would have a significant impact on each insurer's ability to stay in or enter many markets. Forexample, a typical insurer operating in 25 states with an annual general liability insurance premium volume of $50,000,000 pays approximately $75,000 a year for all of ISO's general liability prospective loss costs, rules and forms - less than two tenths of one cent for every dollar of general liability premium the insurer writes. For just one line of insurance, it cost ISO more than $11 million in 2005 to produce those products. That figure represents only ongoing
That is why the economies of scale offered by the availability of ISO advisory products and services are so important. In a business where all-lines industry-wide profit margins for insurers have ranged from -2.2% to 9.1% of written premium over the recent past, the benefits of the availability of essential information at low cost are obviously substantial.
Because advisory organization products and services have a beneficial effect on competition, insurers' access to them should be preserved and protected
In the late 1980s Professor Scott Harrington, then of the University of South Carolina now at the Wharton School, observed that the property liability insurance market was characterized by vigorous competition and that there was no evidence that advisory rates had increased prices or
In 1996, in an administrative proceeding6 before the California Insurance Commissioner, ISO retained the services of noted antitrust scholar Professor Lawrence A. Sullivan7 to analyze evidence concerning the competitive effect of advisory organization manuals containing
To assume that each insurer could replicate the entire prospective loss cost development and analysis process that an advisory organization undertakes to produce these data, is, on its face, unthinkable. If each insurer individually incurred costs even remotely approaching ISO's costs, all save a few of the largest insurers would be driven from the market... [I]ndividual costs could be cripplingly high even if the advisory organization
Our own studies of the competitive structure of the insurance industry confirm the earlier works, which concluded that the property/casualty insurance market is competitively structured and there is no evidence that the availability of advisory organization information has had an adverse affect on competition. In fact, the data suggest the opposite, that there is a high positive
We believe that repeal or substantial modification of the insurance industry's limited antitrust exemption is likely to elevate the level of legal uncertainty with which insurers must cope, resulting only in reduced capacity, availability, and competition in the marketplace. Most
For insurance companies, there would undoubtedly be a tendency to question the wisdom of participating even in those activities that would ultimately be sustained as pro-competitive under an antitrust "rule of reason" analysis. This chilling effect is not likely to be a quick or transitory experience; the evolution of the law interpreting the boundaries of the McCarran-Ferguson Act
I have described for you how the products and services that ISO provides to insurers help them operate in the competitive property/casualty insurance market. By improving insurers' knowledge of their true anticipated costs and by introducing economies of scale, ISO confers
Thank you for giving me the opportunity to present this statement. I would be pleased to answer any questions you may have.