New York Codes, Rules and Regulations
Title 11 - INSURANCE
Chapter V - Rates And Rating Organizations
Subchapter F - Treatment Of Excess Profits In Motor Vehicle Insurance
Part 166 - Treatment Of Excess Profits In Motor Vehicle Insurance
Subpart 166-2 - Discussion Of General Rules
Section 166-2.5 - Discussion of excess profit threshold

(a) Section 677(5) (now section 2329) of the Insurance Law specifies that an excess profit shall be "so far above a reasonable profit as to amount to an excess profit." It is exceedingly difficult to quantify this concept. The department has followed the general approach of its consultant's statistical analysis and, largely on a judgment basis, has modified the excess profit threshold of 22.4 percent that was recommended by Professor Williams.

(b) The consultant discusses at some length the choice of a proper probability level to assure that excess profits are not due merely to chance. In an attempt to be fair to both consumers and insurers, he narrows the choices to a five-percent or 10-percent "confidence" level. (To select, for example, a five-percent confidence level is essentially equivalent to asserting that there is a 95-percent probability that the results observed will be statistically significant and not due to chance). Using New York data for the period 1962- 1978, Professor Williams shows that a five- percent criterion would result in a 22.4-percent excess point; a 10-percent criterion would result in a 21.4- percent excess point. (These figures are based on the observed standard deviation of.0266.) Professor Williams chooses a five-percent confidence level, in part due to a belief that other assumptions made in the formula would tend to produce too low a threshold. Thus, the choice of confidence level is partly a balancing factor, intended to keep the overall result as free from bias (upward or downward) as possible. He states, nevertheless, "The five-percent probability level may be slightly lower than it should be." Thus, if Professor Williams had chosen the 10-percent assumption, an excess profit level of 21 percent would have resulted.

(c) Utilizing the two additional years of data now available to the department, the standard deviation of six-year average rates of return for New York automobile business (1962-1980) has risen from 0.0266 to 0.0416. For comparison, the standard deviation of six-year average rates of return for all lines of insurance business for the entire country from 1917 to 1979 is 0.0360. [FN6]

(d) Although a 10-percent confidence assumption is a reasonable choice in many circumstances, the department must exercise caution in view of:

(e) Stability is an important element in establishing a long-term profitability methodology. In future years, when more annual data points are available, it is highly unlikely that the standard deviation will change so dramatically over a short period of time. At present, it cannot be determined whether the value resulting from the addition of data from 1979 and 1980 is an aberration, or represents a permanent move to a new level. The department prefers not to give full weight to the new value, in part for that reason.

(f) Higher interest rates might imply that insurers are entitled to higher reasonable rates of return. Partly in recognition of this contention, the department chose a reasonable return of 18 percent. At the public hearings some speakers testified that this figure was too high, in view of falling interest rates and the historical failure of the industry to earn such a return over an extended period. Due to a belief in the overall soundness of Professor Williams' methodology, and for the reasons given earlier, the department has chosen to accept the 18-percent figure. However, in order to maintain balance, it is necessary to exercise caution in selecting the margin for fluctuation above the reasonable level. For these reasons, the department has chosen an excess profit threshold of 21 percent, which implies (using data from 1962- 1980) an 80-percent level of confidence that excess profits are not due to chance.

(g) Some speakers at the October 5, 1982 public hearing argued that these choices allow insufficient margin above the reasonable level (only three percentage points) before excess profits are declared. An 80-percent level of confidence, which produced the 21-percent figure, is low in their opinion. This argument assumes that the reasonable level is correct, if not too low, and asserts that the excess point should be some 10 to 20 points higher. Others, as noted, believe the 18-percent figure is too high, and that an excess point of 21 percent might be too far above a more correct reasonable point. The department's decision not to adjust its selections of 18 percent and 21 percent is based in part on the finding that this excess point is consistent with other statistical approaches which would assume a lower reasonable level, coupled with a higher degree of confidence that excess profits are not due to chance. For example, if a reasonable profit of 16 percent had been chosen, an excess point of 21 percent implies an 89-percent confidence level. A reasonable profit of 14 percent together with a 21-percent excess point implies a 95-percent confidence level. For the time being, the department believes that 18 percent is the most reasonable rate of return, but it is encouraging to note that other approaches can also yield comparable excess levels.

(h) It is not unreasonable that the excess profit margin exceeds the reasonable rate of return by only three percentage points. A relatively narrow margin is the consequence of using an all- industry, six-year average approach to stabilize the data base and minimize short-run fluctuations around the reasonable rate of return. The department concludes that the various interests are well served by such a formula, which minimizes distortion and random fluctuation.

[FN6] Williams, Table 2, p. 52b.