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Why Have Malpractice Premiums Risen So Sharply?

Premiums for malpractice insurance are set so that over time, insurers' income from those premiums equals their total costs (including the cost of providing a competitive return to their investors) minus their income from investing any funds they hold in reserve. In the short term, however, premiums may be above or below that equilibrium level, with profits fluctuating or reserves rising or falling as a result.

A full analysis of the reasons for the recent rise in premiums is beyond the scope of this brief. But the available evidence suggests that higher costs for insurers (particularly from increases in the size of malpractice awards), lower investment income, and short-term factors such as cyclical patterns in the insurance market have all played major roles.

Increased Costs

Payments of claims are the most significant costs that malpractice insurers face, accounting for about two-thirds of their total costs. The average payment for a malpractice claim has risen fairly steadily since 1986, from about $95,000 in that year to $320,000 in 2002. That increase represents an annual growth rate of nearly 8 percent--more than twice the general rate of inflation.

Although the cost per successful claim has increased, the rate of such claims has remained relatively constant. Each year, about 15 malpractice claims are filed for every 100 physicians, and about 30 percent of those claims result in an insurance payment.

The other one-third of malpractice insurers' costs comprise legal costs for policyholders who are sued and underwriting and administrative expenses. Those types of costs have also increased. Like claims payments, legal-defense costs grew by about 8 percent annually during the 1986-2002 period, from around $8,000 per claim to more than $27,000. In addition, the many malpractice insurers who buy reinsurance to protect themselves from large losses have seen that part of their underwriting costs rise significantly over the past decade. (Those increases are not related solely to medical malpractice but reflect a general tightening of the reinsurance market in the wake of such catastrophic events as Hurricane Andrew in 1992, the Northridge earthquake in 1994, and the terrorist attacks of September 11, 2001.)

Reduced Investment Income

Insurers generally base the malpractice premiums they charge in a given year on the future payments they expect to make for claims filed in that year. On average, claims are settled five years after the premiums for them were collected, and the income that insurers earn from investing premium receipts in the meantime is an important source of funds for them.

Insurance companies' investment yields have been lower for the past few years, putting pressure on premiums to make up the difference. According to the General Accounting Office (GAO), annual investment returns for the nation's 15 largest malpractice insurers dropped by an average of 1.6 percentage points from 2000 to 2002--enough to account for a 7.2 percent increase in premium rates. That figure corresponds to almost half of the 15 percent increase in rates estimated by the Centers for Medicare and Medicaid Services.

Short-Term Factors

Premium increases in recent years may also reflect temporary adjustments in the reserve levels and profit rates of insurance companies. Premiums rose sharply for a few years in the late 1980s because of insurers' expectations of future claims, which proved to be too high. The result was an accumulation of reserves, which were drawn down in the 1990s during a period of relative stability in premiums. If insurers' current expectations of future claims also turn out to be too high, the same thing could happen again.

The recent increases may also be a self-limiting response to insurers' low profits. In some states, premiums have been significantly affected when major insurers have decided to withdraw from the malpractice market, either locally or nationally. For example, in West Virginia and Nevada, the St. Paul Company had market shares of 43 percent and 36 percent, respectively, when it stopped renewing policies in August 2001 and then left the market entirely. Such a reduction in the supply of malpractice insurance can help drive premiums up sharply in the short run. But those higher premiums encourage other malpractice insurers to expand their insurance offerings in those markets and thus tend to moderate future price increases (all other things being equal).

Source: Congressional Budget Office

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