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conditions for contestability—free entry, costless exit, and slow price response by the incumbent [to market conditions]—are met as closely as possible.”5 Government regulation should focus on “fairness, nondiscrimination, consumer protection, and quality maintenance.”6  Economists agree that free markets, with few exceptions, allocate resources most efficiently. This implies that regulations should strive to eliminate or reduce any imperfections that might exist, so as to enhance market efficiency, not to impede the functioning of an efficient market.

Competition tends to encourage innovation and lower prices. Market failures sometimes occur when certain competitive conditions are not met. Demand for regulations often arises, in large part, due to a perceived lack of a competitive environment within an industry. Regulatory actions should be taken where competitive forces are lacking in an attempt to make markets more competitive.7  Economists argue that the proper role of regulation is to promote and/or monitor competition rather than setting prices or controlling inputs. To the extent that government regulation is warranted, it should be designed to provide policies that instill competitive market characteristics when they are absent from the market or are ineffective.

The insurance industry, as noted previously, has a long history of regulation in the United States which has developed as a result of market failures, either real or perceived. While each state implements its own insurance regulatory system with various degrees of regulation, they all have similar regulatory goals. One goal of insurance regulation is the avoidance of insolvencies. This goal is not critical in other industries because consumers are not typically dependent upon a firm’s financial stability years after the initial purchase. A free market allows firms to dissolve which leads to greater market efficiencies. However, in the insurance industry, regulators attempt to protect consumers by reducing the number of insolvencies and limiting their harm. The other primary goal of insurance regulation is to protect consumers from harm that may occur in the market conduct of insurers including claims practices and pricing.8 An overarching goal for the insurance market is that “quality, reasonably priced products are available from reliable insurers.”9 The role of regulators is to protect the public by seeing to it that fair competition exists to achieve these goals while protecting buyers from anticompetitive or unfair practices. The main disagreements over regulations arise regarding at what point and to what degree regulatory actions are needed in certain locales and situations and what nature those actions should take.

Conditions for a Competitive Market

Although rare, uncompetitive markets can exist in the form of monopolies or oligopolies. More frequently, market deficiencies arise from imperfect information, which may lead to the inaccurate estimation of expected losses and may cause insurers to overreact to unexpected or severe events.  Market deficiencies (e.g., in the form of cyclical markets or steep price hikes) may arise because insurers and investors move slowly in response to markets that are either short on capacity or that have become competitive to the point that profitability is difficult.  As we shall discuss, several important market characteristics must be present in order for a market to function efficiently.  These characteristics of efficient markets are common assumptions found in economic models of perfect competition.  Economists recognize that, in reality, what exists rather than this "perfect" ideal is  a reasonably efficient market that lacks material deficiencies and where government intervention will not lead to a more efficient outcome.

One characteristic of a competitive market is the presence of a large number of buyers and sellers in the market, none of which has the ability to set prices. On the supply side, numerous sellers in the market will put downward pressure on prices and reduce marginal profits (additional profit gained for every additional good or service sold) as businesses compete. On the demand side, numerous buyers in the market will mean that they do not have the ability to negotiate the price below the cost of the seller to provide the good or service. The insurance industry cannot be analyzed as a monolithic whole but should be analyzed on a specific line and geographic market basis. Overall, there are many insurance writers and little concentration in the U.S. market. However, each individual line of business should be looked at individually and in a geographic region, whether a state or smaller area, in order to measure the concentration and competitiveness of an insurance market.

The ease of entry into and exit from the market by both buyers and sellers is another market characteristic that is prevalent in competitive models. From the supply side, it is a common misunderstanding that freedom of entry into and exit from

5 Train, Kenneth. (1991) Optimal Regulation: The Economic Theory of Natural Monopoly. Cambridge, MA: The MIT Press, p. 306.

6 McDowell, Banks. (1989, p. 8).

7 Skipper and Klein (2000, p. 482).

8 Hanson, Jon S., Dineen, Robert E., and Johnson, Michael B. (1974) Monitoring Competition: A Means of Regulating the Property and Liability Insurance Business. Milwaukee, WI: National Association of Insurance Commissioners, p. 674.

9 Skipper and Klein (2000, p. 495).

© 2009 National Association of Insurance Commissioners 6

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