May 27, 2006

Contingent Commissions for Insurance Agents Reflect Efficient Market, Says Article.

UCONN Law School's Sean Fitzpatrick argues that contingent commissions for insurance agents have been used for a century because they are effective and efficient, and good for consumers as well as the insurance industry. His Fordham Law Review article, published in SSRN, reviews the recent investigations by Eliot Spitzer and the limited legislative response in states. He also provides a useful primer on the history and economics of the business of insurance.

He touches on theories introduced in one of his earlier articles that perverse incentives internal to insurance broker and company organizations may have led to the serious malfeasance acknowledged by several national brokerages and insurance companies. Explorations of such perverse incentives may also be of interest to students of public choice theory, the recurring failure of governments to respond to impending disasters such as hurricanes, earthquakes or global warming, and the general challenges of external costs in complex systems subject to "the tragedy of the commons." Fitzpatrick's views were addressed in more detail in "Fear is the Key: A Behavioral Guide to Underwriting Cycles," 10 Conn.Ins.L.J. 255 (2003-2004), which can also be found on SSRN at and was briefly summarized in an earlier posting in this place: Unintended Consequences: Lloyd's Boss Prays for Insurance Underwriting Profit (April 9, 2005).

Fitzpatrick argues that banning contingent commissions could have the unintended consequence of hurting the competitiveness of small, local, independent insurance agents and driving increased consolidation into large, national brokerage houses like Marsh and Aon. He closes with a practical suggestion for a requirement of disclosure of contingent commissions comparable to that found in the real estate industry. SSRN-The Small Laws: Eliot Spitzer and the Way to Insurance Market Reform, Sean Fitzpatrick, University of Connecticut School of Law, Fordham Law Review, Vol. 74, pp. 3041-71, 2006.

Thanks for the tip about this new article to Specialty Insurance Blog: Contingent Compensation (May 26, 2006).

Posted by dougsimpson at 07:14 AM

May 26, 2006

FTC Post-Katrina Gas Price Study Useful Re Other Market-Driven Industries

The FTC's recent report on price activity in the petroleum industry The "FTC Investigation of Gasoline Price Manipulation and Post-Katrina Gasoline Price Increases: A Commission Report to Congress" (Spring 2006) provides some useful material for other industries in which accusations of "price gouging" follow price fluctuations. The full study is 222 pages, but the May 23, 2006 "Commission Testimony Concerning Gasoline Prices" provides an executive level summary of its analysis.

This note will provide some reflections upon the investigatory report based upon examination of the testimony and attempt to relate its approach to regulatory responses to price increases in other market-sensitive industries, particularly the business of insurance, which is regularly subjected to accusations of "excess profits" during "hard market" periods of improving underwriting results. See, for example, "Commissioner John Garamendi Discloses Apparent Excess Profits' by Homeowner and Auto Insurers" (Dept. of Ins. Press Release May 25, 2006).

Read more below the fold

The FTC was charged under two separate statutes to make a study of gasoline prices. Due to the size and complexity of the market, it focused on areas it regarded as most likely to have led to problems for consumers. The Commission was charged to look for "market manipulation or price gouging" particularly in the aftermath of Hurricane Katrina.

One of the Commission's first challenges was to address the meaning of "market manipulation" and "price gouging," which have no particular legal or economic definition. Within the meaning of "price manipulation" the Commission's Report included "(1) all transactions and practices that are prohibited by the antitrust laws, including the Federal Trade Commission Act, and (2) all other transactions and practices, irrespective of their legality under the antitrust laws, that tend to increase prices relative to costs and to reduce output." Testimony p. 3. As to "price gouging, the Commission "analyzed whether specific post-Katrina price increases were attributable either to increased costs or to national or international trends." Testimony p. 4.

The Commission applied decades of experience investigating and analyzing potentially anti-competitive behavior in the petroleum and other industries, and a four-year program of monitoring wholesale and retail prices of gasoline. The FTC began work in August of 2005, including the issuance of 139 Civil Investigative Demands (CIDs), the taking of sworn testimony from petroleum executives and examination of data from the Oil Price Information Service (OPIS).

Up until Hurricane Katrina, the price of crude oil was the principal determinant of the price of gasoline, according to the FTC's findings. They also found that refiners were operating and pricing their products competitively, with no evidence of price manipulation. They also found no indication that refining capacity was limited other than by "competitive market forces that made further investment in refining capacity unprofitable." Testimony p. 10.

The FTC found that like many other industries, petroleum companies have steadily reduced their inventory levels over recent years in order to be more economically efficient. These inventories of gasoline played an important role in enabling recovery from the supply shocks of Hurricanes Katrina and Rita.

The study found that Hurricane Katrina caused the immediate loss of 27% of the nation's crude oil production and 13% of its national refining capacity. Rita took out another 8% of production and 14% of refining capacity. While these led to retail gasoline price rises of 50 cents and 25 cents respectively, the prices had returned to pre-Katrina levels by December 2005. Testimony p. 13.

Although some companies and retailers raised prices more than most did, the Commission found that "ln light of the amount of crude oil production and refining capacity knocked out by Katrina and Rita, the sizes of the post-hurricane price increases were approximately what would be predicted by the standard supply-and-demand paradigm that presumes a market is performing competitively." Testimony p. 14.

The study did find that some individual retailer's prices rose more than the average and produced increased profit margins, a circumstance the FTC regarded as falling in the meaning of "price gouging" used in the statute. Testimony p. 15. It looked closely at 24 retailers that were the targets of state price gouging legal action, but found that their operating margins did not increase significantly, and their average price increases were in line with competitors. The commission did find 5 individual exceptions that indicate that some instances of price gouging did occur. Testimony p. 17.

As to recommendations for legislation, the FTC led with a caution against enacting laws without realization that there are economic downsides to restrictions on price rises in response to supply/demand changes. Their comment is worth noting in full:

The challenge in crafting a price gouging statute is to be able to distinguish gougers from those who are reacting in an economically rational manner to the temporary shortages resulting from the emergency. This is more than just a problem for legislators and prosecutors. Gasoline suppliers may react to this difficulty in distinguishing gougers by keeping their prices lower than they rationally would. Consumers, in turn, may have no incentive to curb their demand as they would in response to a higher price. Other suppliers may have no incentive to send new supplies to the affected area, as they would if the price increased. The possible result may be long gasoline lines and shortages. In short, any decision to enact federal price gouging legislation should be made with full awareness of both sides of the possible tradeoff."

1. The Critical Role of Prices

Consumers might be better off in the short run if they did not have to pay higher prices for the same quantity of goods; in the long run, however, distortions caused by controls on prices would be harmful to consumers’ economic well-being. Prices serve a crucial function in market-based economies. They are signals to producers and consumers that tell how to value one commodity against another, and where to put scarce resources in order to produce or purchase more or fewer goods. If these price signals are distorted by price controls, consumers ultimately might be worse off because producers may manufacture and distribute an inefficient amount of goods and services, and consumers may lack the information necessary to properly value one product against another. Moreover, even in periods of severe supply shock, such as a major reduction in production or distribution caused by a natural disaster like the 2005 hurricanes, higher prices signal consumers to conserve and producers to reconfigure operations to better prepare for the next supply shock. Thus, if there is a “right” price for a commodity, it is not necessarily the low price; rather, it is the competitively determined market price. Relative to past prices, a competitive market price may sometimes be low, and it may sometimes be high; but it will send an accurate signal to producers to manufacture a sufficient amount of goods and services that consumers want to buy at that price, and an accurate signal to consumers to reallocate purchase decisions.

If prices are constrained at an artificial level for any reason, then the economy will work inefficiently and consumers will suffer. Economists have known for years that price controls are bad for consumers, and the deleterious effect extends far beyond strictly fixed prices. (See WILLIAM J. BAUMOL & ALAN S. BLINDER, ECONOMICS: PRINCIPLES AND POLICY 53 (2d ed. 1982). The constraint need not be total or permanent to have adverse effects. “Soft” price caps that allow for some recovery of price increases, or a price gouging statute that temporarily constrains prices during periods of emergency, still may have the effect of misallocating resources by reducing the incentives to produce more and consume less.15 Thus, any type of price cap, including a constraint on raising prices in any emergency, risks discouraging the kind of behavior necessary to alleviate the imbalance of supply and demand in the marketplace that led to the higher prices in the first place. A temporary price cap may have an especially adverse effect on incentives as producers withhold supply in order to wait out the capped period.

An artificially low price may cause producers to shift their fungible resources (of which capital is the most fungible) to other markets. Sooner or later, the result may be shortages, and the relatively scarce goods may be allocated by some method other than a market-clearing price. Experience with past markets in which prices have been held artificially low through price controls has included such results as consumers waiting in lines (and often burning scarce fuel while waiting), a politically designed allocation system, or an illegal “black market” in which the market price is charged."
Testimony, pp. 18-20.

The Commission pointed out that there is no federal law barring price gouging, though many states have laws attempting to address the practice. Beyond the above short lecture on the economics of price controls, the FTC recommended that any federal price gouging law have the following characteristics:

  • it should account for increased costs, including anticipated costs, not just historical costs;
  • it should consider market conditions contributing to a tight supply situation, including international conditions affecting the price of crude oil;
  • it should attempt to account for the market-clearing price, so as to avoid shortages that will leave consumers worse off.

    These same economic considerations recognized by the FTC will apply in other industries. Shock losses and distortions caused by natural or man-made disasters have historically resulted in price changes in insurance, building supplies, labor and other components of economic activity. The FTC's report provides a valuable warning against policy makers succumbing to the temptation to use the force of government to keep consumer prices below a market clearing price. While this may have short-term benefits, the long-term damage may far outweigh the immediate advantages. These insights from experts in the field should be valuable references for policy makers in those other industries and in the area of environmental protection as global warming and population pressures trigger more and bigger crises in climate, weather and availability of natural resources.


    Posted by dougsimpson at 02:01 PM
  • May 19, 2006

    New Mexican CAT bond would be triggered by big quake

    The Mexican government is the latest to arrange securitization of hazard risk with a parametric catastrophe bond that would respond to big quakes in specified regions of Mexico. Mexico Is Offering Bonds to Cover a Major Quake - New York Times (May 13, 2006).

    The General Accountability Office has examined the role of "CAT bonds" in natural disaster and terror risks in several studies. See, e.g.:

  • "Catastrophe Insurance Risks : The Role of Risk-Linked Securities and Factors Affecting Their Use" GAO-02-941 (2002);
  • CATASTROPHE INSURANCE RISKS: Status of Efforts to Securitize Natural Catastrophe and Terrorism Risk GAO-03-1033 (2003)
  • CATASTROPHE RISK: U.S. and European Approaches to Insure Natural Catastrophe and Terrorism Risks - GAO-05-199 (2005)

    Also, major insurance brokers track the market for CAT bonds; Guy Carpenter has an annual report online for year-end 2005 that notes the impact of Katrina and other major storms, which triggered the first recorded total loss on a CAT bond and some "capacity tightening" amidst increasing interest and standardization. Standardization and increased usage could reduce the expense of setting up and placing CAT bonds, which is regarded as significantly higher than reinsurance. The Guy Carpenter report includes some excellent charts showing nine years of history of the CAT bond market and its response to the overall insurance cycle as a source of alternative capacity. The Catastrophe Bond Market at Year-End 2005: Ripple Effects from Record Storms" (Guy Carpenter 2006).

    Thanks to RiskProf for the link to the story about the Mexican securitization. RiskProf : Mexican CAT (May 16, 2006)

    Posted by dougsimpson at 08:10 AM
  • May 12, 2006

    Greenhouse Effect + Intercontinental Pollution => More frequent droughts in India

    Polluted "atmospheric brown clouds" (ABC) travelling from one continent to another interact with oceanic warming and increase variability in the monsoon over the Indian subcontinent, according to recent studies sketched in ScienceDaily. The result may be an increased frequency of drought conditions affecting 2 billion people.

    The recent studies from various sources including the Scripps Institute of Oceanography. Field observations used in the study were obtained as part of the Indian Ocean Experiment (INDOEX), a $25 million international campaign funded by the NSF, the U.S. Dept. of Energy and NOAA.

    Scripps scientist V. Ramanthan is quoted in a ScienceDaily article: "About five to 10 years ago we used to think about pollution as an urban problem. Now we have discovered, with new observations including satellite data, that these pollution clouds travel quickly and can cover an entire ocean. Scientists have shown that in a matter of five days pollution traveled from China to the United States, and in a matter of three to four days it can travel from the U.S. to Europe."

    "The greenhouse gases are pushing in one direction, warming the ocean and trying to make more rain, and the aerosols are pushing in another direction for cooler oceans and less rain. The net effect is to drive the monsoon rain system away from South Asia into the equatorial and southern oceans," said Ramanathan. "Some years the aerosols might win and in some years the greenhouse effect may win. So we are concerned that in coming decades the variability between the two will become large and it will be difficult to cope with rapid changes from year to year."

    ScienceDaily: Pollution, Greenhouse Gases And Climate Clash In South Asia (May 12, 2006)

    Posted by dougsimpson at 08:33 PM

    May 04, 2006

    New Yorker: An Inconvenient Truth "might be the most important" film of the year

    The New Yorker's David Remnick reviewed "An Inconvenient Truth" online April 17, 2006. The film is focused on former vice president Al Gore's lecture circuit to raise awareness of global warming.

    Remnick thought it strong on message though weak on entertainment, saying, "as a means of education, 'An Inconvenient Truth' is a brilliantly lucid, often riveting attempt to warn Americans off our hellbent path to global suicide. 'An Inconvenient Truth' is not the most entertaining film of the year. But it might be the most important." The New Yorker: The Talk of the Town: "Ozone Man"

    He also shares some thoughts about comparison between Gore, who held the first congressional hearing on global warming 26 years ago, and President George W. Bush, who Remnick says "has made fantasy a guide to policy."

    Posted by dougsimpson at 04:44 PM

    Melting Ice Cap Documented by NASA Scientists

    A ten-year study of the polar ice caps documents loss of ice mass, "an expected response to increasing temperatures and precipitation in a warming climate." NASA scientists used satellite radar altimetry data to caculate the loss of ice mass and resulting increase in the sea level due to the release of water into the oceans. Zwally, et al, "Mass changes of the Greenland and Antarctic ice sheets and shelves and contributions to sea-level rise: 1992–2002", Journal of Glaciology, Vol. 41, No. 175 (2005)

    An International Glaciological Society press release points to the study published in its journal. International Glaciological Society (IGS): "NASA survey confirms climate warming impact on polar ice sheets" (March 2006), which quoted a press release by NASA on the paper.

    The March 8, 2006 press release by NASA itself includes satellite photos of the Greenland and Antarctic ice sheets and additional information regarding the environment and glaciological studies. Quoting: "In the most comprehensive survey ever undertaken of the massive ice sheets covering both Greenland and Antarctica, NASA scientists confirm climate warming is changing how much water remains locked in Earth's largest storehouse of ice and snow." "NASA - Impact of Climate Warming on Polar Ice Sheets Confirmed"

    Posted by dougsimpson at 04:01 PM

    May 03, 2006

    Fuel Woes Drive Military to Hybrids

    Military support can boost hybrid vehicle technology, such as that for a new hybrid diesel-electric HEMTT ("Heavy Expanded Mobile Tactical Truck") being built in Oshkosh, Wisconsin. | Hybrid Military Truck In The Works (May 3, 2006). HEMTTs haul big loads in tactical and rough terrain environments in places like Iraq, Afghanistan and post-Katrina Gulf Coast, but their mileage is in the single numbers. The HEMTT A3's "ProPulse" hybrid technology boosts mileage, can idle silently and with minimal heat signature, and can also export 200 kilowatts of AC power, enough to power a CP, small building or emergency medical or relief center.

    Announced in 2005 by Oshkosh Truck Oshkosh Truck Corporation - News Release, a demonstrator was sent to New Orleans to serve as a mobile generator and enabled workers to pump out a flooded hospital basement, according to a article in March, 2006 Defense Tech: Hybrid Truck's Katrina Duty (March 29, 2006)

    For generations, investment in military applications has served to drive technology and infrastructure development that can then be extended to civilian uses. Fuel costs and supply vulnerability in tactical environments provide land forces with a big incentive to conserve fuel. The "stealth" potential of the electric option is a special plus for hybrids to the military, which is applying it in "deep strike" recon vehicles like the RST-V Army Technology - Shadow RST-V - Reconnaissance Surveillance Targeting Vehicle.

    Fascination with military vehicles gave us the gas-chugging, compact-crushing suburban Hummer. Perhaps its more utilitarian big brother, the HEMTT A3, will teach us about how to save fuel, reduce greenhouse gases, and provide some emergency relief vehicles that can haul relief supplies and provide emergency AC power in post-disaster scenarios. Just as the weather is warming up. - Experts: Global warming behind 2005 hurricanes - Apr 25, 2006

    For a listing of bloggers on global warming, see: Technorati Blog Finder: global warming.

    And see the Sundance Film Festival hit "An Inconvenient Truth," about former Vice President Al Gore's personal campaign to fight global warming, in movie theaters May 24.

    Posted by dougsimpson at 01:31 PM

    May 02, 2006

    Environmental Benefits of Rising Gas Prices

    Richard Posner makes a straightforward argument for why higher gas prices discourage consumption and tend to reduce the production of oil, also reducing the threat of global warming. He favors increasing taxes on gasoline as one way to increase prices, and criticizes the absurdity of Congressional grandstanding through superficially pallative remedies such as tax rebates.

    He expresses doubt that a constituency that is ignorant of economics and suspicious of Bush administration motives The Becker-Posner Blog: The Gasoline Price Spike: Another Nonissue--Posner

    Posted by dougsimpson at 03:20 PM