Medial Malpractice Insurance: A Lesson in Econ 101.

By Jeremy Lund

     In anticipation of the upcoming presidential election, the issue of health insurance has again reared its ugly head.  The Bush Administration is claiming that medical malpractice suits brought by America’s trial attorneys are the cause for many physicians to have to leave their practices of medicine.  The theory is that there is an explosion of litigation in the area of malpractice and because of this, malpractice liability insurers are forced to raise there premiums to adjust for the ‘explosion.’

     The Kerry Campaign is also blaming the American trial lawyer.  The theory stems from the perception that the cost of defending ‘frivolous lawsuits’ is unquestionably driving up the cost of medical malpractice insurance premiums doctors must pay.

     At first glance these may seem to be logical explanations.  There has been a trend of increased medical malpractice suits.  The liability rates are increasing at an alarming rate.[1]  However, the numbers don’t add up to equate medical malpractice advocates with the work of the devil.

     This article will expose the fallaciousness of the two theories and plans to solve the medical malpractice insurance premiums as well as offer up a statistically sound rational to this problem.  Finally, it will propose a possible solution to the medical malpractice liability insurance crisis. 

Medical Malpractice Bushisms

The Bush Administration claims doctors are overly exposed to litigation.  This exposure results in increased premiums.  The Bush Plan seeks to limit non-economic damages (pain and suffering, punitive damages) to $250,000 and cap attorney’s fees.[2]  The thought is if you limit the potential liability a doctor will have, the insurance rates should decrease. 

This is a curious proposal by the Bush administration as more than half of the states already have similar limitations on malpractice liability.[3] If the problem as identified by the Bush Administration were accurate, then liability premiums should not be an issue in half of the country. 

Moreover, the Bush theory would mean that the rate increases should be roughly proportional to the increase in insurance payouts due to litigation.  In reality, premiums are increasing at a considerably higher rate than that of malpractice payouts.[4]

As the chart represents, the losses paid out by the insurance companies has been gradually increasing over the years.  Interestingly enough, in past years, premiums have spiked when there was no spike in the insurance payouts.  If the Bush hypothesis were correct, the two would correspond.

The Kerry Camp

The Kerry Camp, too, is blaming litigation, but on a more subtle level.  The theory that a litany of frivolous lawsuits is raising the cost of liability insurance is as unrealistic as the Bush hypothesis.

Medical malpractice suits are among the most expensive suits a lawyer can bring.  Very few of them go to trial.  Only a tiny percent of them result in verdicts for the plaintiffs.  Finally jury awards in favor of the plaintiff are reducing in dollar amount.  All these factors illustrate why frivolous medical malpractice suits are NOT running rampant in the courts.

     The influential factor is the inherent obstacle for attorneys to file frivolous malpractice lawsuits.  They are very expensive to take on.  Moreover, a substantial portion of them are taken on a contingency fee basis.  Unless a lawyer has a lot of money to burn, he/she will not file a suit they don’t think has merit. Lawyers screen out the frivolous suits themselves.[5]

     Many advocates would like to use the fact that few medical malpractice suits win.  The rational is, “well, if they did not win, they must have been frivolous.”  This is a distortion of reality.  Alluding to the criminal justice system illustrates my point.  It’s like saying that because O.J. Simpson was found not guilty, he must not have done it.  The public doesn’t jump to this conclusion.  Rather, they say, the prosecution just couldn’t prove it.  This is what happens in the civil context as well.  The doctor may have been negligent, but the plaintiff simply could not prove it.

     A more reliable figure is comparing iatrogenic (medically caused) injuries with the number of suits filed.  A Harvard study found that for every medical malpractice suit filed, there are approximately eight others injured by negligent doctor who do not file suit.[6]

Finally, to accept the Kerry rational for liability insurance hikes, one would have to assume that attorneys were filing abhorrent numbers of frivolous lawsuits in the in the late 70’s, straightened out there act for ten years, restarted filing ‘junk’ suits again in the late 80’s,  stopped for another ten or so years, and started up again.  There is no method (or rational) behind such madness.

A “Statistically” Rational Explanation

     The true reason for the explosion in malpractice liability insurance is what is called the ‘insurance cycle.’[7]

“The purpose of medical malpractice insurance is to cover the defense costs and damages imposed in a negligence case. Due to the risks of practicing medicine, practically all healthcare providers purchase such insurance. The typical policy held by a physician offers one million dollars of coverage for each incident and a maximum of three million dollars of coverage per year. To ensure coverage in the event of a malpractice claim, the healthcare provider pays a premium to the insurer. The insurer, in turn, invests the premium in the bond and stock markets. In this way, the insurance cycle begins.”[8] 

When comparing the insurance cycle with the nation’s economic cycle, one can see the correlation.[9] 

Comparing the United States stock market performance with the insurance cycle, there is a direct correlation between the peaks and valleys of the two.

     In the insurance cycle, supra, insurance rates peaked in 1972, 1978, 1987, and 1998.  The stock market had sharp declines in the same years.  In the years 1975, 1985, 1992, and 2000 the insurance premium rates bottomed out.  During the same periods the stock markets were experiencing growth, with the exception of 1992 in which the decline in insurance premiums were a result of Hurricane Andrew and other catastrophes in that year.[10]

     Jay Angoff, a former insurance commissioner explains, “Insurance companies profits are tied to their investment income - to the money they make on their investments—but their investments are mostly in bonds, with a relatively small percent of the stock market.  Insurance companies make their money not by taking in more premiums than they ultimately pay out in claims but by investing the premiums they collect.  And by state law, they have to invest the large majority of premiums in bonds.  So today, when interest rates are at a 40-year low, they make very little on their investments.”[11]

     To more fully understand the situation one must become acquainted with the combined ratio.  The combined ratio is the way the insurance industry measures profitability.[12] 

“At its most basic level, the combined ratio represents the percentage of each dollar collected, in the form of insurance premium, spent on claims, legal expenses (defense costs), and underwriting costs. It is the sum of two other ratios: the loss ratio, which expresses the relationship between losses and premiums in percentage terms; and the expense ratio, which expresses the relationship between underwriting costs and premiums in percentage terms. When combined, the loss and expense ratios express profitability or loss in the absence of investment income (i.e., the relationship between the amount of money coming in through underwriting income and the amount of money going out through losses and other expenses).  Conveniently for calculation purposes, a combined ratio of 100 is considered the "break even" point, with combined ratios under 100 indicating a net profit (absent investment income), and combined ratios over 100 indicating a net loss (again, absent investment income).  For example, an insurer with a combined ratio of 95 spends 95 cents on losses and expenses for every dollar of underwriting income it takes in, generating a net profit of 5 cents per premium dollar. Conversely, an insurer with a combined ratio of 105 spends $1.05 on losses and expenses for every dollar of underwriting income it generates, resulting in a net loss of 5 cents per premium dollar.”[13]
     This, of course, is not the full picture.  With the profit line on premiums collected to payments lost low, insurance companies will invest the money collected from the premiums in the market.  By regulation, a great deal of the investments, about 80%, will be in bonds.[14]  The returns on the investments are then used to subsidize premium rates in order to lower them and remain competitive in the medical malpractice insurance market.

     When the market is doing well, the investments return more, allowing the insurance companies to lower premium rates as was seen in the 1990’s.  When the market takes a turn for the worst, investment capital does not provide enough profit. Therefore, insurance companies raise the premium rates to maintain an acceptable level of profitability around 15%.[15]  This was seen in the economic drop-offs of 1987 and 1998.  It is happening again in today’s weak market.

A Solution?

     Now that the true cause of the medical malpractice premium explosion has been identified, one can analyze the situation and come up with some plausible solutions.

     The first issue is the combined ratio measuring stick.  In order to fix this situation, we must close the loopholes found in the insurance market.  Again, the combined ratio is a combination of premiums taken in and their investment income compared to loses or payouts incurred on the policies. 

      The loophole is in the way the insurance companies calculate their losses in this equation.  Insurers follow a different kind of accounting system than the rest of the world.[16]  The rest of the world follow the generally accepted accounting principles (GAAP) to calculate there profits and losses.  The insurance industry follow what is called statutory accounting principles (SAP).[17]

      “Under statutory accounting principles, to determine whether it has a profit or a loss, an insurance company will take its "incurred losses" and divide them by its "earned premium" to get what is called the "loss ratio." People in the industry often say that when the loss ratio is above 100--that is, when incurred losses are greater than earned premium--the company has a loss.
      In commonsense terms, that's wrong. Earned premium is a hard number, a real number: the amount of money that an insurance company takes in on the policies that it writes. Incurred loss, though, is the insurance company's estimate of the amount it will ultimately pay on the policies that are in effect in any given year. Even if the estimated amount was accurate--and it seldom is--that amount would not be paid out fully for 10 years or so. So the fact that the loss ratio is 100 means very little.
      I looked at the numbers for the last crisis in the mid-1980s, did the arithmetic, and found that the amount that medical malpractice insurers projected they would ultimately pay out (the amount they posted for their incurred losses) turned out to be far, far greater than the amounts they actually paid out--in the case of one major malpractice insurer, 38 percent greater. So, on the one hand, yes, insurers today are booking lower profits than they were 5 or 10 years ago. But those are not necessarily their real profits on this year's business, which we won't know until 10 years from now.[18]
     The problem in the loophole is that there are no standards the insurance industry must follow in predicting their losses.  Insurance companies will increase there premium rates pursuant to their incurred losses, but it is the insurance industry who will determine what those losses will be.[19]

     A possible solution to this ill-structured regulation is to eliminate the question marks.  While it is impossible to predict every occurrence that may result in a loss for an insurance company, a formula may be devised to eliminate the unbridled discretion the insurance industry has to calculate future losses.

     Such a formula would need to at the very least look at trends in medical malpractice litigation.  This would have to look at the number of claims, average cost of defense, win loss ratio as well as the payouts resulting from suits.  This formulation should be based on data from previous years (approximately 3-4yrs).  This would of course require the states to collect this data on medical malpractice claims as Missouri does.[20]  Reliable data is hard to come by.  The only way to eliminate this problem is to have a reporting requirement with the state.  Nationwide studies would then be more feasible to conduct.  By virtue of the states collecting the data, compiling the information would allow for those who claim a explosion of litigation to either back up their position, or fade into silence.

     The second prong to the solution is similar to what California has done with Proposition 103. In 1988, California, tired of the absurdly high insurance rates, rolled back insurance premium rates by 20% from those in effect at the date of enactment.[21] Insurance rates are then reviewed for approval by the state’s Department of Insurance.[22]  In order to maintain accountability, the commissioner of the department should be elected rather than appointed.

     In order to prevent future gouging by the insurance industry, regulations should be imposed to make it more difficult to raise premium rates.  One way to accomplish this is to permit hikes in premium rates that conform with the state of inflation while still allowing a profit margin.

 Conclusion

President Bush and Senator Kerry, the current state of affairs do identify a crisis in medical malpractice insurance.  Unfortunately, neither of the plans suggested will manage to alleviate the problems inherent in the status quo.

In order to address the rising cost of medical malpractice insurance, the problem must be properly identified.  As much as blaming trial attorneys for the problem may be popular within the medical population and the public, perhaps its time to stop giving attorney’s the death look.

It’s time to use the government’s peripheral vision and cast that stare at the true cause of the problem, the insurance industry.

The insurance industry has been hiding in a dark corner.  For years they have been telling the medical community and the politicians that it’s the lawyers, it’s the lawsuits.  In reality it’s the insurance industry structure.

When the knot tying the insurance companies to the market to the economy is loosened, by tying up the loopholes allowing the insurance industry to forecast future losses carte blanc, insurance companies will no longer have justification for its astronomical rates premiums will decrease. 

Rolling back the rates and putting the Department of Insurance in a supervisory position over the rates, scaled to inflation while still allowing for a profit margin will prevent a reoccurrence of the situation medical malpractice premiums are in today.