FIRE INSURANCE RATES AND STATE

REGULATION

SUMMARY

I. Introductory; peculiarities as regards fire insurance rates in the United States, 447. How the price of indemnity differs from ordinary prices, 448. II. The theory of these rates, 450.- Classification no sure way of measuring hazard, 452. — Analysis of hazard into component parts, 453. - Influence of geographical area, 455. — III. Conflagrations a disturbing factor in the United States, 457. — IV. State regulation of three kinds: (1) Valued policy laws, 458.- (2) Anticoinsurance laws, 460.— (3) Anti-trust laws, 462. - Conclusion, 464.

I

INTRODUCTORY

RATES in fire insurance, in common with rates for other services which vitally affect the public, are now the subject for much discussion and legislation in the United States. The determination of fair rates in fire insurance is peculiarly difficult in this country for the following reasons: first, on account of the complexity of the elements entering into the cost of the service; second, on account of the past and prospective presence of conflagrations; third, on account of the legal status of insurance in the United States. A few words of introduction will serve to make more clear these peculiarities.

First, as regards rates and cost, two methods of determining fire insurance charges have been followed. In the early history of fire insurance, buildings were divided into the two classes of frame and brick, upon which a rate on the basis of past experience and per

sonal judgment was determined. In the evolution of rate-making, distinctions came to be made between classes of buildings within these two general classes. Special agents, acting with local agents, made all the rates. Later, selected representatives from companies made the rates for all companies for a city. Little effort was made to analyze the factors entering into each risk. It was a method of applying personal judgment and interpreting past experience. Altho the result was in some cases satisfactory, yet the general disregard of the good and bad features in a particular risk did not sufficiently differentiate the particular risk from the fictitious average risk. Later came the second method, under which various systems of schedule rating were developed in which an analysis of the component elements in the risk is made. The application of these schedule systems is now very generally made by organizations independent of the insurance companies.

Fire insurance is an indemnity for the whole or partial loss of property, but the cost of this indemnity cannot be determined with accuracy at the time the indemnity is sold. That is to say, if the cost of the service theory should be accepted as a proper basis for determining the charge, there is no assurance that the price charged will be equal to this cost, since so many variable factors affect the cost.

Whatever the merchant sells has been bought in the open market, and his selling price is ordinarily determined by adding the cost of freight, rent, clerk hire, fuel and light, together with such profit as he may regard as adequate. A manufacturer buys his raw material and by adding cost of labor, operating expenses, interest on his plant and his profit loading, he fixes the price at which he desires to sell his manufactured goods. A common carrier knows approximately what it costs to

transport passengers or merchandise by water or by rail. Whoever has anything to sell attempts to fix in advance the price of what he sells so that he may derive a profit. But the insurer sells neither merchandise nor labor; he sells promises to pay in the form of a contract of indemnity against loss caused by the happening of an uncertain event. But when he sells his contract of insurance- or more properly speaking his bond of indemnity he has no means of knowing whether he will be called upon to pay the stipulated indemnity in whole or in part.

Supply and demand do not affect the price at which this indemnity is sold in the same manner in which supply and demand affect the price of commodities. The losses which occur after the price is determined are the final determinants in fixing this price, and these losses are beyond the control of the insurer. In certain cases, as in preferred risks upon which losses are very likely to be low, a condition of surplus of supply of insurance may exist. This condition may tend to establish inadequate rates. On the other hand it may happen that the supply of insurance for other classes of undesirable risks tends to be below the demand. The result is that the forces of demand and supply do not establish that equilibrium which produces fair prices for all classes of risks.

In the second place, conflagrations introduce a very large disturbing factor in any assumed system of rates which seem at the time equitable.

In the third place, insurance in the United States is a subject under the complete regulation of the states, having been declared neither commerce nor an instrumentality of commerce by the United States Supreme Court. The significance of this fact for rates is that there is a strong tendency on the part of states to estab

lish the state as the geographical unit for rate making purposes. This may seriously prevent the proper working of the law of average, especially in a country where conflagrations are yet common.

II

THE THEORY OF FIRE INSURANCE RATES

On the part of the public there is very little accurate knowledge as to the nature and purpose of fire insurance. The average person considers it in much the same light as he does any common subject of sale and purchase. He assumes that he may go into the market and purchase as much or as little as he chooses at so much per unit of measurement. He confuses it with life insurance, concerning which he has gained considerable knowledge during the last decade. He purchases as much life insurance as his saving power enables him. But fire insurance has no direct relation to saving, but is always a question of indemnity for property loss. The individual demand cannot be measured in fire insurance by the ability and desire to purchase, but must be limited by the value of property possessed; whereas in life insurance full operation of effective individual demand may be permitted, except as it is limited by the physical condition of the applicant, or a maximum limit of insurance in a particular company. That is to say, an individual in normal health could purchase without injury to the business or to other people all the life insurance he desired; but the amount of fire insurance which he should be permitted to purchase is limited by the value of his property.

The simplest statement of the theory of fire insurance rates is that the rate is a resultant of the property loss, the expense element, the maintenance of the reserve

required by the various state laws and a provision for a return on the capital invested. The interest rate is over considerable periods of time a relatively constant factor. It is the property loss element in the final cost which fluctuates. This property loss is for any one year an indeterminate and largely an independent variable. The burning rate is always in process of change, and the range of it on an annual basis is sometimes very great. The fluctuation for a year in the total loss ratio may vary as much as 20%, and the loss ratio on particular kinds of property, or upon all classes of property in particular regions, may vary much more. Yet rates for the future since fire insurance is a service sold for future delivery - must be determined. The only correct method is an analysis of the numerous hazards which make up the fire loss. Past experience must, therefore, play a large part in supplying a basis for this analysis. The true measurement of fire hazard is the placing of every risk in its proper relative position, and while this position of relativity may change from year to year, yet each factor contributing to the hazard should, so far as is possible, be in the proper relation to the total charge.

It is a common doctrine in determining prices that each product should bear its total costs of production. Since insurance is an element in the total costs of producing a product, it is assumed by many that industries should be classified as the only method of assessing this cost of insurance. There is also another aspect to classification, namely, that the class should be limited to the property in a particular state. Both these ideas contain elements of danger as well as impracticability. If the first idea means that a particular business, as for example drug stores, should be placed in one class, for purposes of determining the insurance charge, the