The impact of rate regulation on insurer loss reserving practices: A theoretical and empirical analysis

A primary objective of insurance regulation is to ensure rates that are both affordable to consumers yet adequate to prevent insurer insolvency. The debate continues over whether regulation or competition best achieves this end. Industry studies on rate regulation are primarily confined to its impact on prices and profitability. Few examine the insurer response to rate constraints. The insurance community, however, has long questioned whether rate regulation promotes loss reserve manipulation. The current study probes this question. Specifically, regulators analyze insurer loss ratios to test rate adequacy. Escalating loss ratios may convince authorities to permit higher rates. Insurers can simulate escalating loss ratios by overstating reserves. Since accurate reserve determination is difficult and partially subjective, regulators are not necessarily aware of this kind of accounting manipulation. Insurers, therefore, may be able to obtain authorization to employ higher rates. Insurers writing in competitively rated states can adjust rates freely and have little impetus to manipulate reserves. Those writing in regulated states, however, may have such an incentive, especially if regulation suppresses rates below levels that would exist in its absence. A theoretical model is developed which depicts the optimal reserve for insurers trying to maximize after-tax income. Analysis of the model under both competitive and regulated rating confirms that regulation leads to higher reserves. Extensive empirical testing is then conducted on by-state automobile reserve data. Empirical findings suggest that reserves are positively impacted by rate regulation. The study concludes that regulatory strategy may need to be reevaluated as insurers may be able to circumvent its intended effects