conclude that there is no evidence from our analysis that the property and liability insurance industry is earning excessive rates of return. High and low, of course, are relative terms and we relate earnings to the financial industries as well as other industries in the economy. Capital which is fungible among all industries does not yield its owners a return that is excessive in any sense when invested in the property and liability industry. To state this conclusion more formally, there is no evidence to support the contention that the rate of return earned in the property and casualty insurance industry is above average when compared to all other industries, manufacturing industries alone, or other financial industries. The first analysis, the risk-related rate of return, allows us to make a slightly different but stronger statement. By this analysis we find that the rate of risk-related return in the insurance industry is significantly below what other industries earn. This has important significance, for we assert that it is likely that this industry will not in the future be able to attract or retain capital if it offers to investors prospects of lower rates of return for equal risks.

In short, for the 1955-1965 period, the overall returns earned by the property and liability industry have been significantly below returns earned by industries having similar and even lower risks. They have been below all forms of industry average rates of return for both manufacturing and financial industries. In addition, in the light of our analysis, it would be extremely difficult to argue that lower insurance prices are compatible with a viable and growing insurance industry, for the rate of return is ultimately related to the price of insurance. A lower price would result in a lower rate or return which would place the industry in an even more noncompetitive position for the attraction and reinvestment of capital.

The total rate of return (N4/D2) is the only measure which evaluates overall economic earnings on the totality of economic resources employed. From society's viewpoint this is the critical measure of whether resources are being over- or under-applied to any economic activity. Society is not interested in the financial structure of particular companies. Whether the assets are offset by debt instruments or common stock plays no part in determining their value to the economy as a whole. Consider a steel mill. It is a tangible asset of bricks and steel. Should it be destroyed, society is less rich by the amount of assets that comprised the mill, no matter how these assets were financed. Should they have been financed by bonds rather than common stock, the loss of the economy would be equally great. Nevertheless, an individual investor is (rightfully) concerned with return on net worth. This study does not present a framework for making a risk/return comparison for returns on net worth. However, because the value of N4/D1 (= 9.0%) may appear "reasonable" on the surface, some comments are in order. It should be recalled that N4 includes realized and unrealized capital gains as well as operating income. In fact, well over half of this income (N4) comes from stock market capital gains. This rate of return, then must be compared to stock market portfolios, which, on average, have earned 11-12% after taxes during 1955-1966 period. That was on unlevered portfolios. The common stock owner of a property and liability insurance company holds, in actuality, a 50% levered portfolio. Accordingly, the average rate of return he should expect is 22-24%. His return of 9% is a disadvantaged one when viewed against the alternative of direct market investment.

IV. INDUSTRIAL ORGANIZATION OF THE
PROPERTY AND LIABILITY INSURANCE INDUSTRY

QUESTIONS ADDRESSED

Any examination of industry prices and profits eventually is confronted with questions regarding the form and performance of the industry under consideration. An important part of any inquiry into industry prices and profits is the matter of the nvironmental setting within which the enterprises comprising the industry operate and how they behave in this environment. It is not sufficient to answer questions about price and profit solely in terms of size of profits. The behavior of the industry in acquiring these profits is also of concern. From an economic point of view, an "improper" profit is one that is in some sense, too large or too easily earned. A monopolist, it has been observed, can choose to be rich or lazy. The examination of the industrial organization of the property and liability industry is fundamentally a search for evidence of this undesirable behavior or of absence of competition.

COMPETITION AND INSURANCE

Two words, each having a high order of value in American economic thinking. dominate this discussion. They are "competition" and "insurance." As for "competition," it is a ruling tenet of American political economy that excessive prices and profits are undesirable and are better curbed by the interplay of competitive forces than by governmental prescription. There is, accordingly, a presumption that a reasonably competitive industry should be left alone with respect to prices and profits unless some overriding public necessity can be shown to require its regulation by legislative, judicial, or administrative process. This does not mean that competition can be relied on to yield utopian results, but suggests a social consensus that it is a less mischievous process than public administration of all the variables involved. As for "insurance," it is a fact of American economic life that a vast number of the entrepreneurial undertakings as well as the more routine business transactions that make up the world's largest national income are encouraged and facilitated by the use of insurance and its beneficial effects on expectations.

Thus, these two valued elements, "competition" and "insurance," are not to be curtailed or penalized without demonstrably good cause. The inviting conclusion-that insurance should be allowed to flourish in a laissez-faire climate-is not so simply obvious as one might wish.

It might be obvious, were it not for the fact that the social value of insurance can be nullified by too harsh a system of competitive discipline. The classic penalty in the competitive marketplace is forcible exit from the industry whenever efficiency is inadequate or long-run excess capacity develops. Such exit is the more common wherever the barriers to entry are, as befits a competitive market, low and inviting: easy in; easy out. The reason we do not want too permissive a set of entry and exit conditions in the insurance industry is that insurance companies sell services in futuro, thus enhancing the value of present plans by

contracting to give specific future protection. Insurance depends for its credibility on the prospective solvency of the supplier. Overly casual admission to the industry followed by an exit that leaves vital promises unfulfilled causes ill effects that can reach far beyond the unsuccessful investors in a bankrupt insurance company.

Society, faced with the need to balance two valued concepts, has therefore made a trade-off, diminishing the force of competition in order to increase the likelihood that daims will be paid. Once such a trade-off is made, it is hard for men to agree where to stop, because diminishing the force of competition can have unwanted side effects along with a Jesirable effect on the solvency issue. Will laxity be encouraged and its cost be passed on to the consumer, who nowadays often finds that insurance is a compulsory complement to other necessary purchases? This and similar fears and doubts tempt us to lay down other regulations and prescriptions, only to raise the question of how to cope with their unwanted side effects.

The insurance industry is already extensively regulated because of the need to avoid not only the inadequate rates that foment insolvency, but also the discriminatory pricing and excessive rates that might be developed collusively. The existing regulatory systems represent the efforts of fifty states and the District of Columbia to find that balance of freedom and restraint that will hold the prices of various insurance covers above the level of inadequacy and below the level of excessiveness.

As prices of various kinds of property and liability insurance have continued to rise in recent years, a demand has been made that regulatory bodies should move to restrain prices by requiring that the investment income of insurance companies be taken into acccount in rate-setting formulas. This demand, voiced by consumers who are weary of inflation and other forces pushing up insurance costs, is tantamount to a charge that the insurance industry is insufficiently competitive.

There are two ways of testing the validity of this charge. One is right; the other is

(a) The wrong way is to assume for the sake of the argument that the
industry is not competitive and to take action to hold back or force
down price increases, and then see if the insurance function has
been seriously damaged. If no damage is done, then the charge will
have been correct. This is the approach of the farmer who fires his
shotgun into the chicken coop because there just might be a fox in
there.

(b) The right way to proceed is to perform objective tests to see
whether the characteristics of the insurance industry show that its
prices and profits are developed in a sufficiently competitive
environment to ensure that they are fair and reasonable. This is the
approach which presumes that pricing is fair until proof to the
contrary is adduced.