Should antitrust principles be used to assess insurance residual market mechanisms, such as New York's medical malpractice insurance plan?

• Author: Haskel, Michael A.

State-created insurance residual market mechanisms are typically designed to address flaws in markets in which a significant number of purchasers have difficulty obtaining affordable insurance; such programs, however, have often led to crises in such markets, and occasionally to economic catastrophe. (1) In this Paper, particular attention will be paid to New York's Medical Malpractice Insurance Plan (MMIP or Plan), which presents the latest warning that there will be widespread market failures unless greater thought is given to the dynamics of such programs. (2) If the best teacher of the right way is the wrong way, then the MMIP is an excellent source of instruction. Laden with features that have resulted in hundreds of millions of dollars in losses, the MMIP has been a financial debacle that invites the attention of the legal and economic communities. Although the MMIP is susceptible to attack on several levels, (3) the MMIP's shortcomings are particularly obvious when analyzed through the prism of antitrust law principles, specifically those used in construing the Sherman Act (the Act). (4) To be certain, residual market programs, including the MMIP, may be largely exempt from the antitrust laws, as two recent federal circuit court decisions have noted; (5) yet, the application of the Act's legal and economic tests to the MMIP's operations provides learning opportunities, and suggests the need for reform. For a greater appreciation of the subject matter, this Article will: (1) consider the nature of insurance as a commodity, (2) discuss residual market mechanisms in general and the MMIP program in particular, (3) evaluate the MMIP on the basis of economic and legal tests developed in applying the Act, (4) address relevant exemptions that place aspects of residual market programs beyond the reach of the antitrust laws, and (5) suggest ways that the MMIP and similar programs can be improved through remedial legislation.

1. NATURE OF INSURANCE AS A COMMODITY

   1. Markets for Goods in General

      Insurance may be viewed as a commodity, and as with any good, the market for its purchase and sale can be visualized in terms of classic supply and demand curves. Figures 1 and 2 are graphs representing the purchase and sale of insurance in the voluntary market from one individual insurer, and from all insurers in the voluntary market, respectively. (6) In each graph, the vertical axis shows the premium, which in the insurance market is the equivalent of price, charged per $1,000 of insurance coverage written by the insurer(s). (7) Premiums for each individual insured, in turn, are calculated based on formulas known as rates, which are often subject to governmental approval. The horizontal axis represents the total amount of insurance coverage written by the insurer(s) (or, viewed alternately, purchased by insureds), the equivalent of output in the insurance market. (8) The demand curve (DD in Figure 1 and [D.sub.I][D.sub.I] in Figure 2) represents "the quantity of [the] good that [consumers will] purchase at each price." (9) The supply curve (SS in Figure 1 and [S.sub.I][S.sub.I] in Figure 2) shows "the quantity of [the] good that suppliers ... [will] sell at each price." (10)

      There are two categories of production costs: fixed costs (FC) and variable costs (VC). An illustration of the former, which is unrelated to the quantity produced, would be the rent for the firm's premises. (11) The latter varies with the firm's "level of output." (12) An example of VC is a firm's payroll. (13)

      Marginal cost (MC) is the expense of producing one additional unit of the product offered for sale. (14) In Figure 1, the marginal cost curve (MC curve) represents the MC at every level of output. (15) Since FC does not change with output, MC consists entirely of VC. At low levels of output the MC curve is downward-sloping (i.e., falling from left to right). (16) This reflects the fact that as a firm initially starts producing, increases in the amount of one input, such as capital or labor, while holding the others constant, will lead to proportionately greater increases in output. (17) This phenomenon is called increasing marginal returns. (18) At higher levels of output, this curve becomes upward-sloping. (19) This is because as output increases beyond a certain level, increases in the amount of any one input, while holding the others constant, will lead to proportionately smaller increases in output. (20) This circumstance is called diminishing marginal returns. (21) Because increasing marginal returns exist at low levels of production, and decreasing marginal returns prevail at high levels, the MC curve will have a U-like shape. (22) This has been empirically shown to be true of the insurance industry specifically. (23)

      When prices are set by competitive market forces, the firm's supply curve (SS) will be identical to the upward-sloping portion of the firm's MC curve. (24) This identity results from the fact that as long as the cost of each additional unit of a good produced is less than the price at which the good is sold, the seller will continue to produce. (25)

      The average cost (AC) curve (AC curve) represents the average cost of production among all the units a given firm produces, or put another way, the "total cost divided by the number of units produced." (26) Its U-like shape corresponds to the U-like shape of the MC curves. Because AC is merely the sum of the FC and the average of the MC of all of the units produced, AC will fall whenever MC is below it, and rise whenever MC lies above it. (27) Consequently, MC will intersect AC at AC's lowest point. (28)

      To arrive at the market-wide figures for cost in Figure 2, one adds up each firm's output as it corresponds to a given level of that firm's cost (be it AC or MC). (29) The sum of these outputs is the market's output, as a whole, associated with that cost. The market supply curve is derived by adding together each firm's supply curves in the same manner. (30) As each individual firm's cost and supply curves have similar shapes (i.e., U-like MC, AC, and SS), so will the corresponding market curves ([MC.sub.I], [AC.sub.I], and [S.sub.I][S.sub.I]).

      In Figure 2, the demand curve ([D.sub.I][D.sub.I]) represents the aggregate amount of insurance that will be purchased from all insurers at any given price level. (31) For most products at the market level, the demand curve is downward-sloping, i.e., as a consumer buys more units of a good, he is not willing to pay as much on average for each individual unit thereof. (32) This reflects that the more units of a given product a consumer purchases, the less enjoyment, or utility, the consumer will derive from each additional unit. (33) As he would receive less utility from another unit, he is not willing to pay as much for it as he paid for its predecessors. (34) Because the market demand curve is simply the sum of all consumers' individual demand curves, and each consumer's demand curve is downward-sloping, the market demand curve is downward-sloping as well. (35) In Figure 1, however, which represents an individual insurer's market, the demand curve is horizontal. (36) This reflects the assumption that one individual producer (here, insurer) is too small, in proportion to the aggregate of all producers in the market, to be able to affect market price, regardless of how much such firm produces. (37)

      In a free-market setting, the market equilibrium point is where the curves in the market graph intersect, i.e., where the forces of supply and demand coincide. (38) The equilibrium point sets the premium that insureds are willing to pay for and the aggregate coverage that insurers are willing to write. (39) In Figure 2, this equilibrium, [E.sub.I], is the point where supply meets demand, i.e., consumers are willing to pay for the same amount of output as suppliers are willing to sell. (40) At [E.sub.I], the price, [P.sub.I], is $2.50 (per $1,000 of insurance coverage), and output, [Q.sub.I], is $250 billion (of aggregate insurance coverage). (41)

      As long as the AC curve remains below the premium charged at the equilibrium, there will be a profit on the insurance written. (42) In Figure 2, the AC curve intersects the equilibrium output level at point B, which is below [E.sub.I]. (43) The area [AE.sub.I]BC shows the aggregate profits realized by all insurers, i.e., price ($2.50) minus average cost ($2.25) equals profit ($0.25 per $1,000 in coverage purchased); $0.25 profit multiplied by 0.001 (per $1,000) multiplied by $250 billion (aggregate of insurance coverage purchased) equals $62.5 million in profit for the industry. (44)

      As described above, the firm in Figure 1 is a price taker that cannot affect the market price arrived at in Figure 2, so the price charged in Figure 1 is the same as that in Figure 2, i.e., $2.50 per $1,000 in insurance written. (45) To maximize its profits, the firm will produce up to the point at which the marginal cost of the last unit produced equals the price received from the sale of the last unit produced. (46) This is the level of output at which the MC curve intersects the DD curve, at point E, which is $250 million in Figure 1. (47) The individual firm's profit is the area of the rectangle AEBC in Figure 1. (48)

   2. Distinguishing Characteristics of Insurance as a Good

      Insurance policies are not widgets, i.e., they are not simple articles as to which value is easily determinable. The value of liability insurance is the insurer's contractual obligation to satisfy losses within the limits of the policy, here assumed to be claims-made. (49) Over its fixed term, an insurance policy covering liability claims is, from the insured's perspective, a wasting asset that over time declines in value. A claims-made liability policy has intrinsic worth only as a source of protection against risk during the time that the policy is in force. Any premium paid in advance of the coverage period is earned by the insurer...