Petition for Writ of Certiorari — Fitzgerald v. Bayham

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DEC 21 1983

——_

In THE

Supreme Comt of the United States

OCTOBER TERM, 1995

STATE FARM MUTUAL AUTOMOBILE

INSURANCE COMPANY,

¥. Petitioner,

STATE OF NEW JERSEY,

COMMISSIONER OF INSURANCE, et al.,

Respondents.

Petition for a Writ of Certiorari to the

Superior Court of New Jersey,

Appellate Division

PETITION FOR A WRIT OF CERTIORARI

MARTIN R. BROWN JOHN G. ROBERTS, JR.*

STATE FARM INSURANCE HOGAN & HARTSON L.L.P.

COMPANIES 555 Thirteenth Street, N.W.

One State Farm Plaza Washington, D.C. 20004

Bloomington, IL 61710 (202) 637-5810

(309) 766-4593 DAVID A. STRAUSS

THOMAS P. WEIDNER 1111 East 60th Street

Ross A. LEWIN Chicago, LL 60637

DAVID F. SWERDLOW (312) 702-9601

JAMIESON, MOORE, PESKIN

& SPICER

800 Alexander Park

Princeton, NJ 08543

(609) 951-4111

* Counsel of Record Counsel for Petitioner

WILSON - EPgs PRINTING Co., INC. - 789-0096 - WASHINGTON, D.C. 20001

QUESTIONS PRESENTED

1. Whether a state may, consistent with the Fifth and

Fourteenth Amendments to the United States Constitu-

tion, reduce a regulated firm’s returns below the reason-

able cost of capital.

2. Whether a state may, consistent with the Fifth and

Fourteenth Amendments to the United States Constitution,

require a regulated firm to pay taxes but refuse to provide

a clear and certain after-the-fact procedure to determine

whether those taxes are confiscatory.

(i)

PARTIES TO THE PROCEEDING

AND RULE 29.6 STATEMENT

Petitioner and plaintiff-appellant below State Farm

Mutual Automobile Insurance Company is a mutual in-

surer owned by its policyholders. It has no non-wholly

owned subsidiaries.

Respondents and defendants-appellees below are the

State of New Jersey; Elizabeth E. Randall (successor to

Samuel Fortunato), Commissioner of Insurance of the

State of New Jersey; James J. Ciancia (successor to

Edward J. Dauber), Acting Attorney General of the

State of New Jersey; Brian W. Clymer (successor to

Samuel Crane), Treasurer of the State of New Jersey;

and Neil Pearson (successor to Marshall Selikoff), Acting

Trustee of the New Jersey Full Insurance Underwriting

Association. The Property Liability Insurance Guaranty

Association was also a defendant below.

TABLE OF CONTENTS

QUESTIONS PRESENTED ................2..0.-0:-c-cc-cesseseesseees

PARTIES TO THE PROCEEDING AND RULE 29.6

TITTY cdichianihetinstsenscnienctisnnsinasenestneescendeesnsanssnibannees

GET NE OI eeecctcicasenncvsnscocetnscensemesescoenees

OPINIONS BELOW .......................... plcaisticaiaicthidsladiaaiciastaise

i. ssieiadebibdanatiaaicamiohecamicadaes

PERTINENT CONSTITUTIONAL AND STATU-

I EIIUEE - wicectinncisiperenicscinmneseneasstecteecenbeneiention

STATEMENT OF THE CASE

REASONS FOR GRANTING THE WRIT |...

I. THE COURT BELOW, IN CONFLICT WITH

DECISIONS OF THIS COURT AND SEVERAL

LOWER COURTS, REJECTED THE PRIN-

CIPLE THAT A REGULATED FIRM IS EN-

TITLED TO AN OPPORTUNITY TO RE-

COVER ITS COST OF CAPITAL ..............

A. This Court’s Decisions Establish That The

Cost Of Capital Standard Applies When A

State Regulates The Rates A Firm May

B. The Retrospective Nature Of A Proceeding

Does Not Justify A Departure From The

Cost Of Capital Standard, And The Alterna-

tive Standard Adopted By The Court Below

Is Unfounded And Invites Abuse

(iii)

TABLE OF CONTENTS—Continued

II. NEW JERSEY’S FAILURE TO PROVIDE A

CLEAR AND CERTAIN REMEDY, PURSU-

ANT TO A CONSISTENT STANDARD, VIO-

LATED THE DUE PROCESS CLAUSE ...........

Ill. THE DECISION BELOW REFLECTS A RE-

CURRING PATTERN THAT WARRANTS

THIS COURT'S INTERVENTION .................

CO I sccewccsctsincwitisnineneiencinctemsavesccnienacdgnanibacanumsonmnts

APPENDIX A:

Opinion of the Superior Court of New Jersey,

Appellate Division, filed May 12, 1995 —..................

APPENDIX B:

Order of the New Jersey Supreme Court denying

petition for certification, filed September 27, 1995..

APPENDIX C:

Decision of the Commissioner of Insurance, filed

pe I EAR rR: IR Ea el IED ts ai

APPENDIX D:

Decision of the Administrative Law Judge, filed

Ce Gi, Te eka. tina:

APPENDIX E:

Order of the Chancery Division, filed August 6,

| aaa aha i ceheP atti pa ieahlPo tI atch Se SEEN OTT MEE

APPENDIX F:

Transcript of Opinion of the Chancery Division,

I Bi, FI triinitinenhccctnlettinepenpsslitctimnereipinibtovians

APPENDIX G:

Order of the Chancery Division, filed December 3,

APPENDIX H:

Pertinent Constitutional and Statutory Provisions..

Page

43a

44a

113a

120a

124a

TABLE OF AUTHORITIES

Cases Page

20th Century Ins. Co. Vv. Garamendi, 8 Cal. 4th 216,

878 P.2d 566, 32 Cal. Rptr. 2d 807 (1994), cert.

dismissed, 115 S. Ct. 1085 (1996), cert. denied,

tie Ss | ) | Ree eee 16, 18, 23, 24

Alabama Power Co. v. Alabama Pub. Serv.

Comm’n, 422 So. 2d 767 (Ala. 1982)... 14

Appeal of Cheshire Bridge Corp., 126 N.H. 425,

ie Bie See GT cide ee 13

Atchison, T. & S.F.Ry. v. O’Connor, 223 U.S. 280

6 RS Erie Sst 2, apes aan sees WEEN eee eT 20, 22

AT&T v. FCC, 836 F.2d 1386 (D.C. Cir. 1988)...... 14

Attorney General v. Department of Pub. Utils., 392

Mass. 262, 467 N.E.2d 72 (1984) 000000000000... 14

Boston Edison Co. Vv. FERC, 885 F.2d 962 (1st Cir.

EE eetelathidh ae iiadinetnieatinnacinalniabgstedieadgaabetiadcectedes 13

Brinkerhoff-Faris Trust & Sav. Co. v. Hill, 281

Cee II nsonnecsistibicitbedetncteldibeasniadchicdslbcuibies 21

Central Maine Power Co. Vv. Public Utils. Comm’n,

153 Me. 228, 186 A.2d 726 (1957) ........................ 14

Distrigas of Mass. Corp. v. FERC, 737 F.2d 1208

CR Ti EE ciclicatsepeaacetstsbniclhdatiaadiadiadg aida dlahbiglcath ike 13

Duquesne Light Co. Vv. Barasch, 488 U.S. 299

CR lila chirinienintitsaeiendicin eotcbbeedsth doa etude 10, 11-12, 18

Federal Power Comm’n Vv. Hope Natural Gas Co.,

tt Os | ah ea Re ee passim

Guaranty Nat'l Ins. Co. v. Gates, 916 F.2d 508

2 CEE Rar ne. Fs .: F 13, 24

Hastings v. Village of Stowe, 125 Vt. 227, 214

PY ps eatin elu hiertto hcnae lc baie tue ns deans 14

Iowa-Des Moines Nat’! Bank v. Bennett, 284 U.S.

RN GER» siiicnciiten nsssasninhtnscadtceninlecctapainlababeanbiadte dedsnice 22

Kansas Gas & Elec. Co. v. State Corp. Comm’ n,

239 Kan. 483, 720 P.2d 1063 (1986), prob. juris.

noted, 479 U.S. 1082, app. dismissed, 481 U.S.

jE ty amenneennemerrne teh RS TLS meee Se Cees 24

Market Street Ry. v. Railroad Comm’n, 324 U.S.

548 (1945) ......... schaniiiaieldiiabiitaesda take Ale SMO BO ra 12

McKesson Corp. V. Division of Alcoholic Bever-

ages, 496 U.S. 18 (1990) ......................... 8, 19, 20, 21, 22

TABLE OF AUTHORITIES—Continued

Page

Mountain States Tel. & Tel. Co. v. Department of

Pub. Serv. Regulation, 191 Mont. 331, 624 P.2d

GBR CROBRD cececccccesicrsectitndsncsntienscstecstnceincasastabiessinneses 14

New England Tel. & Tel. Co. v. Department of

Pub. Utils., 327 Mass. 81, 97 N.E.2d 509 (1951) .. 14

Ohio Edison Co. ¥. Public Utils. Comm'n, 63 Ohio

St. 8d 555, 589 N.E.2d 1292 (1992) —.................. 24

Pennsylvania Elec. Co. v. Pennsylvania Pub. Util.

Comm'n, 509 Pa. 324, 502 A.2d 180 (1985), ap-

peal dismissed for want of substantial federal

question, 476 U.S. 1187 (1986) ......................---- 24-25

Permian Basin Area Rate Cases, 390 U.S. 747

(| | 11

PruneYard Shopping Center v. Robins, 447 U.S.

FE CADBDD cncesececcsecsassesssccscemenenseenecsenstnssensccnsemcatsniseees 21

Public Service Co. of New Hampshire, 130 N.H.

748, 547 A.2d 269 (1988) .......-.--.-------------eeeeeeeeees 13

Reich Vv. Collins, 115 S. Ct. 547 (1994) ................... 20, 22

Smith v. Allwright, 321 U.S. 649 (1944) —.............. 18

Southwestern Bell Tel. Co. v. Public Serv. Comm'n,

I GS, Oy —————EEEYE 11

State Farm Mut. Auto. Ins. Co. v. State, 124 N-J.

$2, 590 A.2d 191 (1991) ~..........--.-------n-an--eees 4, 5, 6, 22

Tennessee Gas Pipeline Co. v. FERC, 926 F.2d _

1206 (D.C. Clr. 1901) .....-.---...--c-c.escceccecenneceocneee 14

United States v. FCC, 707 F.2d 610 (D.C. Cir.

| | en 13

Constitutional, Statutory, and Regulatory Provisions

UD, Comat, GUROI, Y cnccccnscnectsccseceseesecttnsesssiitanesease 2,9, 10,18

U.S. Const. amend. XIV ........................ siesanaeie 2, 10, 19, 22

it ls). | <tttthicbsdiniddamanaaal 2

BUF B.A. 29s BAAS 6B COG e 2ceeccnecceccvececeecsrsssccssssesscsssses 16

a a oe 2

OER EY, 5

PES 8 EY) ane 5

I yxy 5

DE TBA. BG sBRB-d 6B GOs cccnceersctnccscesscccssnssssssccsscssssseseed passim

75 Pa. Cons. Stat. § 1799.7(b) ........

S.C. Code Ann. § 38-73-465(D) ...

TABLE OF AUTHORITIES—Continued

Page

N.J.S.A. 17:33B-49(a) -............ Pb A = 5

PP Sly .. ) ae ne eee 5

A Ae Ty A a et DS A AO. oe

DE A a nt

ai arts os

IN THE

Supreme Court of the United States

OcTOBER TERM, 1995

No. 95- ——

STATE FARM MUTUAL AUTOMOBILE

INSURANCE COMPANY,

~ Petitioner,

STATE OF NEW JERSEY,

COMMISSIONER OF INSURANCE, ef al.,

Respondents.

Petition for a Writ of Certiorari to the

Superior Court of New Jersey,

Appellate Division

PETITION FOR A WRIT OF CERTIORARI

State Farm Mutual Automobile Insurance Company

petitions for a writ of certiorari to review the judgment

of the Superior Court of New Jersey, Appellate Division,

entered in this case on May 12, 1995.

OPINIONS BELOW

The opinion of the Superior Court, Appellate Division,

is unreported and is reprinted in the appendix hereto

(“App.”) at la. The decision of the Commissioner of

Insurance is unreported and is reprinted at App. 44a.

The decision of the Administrative Law Judge is un-

reported and is reprinted at App. 68a. Opinions of the

Chancery Division entered in the course of the litigation

are unreported and are reprinted at App. 113a, 120a,

and 123a.

JURISDICTION

The Appellate Division of the Superior Court of New

Jersey entered its judgment on May 12, 1995. App. 1a.

A timely petition for certification was denied by the New

Jersey Supreme Court by order filed on September 2i,

1995. App. 43a. The jurisdiction of this Court is in-

voked pursuant to 28 U.S.C. § 1257.

PERTINENT CONSTITUTIONAL AND

STATUTORY PROVISIONS

The Takings Clause of the Fifth Amendment and the

Due Process Clause of the Fourteenth Amendment to the

United States Constitution, and pertinent sections of the

Fair Automobile Insurance Reform Act, L. 1990, c. 8,

N.J.S.A. 17:33B-1 et seq., 17:30A, are set forth at App.

124a-136a.

INTRODUCTION

This case presents, with stark clarity, a recurring issue

of great importance on which the lower courts are in dis-

agreement: whether a regulator denies a regulated firm

the constitutionally-mandated fair rate of return when the

regulator’s actions prevent the firm from recovering its

reasonable cost of capital. New Jersey, like nearly every

other state, regulates the rates that automobile insurance

companies may charge. In this case, New Jersey, again

like several other states, enacted an insurance “reform”

measure that imposed substantial financial burdens on

automobile insurers, including petitioner State Farm.

Specifically, New Jersey required insurers to pay large

surtaxes and assessments—$41 million in State Farm’s

case just during the two years at issue in this litigation—

to bail out the state’s debt-ridden association for insuring

high-risk drivers.

Rather than allowing insurance companies to treat these

surtaxes and assessments like other costs, which are re-

flected in the rates insurers are permitted to charge, New

Jersey relegated State Farm to an after-the-fact proceeding

————————————————— CC

Mes dR ath RE et dO Feet BRI AL Medea ta om ab

SAY OMI. a at eth AN EEA ES ied 2B

at which State Farm was required to prove that its returns

had been inadequate. When State Farm did prove that

its returns were inadequate—falling well below the level

that even the court below conceded was the “fair rate of

return” and the “cost of capital”—-New Jersey simply

changed the rules of the game: the court below decided

that in a “retrospective” proceeding, held not to set rates

for the future but to determine whether there has been

confiscation in the past, a firm’s reasonable cost of capi-

tal—the standard established by a half-century of this

Court’s decisions—should no longer be the constitutional

minimum. Instead the court below, on its own initiative,

looked to the annual nationwide industry average return——

an analytically flawed standard with no support in the

decisions of this or any other court.

The course New Jersey followed here—insurance “re-

form” consisting of monetary exactions, followed by an

after-the-fact conclusion that the insurer has actually

received adequate returns—has been used by other states

in the past, and will be used again. It is a particularly

dangerous combination. Retrospective proceedings to de-

termine whether there has been an inadequate rate of

return are rife with possibilities for manipulation. Deter-

mining the actual returns of a firm is a complex process,

in which the regulator’s findings of fact and judgments

on technical questions receive great deference. Deter-

mining the cost of capital can also be complicated, and

the regulators again receive great deference.

The decision below, however, is distinctive in its clar-

ity. The court frankly acknowledged that State Farm’s

returns fell below the cost of capital; that the state’s

exactions were the only reason they did so; and that the

state’s action could be upheld only if the cost of capital

standard were abandoned. For this reason, this case

squarely presents the issue that, in other instances, will

typically be buried in a welter of technical considerations:

whether the cost‘of capital standard established in this

Court’s decisions remains the governing constitutional

principle. This case accordingly provides a signal oppor-

tunity for the Court to ensure that an increasingly popular

governmental action—insurance “reform,” generated by

political pressure and designed to reduce rates—be con-

ducted according to the proper constitutional standards.

STATEMENT OF THE CASE

1. The Reform Act. New Jersey, like nearly every

state in the Nation, regulates the premiums that may be

charged for private passenger automobile insurance. For

some time, New Jersey has faced what its own Supreme

Court characterized as “an intractable problem of pro-

viding coverage for high-risk drivers.” State Farm Mut.

Auto. Ins. Co. v. State, 124 N.J. 32, 40, 590 A.2d 191,

195 (1991). New Jersey responded to this problem in

1983 by establishing an agency commonly known as the

Joint Underwriting Association (“JUA”) to provide in-

surance to high-risk drivers. Because the JUA was for-

bidden to charge rates higher than those set in the volun-

tary market, “it was anticipated that [the JUA’s] premium

revenues would not cover costs of claims against JUA

policies.” Jd. at 41, 590 A.2d at 196. Although the

JUA had other sources of income, including surcharges

on the premiums paid by voluntarily insured drivers, it

not surprisingly incurred increasingly large deficits. By

1990, the JUA had accumulated a deficit of over $3.3

billion. Id. at 41-42, 590 A.2d at 195-196.

Following a gubernatorial campaign in which the cost

of automobile insurance was one of the leading issues,’

New Jersey, in 1990, adopted the Fair Automobile In-

surance Reform Act, N.J.S.A. 17:33B-1 et seq. (“Reform

Act”). The Reform Act provided, among other things,

that the JUA deficit would be paid off in large part

1 As a candidate, Governor Florio promised to abolish the JUA,

reduce rates by 20 percent, and “send the JUA bill where it be-

longs: to the insurance companies.” Appellant’s App. at 290a,

State Farm v. State, 124 N.J. 32, 590 A.2d 191.

through surtaxes and assessments imposed on all firms

licensed to write automobile insurance in the state.” The

Reform Act also provided explicitly that the surtaxes and

assessments—more than double the operating profit al-

lowed under New Jersey law—could not be passed

through into the premiums that insurance companies

charged their New Jersey customers. N.J.S.A. 17:33B-

51; N.J.S.A. 17:30A-16(b); State Farm v. State, 124

N.J. at 45, 590 A.2d at 197. Indeed, when the Reform

Act was introduced, the New Jersey Governor pledged

that “[t]here would be no pass through to consumers of

any assessment or premium tax.” Appellant’s App. in

Appellate Div., at 473.

Several insurance companies, in a case that preceded

this one, challenged the Reform Act on its face as a vio-

lation of the Takings Clause of the United States Con-

stitution. The New Jersey Supreme Court rejected the

challenge. The court highlighted one section of the Re-

form Act which acknowledged that insurers are entitled

to a rate of return that satisfies the constitutional mini-

mum. Relying on that section and procedures established

by the Commissioner of Insurance that would allow in-

surers to apply for adjustments in their rates to secure

the constitutional minimum, the court concluded that it

could “{]not now say that * * * the Reform Act would

make it impossible for any insurer to achieve a fair rate

of return.” State Farm v. State, 124 N.J. at 61, 590

A.2d at 206 (emphasis added). The court stated that the

proper way for an insurer to raise the constitutional issue

was to apply to the Commissioner of Insurance for an

adjustment; after the Commissioner acted, if the firm

believed that imposition of the surtaxes and assessments

2The Reform Act imposed a 5% premium surtax on all private

passenger automobile insurers for the years 1990 to 1992, N.J.S.A.

17:88B-49(a), and also imposed assessments on all property and

casualty insurers to raise an additional $160 million each year from

1990 to 1997. N.J.S.A. 17:30A-8(a) (9), (10). The assessment was

2.71% and 2.6% of all property and casualty premiums in 1990 and

1991, respectively.

ie |

caused its returns to fall below the constitutional mini-

mum, it could then claim that the Reform Act was un-

constitutional as applied. Id. at 63, 590 A.2d at 207.

Although the state supreme court ruled that these pro-

ceedings before the Commissioner (and any subsequent

court challenge) were the only way for an insurance com-

pany to challenge the constitutionality of the surtaxes and

assessments, the court felt constrained to “acknowledge

uncertainty about how the Act may be applied by the

Commissioner in individual rate-increase determinations”

and to admit that “the rate application process * * * by

its very complexity may carry the potential for frustrating

in practice the achievement of a fair rate of return.”

Id. at 62, 590 A.2d at 207. Justice Garabaldi, in a

special concurrence, went even further, saying: “I have

grave doubts about the ability of the Commissioner of

Insurance * * * to guarantee insurance companies a con-

stitutionally-adequate rate of return.” Jd. at 66, 590 A.2d

at 209.

2. The Administrative Proceedings Below. State Farm

pursued just the course specified by the state supreme

court, through long and tortuous proceedings. First,

State Farm applied to the Commissioner for adjustments

to its rates that would reflect the surtaxes and assessments.

The Administrative Law Judge (“ALJ”) assigned to the

case refused to consider State Farm’s request to adjust

its future rates to account for the taxes it had already

paid, adopting the Department of Insurance position that

this would “constitute[] impermissible retroactive rate-

making.” Appellant’s App. in Appellate Div., at 146.

See App. 116a. State Farm sought judicial review, and

a Chancery Judge overturned the ALJ’s action, declaring

it “inexplicable.” Jd. at 117a. He remanded the matter

to the ALJ with instructions to answer the specific ques-

tions necessary to decide State Farm’s claim: what State

Farm’s rates of return were in 1990 and 1991, both with

and without the challenged surtaxes and assessments, and

what the fair rate of return was for those years. Id. at

117a-119a.

On remand, the ALJ concluded that the fair rate of

return for the period in question was approximately 13%,

and that State Farm’s earnings were 3.4% for 1990 and

1.5% for 1991 after consideration of the surtaxes and

assessments. Id. at 91a, 102a. The ALJ nonetheless de-

nied relief. He did so by invoking a statistical device

known as a “confidence interval”—a device whose use

was subsequently repudiated by the court below (see id.

at 3la-32a)—concluding that rates as low as negative

3.6% would satisfy the constitutional standard. Id. at

92a. The Commissioner of Insurance adopted this con-

clusion and upheld the denial of relief. Id. at 44a.

3. The Decision Below: the Takings Clause Issue.

The court below, reviewing the Commissioner’s decision,

upheld the ALJ’s findings that State Farm’s achieved rate

of return was 3.4% in 1990 and 7.5% in 1991. App.

3a. The court below also accepted the ALJ’s and Com-

missioner’s conclusion that the “fair rate of return” for

those years was 13%. Id. at 10a-11a. Notably, the court

explicitly equated “the fair rate of return” to “the cost of

capital”: “[(TJhe fair rate of return in a prospective pro-

ceeding is one needed to attract investors, often called by

the experts the cost of capital.” Id. at 9a.

The court below did not disturb the ALJ’s conclusion

that without the surtaxes and assessments, State Farm’s

returns would have covered its cost of capital, or nearly

so: 12.7% in 1990 and 16.4% in 1991. Id. at 12a. The

court below also noted that State Farm had demonstrated

that “it experienced no unusual casualties or other factors

which reduced its rate of return” and that even the state’s

experts “all conceded that they could find nothing in State

Farm’s experience in New Jersey, other than the surtaxes

and assessments, which would produce the low rate of

return.” Id. at 31a (emphasis added). The court pointed

out that nothing in the ALJ’s findings supported the con-

clusion “that State Farm’s rate of return was caused by

factors other than the surtaxes and assessments.” Jd. at

31a.

The court below nonetheless balked at the apparent

conclusion of this syllogism—that if the state’s imposition

of nonrecoverable surtaxes and assessments forces a firm’s

returns below the cost of capital, the state has violated

the Takings Clause. The court rejected this conclusion on

the ground that the “cost of capital” standard “is a pro-

spective concept.” App. 9a. In this case, the court ex-

plained, it was not establishing rates for the future but

deciding whether there had been confiscatorily low rates in

the past. Accordingly, the court insisted, the appropriate

standard was not the reasonable cost of capital but the

nationwide industry average return—4.8% for 1990.

“The ‘takings’ clause requires no remedy where the effect

of price regulation has been to reduce actual return to the

industry average.” /d. at 23a. It was a “misconception{],”

the court said, to believe that the cost of capital standard

applies “in a retrospective proceeding” or “is the min-

imally acceptable rate of return.” Jd. at 24a.

4. The Decision Below: the Due Process Issue. The

court below also rejected State Farm’s argument that the

after-the-fact remedy afforded to it was not “clear and

certain” and thereby violated the Due Process Clause, as

interpreted by this Court in McKesson Corp. v. Division

of Alcoholic Beverages, 496 U.S. 18 (1990). The court

below admitted that the procedures established by the

Commissioner to consider State Farm’s claims did not

provide “meaningful standards.” App. 40a. The court

below also recognized that the Commissioner’s regulations

did not even specify standards for determining the two key

components in any rate regulation confiscation case: (1)

“what constituted a ‘constitutionally adequate return’ ”

and (2) “how the Commissioner proposed to compute the

achieved return.” Jd. at 32a.

In fact, the absence of advance standards on these

key points allowed the Commissioner to devise an ad hoc

approach calculated to deny State Farm any relief. Thus,

rather than follow the established procedure in New Jersey

law for calculating an insurer’s operating results in a retro-

spective proceeding (see note 5, infra), the Commissioner

picked and chose among various expense and income

items, with “some inconsistencies,” to arrive at an achieved

rate of return calculation that “did make it difficult for

insurers generally to succeed” in their constitutional chal-

lenges. Id. at 41a. While the court below repudiated the

bizarre “confidence interval” theory for determining the

constitutionally adequate rate of return, it also came up

with a novel approach of its own with its invocation of

the nationwide industry average standard. /d. at 3a. De-

spite the fact that these key standards were settled on

only after the fact—when it was clear they would lead to

a denial of relief—the court concluded summarily that

State Farm “received fair treatment and achieved a fair

rate of return.” Jd. at 40a.

The New Jersey Supreme Court denied a timely peti-

tion for certification. App. 43a.

REASONS FOR GRANTING THE WRIT

I. THE COURT BELOW, IN CONFLICT WITH DECI-

SIONS OF THIS COURT AND SEVERAL LOWER

COURTS, REJECTED THE PRINCIPLE THAT A

REGULATED FIRM IS ENTITLED TO AN OPPOR-

TUNITY TO RECOVER ITS COST OF CAPITAL

The court below rejected the principle that, under the

Takings Clause of the Fifth Amendment, a regulated

firm is entitled to an opportunity to recover the cost of

its capital and reasonable expenses. This ruling is irrecon-

cilable with this Court’s decisions and in conflict with

decisions of several other lower courts.

A. This Court’s Decisions Establish That The Cost

Of Capital Standard Applies When A State Regu-

lates The Rates A Firm May Charge

1. As the Court has recently reiterated, a firm whose

prices are regulated by the government is protected, by

the Constitution, against having its rates set too low.

“If the rate does not afford sufficient compensation, the

State has taken the use of [the regulated firm’s] property

without paying just compensation and so violated the

Fifth and Fourteenth Amendments.” Duquesne Light Co.

v. Barasch, 488 U.S. 299, 308 (1989). Calculating the

precise rate that a firm should receive can, of course, be

a dauntingly technical task. But this Court’s opinions,

for the last 50 years or more, have made at least one

point clear: “sufficient compensation” means “enough rev-

enue not only for operating expenses but also for the

capital costs of the business.” Federal Power Comm'n v.

Hope Natural Gas Co., 320 U.S. 591, 603 (1944).

“These include service on the debt and dividends on the

stock.” Id. A regulated firm’s return, the Court explained

in Hope, must be “sufficient to assure confidence in the

financial integrity of the enterprise, so as to maintain

its credit and to attract capital.” Jd.

The reason that a firm is entitled to recover its cost of

capital is not technical or esoteric: it is simply that, from

the point of view of the Takings Clause, there is no dis-

tinction between a firm’s operating costs and the cost of

its capital. Investors who have not received a fair return

on their investment because of state regulation have had

their property “taken” just as surely as if they were denied

the opportunity to recover operating expenses paid out of

their pockets. Justice Brandeis explained this point in the

opinion that—as this Court has noted (see Duquesne

Light, 488 U.S. at 309)—laid the conceptual foundation

for Hope: “[T]here is no difference between the capital

charge and operating expenses * * *. Each is part of the

current cost of supplying the service; and each should be

aaa err

met from current income.” Southwestern Bell Tel. Co.

v. Public Serv. Comm'n, 262 U.S. 276, 306 (1923)

(concurring opinion).

Justice Brandeis could not have been more explicit in

stating that the right to recover the cost of capital is a

constitutional guarantee:

The thing devoted by the investor * * * is not spe-

cific property * * * but capital embarked in the

enterprise. Upon the capital so invested the Federal

Constitution guarantees to the [regulated firm] the

opportunity to earn a fair return. Thus, it sets the

limit to the power of the State to regulate rates.

* * * *

The compensation which the Constitution guarantees

an opportunity to earn is the reasonable cost of con-

ducting the business. Cost includes not only operat-

ing expenses, but also capital charges. Capital charges

cover the allowance * * * for the use of the cap-

ital[;] the allowance for risk incurred; and enough

more to attract capital. [Jd. at 290-291 (footnote

omitted ).]

Since Hope, the Court has held fast to this principle.

In Permian Basin Area Rate Cases, 390 U.S. 747, 792

(1968), the Court emphasized that a court reviewing a

rate order “must determine whether the order may rea-

sonably be expected to maintain financial integrity, attract

necessary capital, and fairly compensate investors for

the risks they have assumed.” In Duquesne Light, the

Court rejected a claim that rates were confiscatory pre-

cisely on the ground that they covered the reasonable

cost of capital:

No argument has been made that these * * * rates

jeopardize the financial integrity of the companies,

either by leaving them insufficient operating capital

or by impeding their ability to raise future capital.

Nor has it been demonstrated that these rates are

inadequate to compensate current equity holders for

the risk associated with their investments. [488 U.S.

at 312 (footnote omitted ).]

2. The issue in any case in which there is a claim

that rate regulation has resulted in a taking is the end

result of the state’s actions. See Duquesne Light, 488 U.S.

at 310 (“ {I]t is * * * the impact of the rate order which

counts.’”) (quoting Hope, 320 U.S. at 602). The court

below concluded that State Farm’s “fair rate of return”

—explicitly equated to the “cost of capital”—was 13%

for the years in question. It nonetheless ruled that the

Constitution permitted New Jersey—through the Reform

Act’s nonrecoverable surtaxes and assessments—to drive

State Farm's returns far below that. The inconsistency

between the decision below and the governing standards

of this Court could not be more clear. Indeed, the court

below was able to reach the result it did only by brushing

aside the Hope cost of capital standard, declaring it a

“misconception[]” tc suppose that the cost of capital “is

the minimally acceptable rate of return.” App. 74a.°

Ordinarily, ratemaking cases present complex issues

concerning such relatively technical matters as the actual

rate of return, the reasonableness of various expenses, the

rate base, and the reasonable return on the rate base.

This case presents none of those factual complexities. It

instead starkly poses the legal question whether a state

may reduce a regulated firm’s return below the cost of

capital.

3. The decision below, not surprisingly, also conflicts

with many decisions in the lower courts that have recog-

nized the cost of capital standard. As we discuss in

* If a regulated industry is in decline for market-related reasons

unconnected to price regulation and firms in the industry “could

not attract capital on any possible rate,” the cost of capital standard

may not apply. Market Street Ry. v. Railroad Comm'n, 324 U.S.

548, 566 (1945). Neither New Jersey nor the court below ever

suggested that comparable circumstances account for the ruling in

this case, and no such suggestion would be plausible.

——&<«_

Point III, there has been some significant erosion of the

cost of capital standard in the lower courts, and the New

Jersey court’s decision in this case is sure to accelerate

that problematic trend. But for the most part the lower

courts have adhered to the cost of capital standard.

For example, as Justice Souter explained for the New

Hampshire Supreme Court, “[a]t a minimum, the return

must equal the cost of capital * * * [which] is the cost

of borrowing money and the cost of attracting equity

investment.” Appeal of Cheshire Bridge Corp., 126 N.H.

425, 493 A.2d 1151, 1156 (1985). Justice Souter went

on to say: “[OJnce the cost of capital has been determined

* * * it marks the minimum rate of return to which the

company is lawfully entitled.” Jd. at 1157 (internal quo-

tation marks omitted). See also Public Service Co. of

New Hampshire, 130 N.H. 748, 547 A.2d 269, 271

(1988) (Souter, J.) (“[A] utility’s threshold entitlement

is to a rate of return equal to the cost of capital.”).

Many courts of appeal agree. See, e.g., Boston Edison

Co. v. FERC, 885 F.2d 962, 964-965 (1st Cir. 1989)

(Breyer, J.); Distrigas of Mass. Corp. v. FERC, 737

F.2d 1208, 1211 (1st Cir. 1984) (Breyer, J.); Guaranty

Natl Ins. Co. v. Gates, 916 F.2d 508, 515 (9th Cir.

1990). As the District of Columbia Circuit—which has

perhaps the most extensive experience with rate regula-

tion among the federal courts of appeals—explained:

Regulated industries are entitled to earn enough

revenue not only to cover operating expenses but

also to pay for the capital costs of doing business,

including service on debt and dividends on stock.

The return to the equity owner must be “sufficient

to assure confidence in the financial integrity of the

enterprise,” * * * in order that its credit may be

maintained and capital may continue to be attracted.

[United States v. FCC, 707 F.2d 610, 612 (D.C.

Cir. 1983}, citing Hope, 320 U.S. at 603.]

See Tennessee Gas Pipeline Co. v. FERC, 926 F.2d 1206,

1208 (D.C. Cir. 1991) (“investors must be allowed an

opportunity to earn returns sufficient to ‘attract capital’

* * * and ‘to compensate [the] investors for the risks

assumed’”) (quoting Hope, 320 U.S. at 605); AT&T Vv.

FCC, 836 F.2d 1386, 1389-90 (D.C. Cir. 1988) (“The

rate of return * * * must be sufficient to cover the cost of

capital the carrier must raise to do business” ).*

B. The Retrospective Nature Of A Proceeding Does

Not Justify A Departure From The Cost Of Capital

Standard, And The Alternative Standard Adopted

By The Court Below Is Unfounded And Invites

Abuse

1. The court below explained its conclusion by assert-

ing that a firm is entitled to recover its cost of capital

only in a “prospective” proceeding, not in a retrospective

4See also, e.g., Alabama Power Co. V. Alabama Pub. Serv.

Comm'n, 422 So. 2d 767, 770 (Ala. 1982) ( “constitutionally man-

dated fair rate of return * * * involves cost of debt capital, cost

of preferred stock, and cost of equity capital”) ; Central Maine

Power Co. Vv. Public Utils. Comm’n, 153 Me. 228, 186 A.2d 726,

740 (1957) (“It is repeatedly stated or implied in the decided

cases, so far as we know without contradiction, that one of the

constitutional rights of a regulated utility is the right to earn a

sufficient return to maintain its credit and to obtain additional

capital when needed to enable it to serve its public”) (quoting

New England Tel. & Tel. Co. v. Department of Pub. Utils., 327

Mass. 81, 97 N.E.2d 509, 516 (1951) ) ; Attorney General v. Depart-

ment of Pub. Utils., 392 Mass. 262, 467 N.E.2d 72, 75 (1984)

(“In general, the return on equity must equal at least the amount

which the company would have to pay in order to ‘hire’ its equity

capital under current conditions”) (citations omitted) ; Mountain

States Tel. & Tel. Co. v. Department of Pub. Serv. Regulation,

191 Mont. 331, 624 P.2d 481, 482 (1981) (“In determining a fair

and reasonable rate of return, it is necessary to determine what

it costs the utility to secure the required capital to finance its

operations”) ; Hastings V. Village of Stowe, 125 Vt. 227, 214 A.2d

56, 61 (1965) (“the rate of return must be sufficient to provide

enough revenue for capital costs of the business, including service

on the debt and dividends on the stock”).

proceeding. But this distinction is illogical on its face.

A regulated firm is entitled to its cost of capital for the

reason given 70 years ago by Justice Brandeis and repeat-

edly reaffirmed by this Court: that otherwise investors

have had property taken from them. An investment on

which they could have earned a 13% return elsewhere, at

comparable risk, yielded only 3.4%, not because of market

conditions but because of government fiat. This common

sense definition of a taking applies regardless of when a

state elects to provide a regulated firm the constitutionally

mandated opportunity to present its takings claim; it does

not cease being true when a regulator suppresses rates at

the outset and forces the regulated firm to prove inade-

quate returns in a retrospective proceeding.

In retrospective hearings, of course, more is known

about a firm’s actual performance. Regulators need not

rely on projections and extrapolations about the firm’s

costs and revenues, as they must in setting rates for the

future. On the other hand, the fact that a firm has a low

or even negative return in a certain period does not mean

that its rates were set unconstitutionally low. The con-

stitutional guarantee is of an opportunity to earn the cost

of capital plus operating expenses. Low returns for a

particular period may be the result of poor management,

a catastrophe, or adverse market conditions; if they are,

then the firm is of course entitled to no relief.

In this case, it was not difficult to determine whether

State Farm’s poor bottom line was the result of market

conditions or of government intervention. The effect of

the surtaxes and assessments was so dramatic that even

the expert witnesses supporting the state, not to mention

the court below, had to admit—and did admit—that

State Farm’s shortfall resulted from the state’s actions.

See App. 31a. Thus, in this case, the retrospective nature

of the proceeding simply allowed State Farm to show

with certainty that it was subjected to confiscatory rate

regulation.

The court below referred repeatedly to the “novelty” of

a retrospective hearing.’ But the novelty of a procedure

does not justify abandoning established constitutional

standards. The retrospective hearing was the result, of

course, not of State Farm’s actions, but of the state’s

refusal to allow the surtaxes and assessments to be treated

like other expenses and built into the rates prospectively.

In fact, around the Nation, proceedings of this kind are

less novel than they once were, and are destined to be-

come less novel still—should this Court not intervene

here—as other states adopt the techniques that have effec-

tively allowed New Jersey to take $41 million of State

Farm’s property. The court below explicitly relied on a

recent decision of the California Supreme Court that also

refused to adhere to the cost of capital standard in a

retrospective proceeding. 20th Century Ins. Co. v. Gara-

mendi, 8 Cal. 4th 216, 878 P.2d 566, 32 Cal. Rptr. 2d '

807 (1994), cert. dismissed, 115 S. Ct. 1085 (1995),

cert. denied, 115 S. Ct. 1106 (1995). The court below

called this aspect of the California Supreme Court’s

opinion “soundly reasoned.” App. 28a.

2. Having jettisoned the Hope cost of capital standard,

the court below was compelled to devise a new constitu-

tional touchstone. It settled on the “nationwide industry

average” return, even though no party ever advocated or

5In fact retrospective reviews of profitability are, in an impor-

tant sense, not novel under the New Jersey regulatory regime.

New Jersey has the country’s most stringent excess profits law :

capping insurer profits, N.J.S.A. 17:29A-5.6 et seq., and that law

requires insurers to compute retrospectively the revenue and ex-

penses from their insurance operations and to rebate to policy-

holders any “excess” operating profit. State Farm vigorously (but

unsuccessfully) argued below that this proceeding should be treated

just like other after-the-fact determinations of an insurer’s returns

already regularly undertaken by New Jersey. If the state had

followed its own established excess profits methodology in this case,

State Farm’s returns would have been negative 4.6% in 1990 and

1.2% in 1991, even more clearly confirming that State Farm is

entitled to relief on its confiscation claim. See Pet. for Certification

at 5-6.

, 7

even mentioned such a s.andard. The “nationwide in-

dustry average” standard is analytically unsustainable, and

the court below failed to cite a single case from any

court—let alone from this Court—to support it. More

important, however, the use of a standard of this kind in

a retrospective proceeding opens the door for violations

of a regulated firm’s rights under the Takings Clause.

The nationwide industry average return standard ex-

poses a regulated entity’s assets to seizure in any year

in which the industry, as a whole, had poor earnings.

Those assets would be at risk regardless of the individual

company’s earnings, or the factors that distinguished that

company from the industry as a whole. The standard is

affected by factors that have no bearing on State Farm’s

conduct of its insurance business in New Jersey. In any

one year, there can be sharp regional variations in the

claims experience of insurance companies; earthquakes,

hurricanes, or economic conditions in other parts of the

country should not reduce the returns insurers are allowed

in New Jersey. Poor performance by some insurance

firms can depress the nationwide industry average return;

it is perverse to use that as a reason to force lower rates

on well-managed firms.

Finally, of course, the nationwide industry average is

affected by the decisions of regulators. If regulators in

California suppress rates, the industry average standard

allows regulators in New Jersey to do likewise, and vice

versa. It is circular, and absurd, to adopt a standard

that allows this to happen. These are the reasons that

this Court has never suggested, much less adopted, the

nationwide average standard.

6 Automobile insurance is counter-cyclical; returns decline in

periods of economic growth, because people drive more and there-

fore have more accidents. Economic conditions often vary greatly

from region to region, so the nationwide average return will be

affected by conditions that have nothing to do with the environment

in which a particular firm is operating.

The Hope cost of capital standard is different. Although

not a mathematically precise number, it is a well-estab-

lished concept in this Court’s decisions, far less subject

to manipulation by the very governmental authorities the

Takings Clause was intended to constrain. Once that

constitutional floor is abandoned, the regulated entity’s

right to be free of confiscatory rates is at the mercy of a

standardless and ever changing target. Here, the court

below selected the 4.8% return figure from among no

fewer than 45 different assertedly applicable historic re-

turns in the record, ranging from 1.6% to 20.7%.’ The

constitutional protection against confiscatory rates is

meaningless if the cost of capital standard is abandoned

and government is allowed to pick and choose among a

wide array of historic returns, settling upon not a standard

at all but a rate that is like “a restricted railroad ticket,

good for this day and train only.” Smith v. Allwright,

321 U.S. 649, 669 (1944) (Roberts, J., dissenting). See

Duquesne Light, 488 U.S. at 315.

The constitutional infirmity of this approach is height-

ened when this ad hoc selection of a “standard” takes

place in a retrospective inquiry. At that point a regulated

firm can do nothing to increase revenues or decrease

expenses to improve its returns, nor can the firm elect to

withdraw from the regulated business. The returns are

already in and the regulator—if not constrained by a

previously adopted, objective standard—can choose the

rules that will lead to the desired result. Such an approach

makes no sense under the Takings Clause, which was

after all designed to bridle government officials, to prevent

7 Although the court below looked to the California Supreme

Court’s decision in 20th Century for support, App. 3a, 26a-28a,

that case involved a different standard—a 10-year industrywide

historic return yielding a 10% rate of return. 8 Cal. 4th at 302,

878 P.2d at 621, 32 Cal. Rptr. 2d at 862. If the court below had

picked that standard, State Farm would have been entitled to

significant relief on the undisputed facts. The point is that once

the cost of capital standard is abandoned, there is no meaningful

objective standard to take its place.

them from doing exactly what New Jersey did here—take

private property for public use, without just compensation.

II. NEW JERSEY’S FAILURE TO PROVIDE A CLEAR

AND CERTAIN REMEDY, PURSUANT TO A CON-

SISTENT STANDARD, VIOLATED THE DUE

PROCESS CLAUSE

The court below rejected State Farm’s argument that

the administrative procedures established by the Commis-

sioner violated the Due Process Clause because they pro-

vided no “clear and certain” remedy. See McKesson

Corp. Vv. Division of Alcoholic Beverages, 496 U.S. 18,

39, 51 (1990). Under the state supreme court’s earlier

decision, those procedures provided the sole remedy for

an insurance carrier who claimed that the surtaxes and

assessments were confiscatory. State Farm asserted that

the criteria used in these remedial proceedings were so

shifting and vague that they could not be said to be clear

and certain.

The court below essentially agreed with State Farm’s

description of the procedures that were afforded to it.

The court said: “We do not think the Commissioner has

provided meaningful standards” to guide the determination

whether an insurer was subjected to confiscatory rates.

App. 40a. The court acknowledged that “the regulations

did not specify precisely what constituted a ‘constitution-

ally adequate return’ nor did they inform insurers how

the Commissioner proposed to compute the achieved re-

turn.” Jd. at 32a. But the court nonetheless denied relief,

concluding that State Farm “received fair treatment and

achieved a fair rate of return.” /d. at 40a.

State Farm’s Due Process Clause argument cannot be

answered, however, by a conclusory assertion that it has

been treated fairly. The Reform Act imposed an enor-

mous tax on State Farm, which State Farm promptly

challenged on constitutional grounds. The state supreme

court ruled that State Farm had to pay the tax and could

raise its constitutional claim only in after-the-fact pro-

ceedings. This is just the factual pattern of McKesson,

and in these circumstances the law is clear:

When a State penalizes taxpayers for failure to remit

their taxes in timely fashion, thus requiring them to

pay first before obtaining review of the tax’s validity,

federal due process principles long recognized by

our cases require the State’s postdeprivation proce-

dure to provide a “clear and certain remedy.” [Mc-

Kesson, 496 U.S. at 51, quoting Atchison, T. &

S.F.Ry. v. O’Connor, 223 U.S. 280, 285 (1912).]

The court below admitted that the remedy afforded to

State Farm was anything but “clear and certain”; it fol-

lows that State Farm is entitled to relief.

This point is not an abstract one, and its importance

extends beyond this case. The state’s failure to provide

a clear remedy significantly prejudiced State Farm. As

the court below conceded, the Commissioner never speci-

fied the standard that he would apply in determining

whether an insurer had received a constitutionally ade-

quate return. That standard shifted throughout this pro-

ceeding. The Commissioner, after failing to specify any

standard in his regulations, adopted a wildly novel “con-

fidence interval” approach and took the position that a

negative rate of return could be adequate—a course that

even the court below was obliged to repudiate. See App.

28a-32a. The “nationwide industry average” standard on

which the court below relied made its first appearance in

the opinion below—it had not been urged by the Com-

missioner or even any of the expert witnesses (and, as we

have said, had never been suggested by this Court nor,

so far as we are aware, any other court). In a word, the

state did precisely what this Court held, just last Term,

to violate McKesson—it “reconfigure[d] its scheme, un-

fairly, in midcourse.” Reich v. Collins, 115 S. Ct. 547,

550 (1994) (emphasis in original). The process afforded

State Farm was like playing a game first and then being

told the rules—by your opponent. See App. 41a (“the

Commissioner did make it difficult for insurers generally

to succeed in an as-applied challenge” ).

As it happens, State Farm did not, in fact, receive the

nationwide industry average return. State Farm’s return

in 1990, according to the ALJ and the court below, was

3.4%; the nationwide average was 4.8%. In 1991, State

Farm’s return was found to be 7.5%; the nationwide

average was 10.6%.*° But State Farm never had an

opportunity to make this argument—the 4.8% “standard”

was not contested in the administrative proceedings, and

the 10.6% figure was not even in the record—because

the state never suggested, until the court below filed its

opinion, that the nationwide industry average was the

applicable standard.°

McKesson requires that a postdeprivation remedy be

not only “clear and certain” but also “fully adequate.”

496 U.S. at 41. A state may relegate a taxpayer to a

postdeprivation remedy for illegally collected taxes, but

only if the state’s postdeprivation remedy affords the same

substantive constitutional protection to which the taxpayer

would be entitled in the predeprivation remedy the state

otherwise would have to provide. See, e.g., McKesson,

496 U.S. at 43 (postdeprivation remedy for discrimina-

tory taxation in violation of the Commerce Clause must

“bring about the nondiscrimination that ‘prompt injunctive

relief would have achieved’ ”) (emphasis omitted; quoting

respondents’ brief on reargument). If, for example, the

taxpayer’s claim would have blocked the collection of

any taxes had it been heard prior to their collection, the

postdeprivation remedy must provide for a full refund.

8 See Pet. for Certification at 13 n.8, Pa 135.

® State Farm did raise its right to relief even under the nation-

wide industry average standard at its first available opportunity,

in its petition for certification before the New Jersey Supreme

Court. Pet. for Certification at 18 n.8. See Brinkerhoff-Faris

Trust & Sav. Co. V. Hill, 281 U.S. 678, 677-678 (1930) ; PruneYard

Shopping Center v. Robins, 447 U.S. 74, 85-86 n.9 (1980).

See, e.g., O'Connor, 223 U.S. at 285-286; lowa-Des

Moines Nat'l Bank v. Bennett, 284 U.S. 239, 247 (1931).

A postdeprivation remedy that authorized a refund of

only 50 percent of illegally collected taxes would plainly

not satisfy the “McKesson line of cases.” Reich v. Collins,

115 S. Ct. at 551.

Yet that is precisely the result of the decision below.

The court below recognized that, in a prospective pro-

ceeding, State Farm would be entitled to a rate of return

reflecting the reasonable cost of capital—13%. New

Jersey, however, denied State Farm the opportunity to

press its claim in a prospective proceeding, relegating it

to a retrospective remedy. State Farm v. State, 124 N.J.

at 63, 590 A.2d at 207. But then the court below held

that in that retrospective proceeding, State Farm was

entitled to a rate of return of only 4.8%—less than half

the return it would have been entitled to for the same

period had the issue been addressed in a prospective pro-

ceeding. Such a postdeprivation remedy subjecting the

claimant to a materially harsher constitutional standard

does not “satisfy the Due Process Clause’s requirement

of a fully adequate postdeprivation procedure.” Mc-

Kesson, 496 U.S. at 41.

This issue has important ramifications beyond what has

happened in this case because, as we have said, there is

a great danger of abuse in retrospective rate regulation

proceedings. This is especially true when the fact that

the proceeding is retrospective is held to free regulators

from the Hope cost of capital standard; but the danger

is further heightened when regulators are also allowed to

shift standards back and forth and select among them

smorgasbord-style until they find the combination that

(lo and behold) leads to a denial of relief. Because, as

we have said (and as we discuss further below), regu-

lators in many states will be under pressure to resort to

devices like this, the Court should grant review to make

clear the application of McKesson in this setting.

Ill. THE DECISION BELOW REFLECTS A RECUR-

RING PATTERN THAT WARRANTS THIS COURT'S

INTERVENTION

Unfortunately the events in New Jersey do not repre-

sent an isolated development. As we have said, many

lower courts do continue to adhere faithfully to the cost

of capital standard. See pages 13-14 above. But other

states have done, or attempted to do, what New Jersey

has done, and more can be expected to do so if the Court

does not intervene.

It is not likely, however, that there will be another

decision as clear as this one in spelling out just what has

occurred. In this case the lower court’s rejection of the

cost of capital standard is fully explicit and unencumbered

by technical regulatory issues. This is, therefore, a singu-

larly appropriate occasion for the Court to grant review.

Even before New Jersey adopted its Reform Act, Cali-

fornia, by popular initiative, adopted an insurance “roll-

back” measure. California insurers were ordered to re-

duce their rates, while review of the insurers’ constitu-

tional confiscation claim was postponed to retrospective

proceedings. The state supreme court upheld the denial

of that claim in those proceedings by jettisoning the cost

of capital standard in favor of, in that case, an open-

ended balancing approach. 20th “Century Ins. Co. V.

Garamendi, 8 Cal. 4th at 293-296, 878 P.2d at 615-616,

32 Cal. Rptr. 2d at 856-857." Not surprisingly, the court

1° The contrast between 20th Century and this case illustrates

why review by this Court is especially appropriate here. In 20th

Century, the reasoning of the lower court was complex and obscure,

and the lower court never specified just what standard it was

adopting. Instead, it purported to adopt a “balancing” approach,

thus leaving unclear exactly how it would review rate regulation

in the future. By contrast, the lower court here made its reasoning

plain: it boldly stated that it was abandoning the cost of capital

standard, and gave as its reason the fact that this was a retrospec-

tive proceeding. That makes this a vastly more appropriate case

below, in seeking to justify its action, relied on the Cali-

fornia Supreme Court’s decision. App. 26a-28a.

Nevada sought to adopt a rollback similar to Califor-

nia’s, but the Ninth Circuit turned the effort aside on the

ground that the state scheme did not guarantee insurers

an opportunity to earn “the constitutionally required ‘fair

and reasonable return,’ ” defined to include “ ‘enough rev-

enue not only for operating expenses but also for the cap-

ital costs of the business.’” Guaranty Nat'l Ins. Co. v.

Gates, 916 F.2d at 515 (quoting Hope, 320 U.S. at 603).

In the meantime, Pennsylvania and South Carolina adopted

comparable measures. See 75 Pa. Cons. Stat. § 1799.7(b);

S.C. Code Ann. § 38-73-465(D). Efforts to adopt such

proposals are underway in several other states. The popu-

larity of these measures is unlikely to abate.

At the same time, courts in several states have begun

to drift away from the cost of capital standard. Often, as

in California, they have adopted an open-ended “balanc-

ing” test in which the cost of capital is only one com-

ponent. This is true, for example, of sharply divided state

supreme courts in Ohio and Kansas. See Ohio Edison

Co. v. Public Utils. Comm’n, 63 Ohio St. 3d 555, 589

N.E.2d 1292 (1992); Kansas Gas & Elec. Co. v. State

Corp. Comm'n, 239 Kan. 483, 720 P.2d 1063 (1986),

prob. juris. noted, 479 U.S. 1082, app. dismissed, 481

U.S. 1044 (1987). See also Pennsylvania Elec. Co. v.

Pennsylvania Pub. Util. Comm'n, 509 Pa. 324, 502 A.2d

130 (1985), appeal dismissed for want of substantial

for review. Indeed it seems doubtful that the Court will see a

ratemaking case with this degree of clarity at any time in the

foreseeable future.

In addition, the court below explicitly followed the California

ruling in crucial respects. California and New Jersey are, of

course, two of the most populous states, with perhaps the most

closely observed insurance markets in the Nation. Thus a nation-

wide pattern, justifying this Court’s intervention, has become even

more apparent since 20th Century.

federal question, 476 U.S. 1137 (1986). Such a “bal-

ancing” approach necessarily obscures the issue and makes

it difficult to review the lower courts’ decisions. By con-

trast, the New Jersey court made no feint at balancing;

it was fully explicit in its rejection of the cost of capital

standard. The cost of capital was not described as simply

one component in a multi-factored balancing test; it was

expressly rejected in favor of a new and entirely unprece-

dented standard. This Court is, therefore, unlikely ever

to have a better vehicle for dispelling the confusion that

exists in the lower courts and for ensuring that future

legislative action in this area conforms to proper consti-

tutional standards.

CONCLUSION

For the foregoing reasons, this Court should grant the

writ and reverse the decision below.

Respectfully submitted,

MARTIN R. BROWN

STATE FARM INSURANCE

COMPANIES

One State Farm Plaza

Bloomington, IL 61710

(309) 766-4593

THOMAS P. WEIDNER

Ross A. LEWIN

DAVID F. SWERDLOW

JAMIESON, MOORE, PESKIN

& SPICER

300 Alexander Park

Princeton, NJ 08543

(609) 951-4111

* Counsel of Record

JOHN G. ROBERTS, JR.*

HOGAN & HARTSON L.L.P.

555 Thirteenth Street, N.W.

Washington, D.C. 20004

(202) 687-5810

DAVID A. STRAUSS

1111 East 60th Street

Chicago, IL 60637

(312) 702-9601

Counsel for Petitioner

APPENDICES

APPENDIX A

SUPERIOR COURT OF NEW JERSEY

APPELLATE DIVISION

A-2042-92T5

STATE FARM MUTUAL AUTOMOBILE

INSURANCE COMPANY,

Plaintiff-A ppellant,

Vv.

Tue STATE OF New Jersey; SAMUEL FORTUNATO, Com-

missioner of Insurance of the State of New Jersey;

Epwarp J. DauBeR, Acting Attorney General of the

State of New Jersey; SAMUEL CRANE, Treasurer of the

State of New Jersey; MARSHALL SELIKOFF, as Trustee

of the New Jersey Full Insurance Underwriting Asso-

ciation, Defendants-Respondents.

and

PROPERTY LIABILITY INSURANCE

GUARANTY ASSOCIATION,

Defendant.

Argued: March 22, 1995—Decided: May 12, 1995

Before Judges King, Muir, Jr. and D’Annunzio.

On appeal from the Superior Court of New Jersey,

Chancery Division, Mercer County.

The opinion of the court was delivered by KING,

P.J.A.D.

This case involves an “as-applied” challenge to the

constitutionality of the Fair Automobile Insurance Re-

form Act, L. 1990, c. 8 (Fair Act or Act), which com-

pels property and casualty insurers to pay a 5% surtax

on automobile insurance premiums for 1990 through

1992 and a 2.7% assessment on all property casualty

premiums from 1990 through 1997. These charges were

designed to aid in eliminating the deficit accumulated by

the now-defunct New Jersey Automobile Full Insurance

Underwriting Association, known as the JUA.

Appellant, State Farm Mutual Automobile Insurance

Company (State Farm) previously claimed that the Fair

Act was facially unconstitutional since it precluded in-

surers from recouping these surtaxes and assessments

through ratemaking, depriving them of the constitutional

right to the opportunity to realize a fair, reasonable re-

turn on investment. State Farm v. State, 124 N.J. 32

(1991) (State Ferm). Relying on the section of the

Fair Act stating that automobile insurers are entitled to

earn an adequate rate of return through the rate-making

process, our Supreme Court held that the “anti-pass

through” provisions did not necessarily preclude all in-

surers from earning a fair rate of return. /d. at 62. The

Court did hold that insurers were free to institute “as-

applied” challenges, id. at 63, which is what State Farm

has done here.

This case involves an unprecedented regulatory pro-

ceeding. Ratemaking is normally prospective. But here

State Farm seeks relief from rates for the years 1990 and

1991. No claim was made for 1992. State Farm alleges

that rates for those two years were too low and denied

it a reasonable rate of return, mainly because of the 5%

surtax and 2.7% assessment which totalled over $41 mil-

lion for the two years.

None of the highly-qualified experts who testified at the

administrative hearings were aware of any similar pro-

ceeding. These experts offered quite divergent views on

(1) what constitutes a fair rate of return, and (2) the

income and expenses properly considered in computing

the achieved rate of return. After the hearings were con-

cluded in this case, the California Supreme Court issued

a lengthy opinion addressing the subject of a fair rate of

return for insurers in a retrospective proceeding. 20th

Century Ins. Co. v. Garamendi, 878 P.2d 566, 632 (Cal.

1994).

We conclude from the record that State Farm has not

shown an entitlement to monetary relief in the form of

either a future tax credit, tax refund, higher future rates,

or otherwise. Administrative Law Judge McGill (ALJ)

decided that State Farm actually achieved a rate of re-

turn of 3.4% in 1990 and 7.5% in 1991, notwithstand-

ing the surtaxes and assessments. This was a rate of re-

turn higher than realized by private-passenger automobile

insurers nationally. We hold that the record supports

this conclusion of the ALJ, which was adopted by the

Commissioner of Insurance. We find that the rates ac-

tually realized by State Farm were not confiscatory be-

cause it obtained about the same return on the average

as its competitors nationally, who were not subject to

the surtaxes and assessments imposed by the Fair Act.

This is the relevant procedural history. This case is

rooted in the Supreme Court’s May 16, 1991 decision

that State Farm did not establish that the Act was con-

fiscatory on its face. 124 N.J. at 61-63. The Court pre-

sumed that the special rate-relief regulations adopted by

the Commissioner, N.J.A.C. 11:3-16.11, would be ad-

ministered to assure an insurer’s constitutionally man-

dated fair rate of return. 124 N.J. at 62-63. Observing

that successful challenges to the facial constitutionality of

price control statutes are “exceedingly rare,” id. at 46,

the Court held that insurers remained free to mount an

as-applied challenge should the Act, as administered, not

provide them with a fair rate of return. /d. at 62-63. The

Court declared it “appropriate for the Commissioner to

render determinations on individual insurers’ rate-increase

applications in the first instance, before challenges to the

constitutionality of the application of the statute and reg-

ulations are brought” because the Department of Insur-

ance (DOI) has the “particular expertise necessary” to

develop a detailed record and to make findings on an

as-applied challenge. /d. at 63.

State Farm had requested a rate increase on March 21,

1990, a few days after passage of the Act. Lengthy pro-

ceedings followed, but no hearing; State Farm and the

Commissioner blamed each other for the delay. Shortly

before the Court decided State Farm, appellant filed a

notice of appeal with this court to have its application

declared complete. On June 14, 1991 appellant and the

DOI filed a stipulation of dismissal of the appeal and the

matter was sent to the Office of Administrative Law

(OAL).

A period for discovery ensued and a motion was made

by DOI on October 8, 1991 to preclude State Farm

from using any 1990 profit and loss data, on the theory

that past losses were irrelevant to proceedings pending

before the OAL. On January 2, 1992 ALJ McGill

granted DOI’s motion ruling that “any means by which a

regulated company recovers an additional charge for past

losses constitutes impermissible retroactive rate-making.”

Four weeks later, the ALJ scheduled hearings for late

June and early July.

On May 19, 1992 State Farm, DOI and the Depart-

ment of Public Advocate, Division of Rate Counsel (Rate

Counsel). filed a stipulation dismissing State Farm’s sur-

tax and assessment filings, conditioned on and without

prejudice to State Farm’s. right to bring an as-applied

challenge. State Farm brought such a challenge on

June 1, 1992, filing a complaint in the Chancery Division

against the Commissioner, the Attorney General and

See ee aeee eens nn nnn

others. Count one alleged that State Farm had been de-

prived of substantive and procedural due process by

DOI’s delay in processing the application for higher rates

and refusal to consider the surtax and assessment payments

made in 1990 and 1991 in determining whether State

Farm earned a fair and reasonable return in those two

years. Count two alleged that DOI had deprived State

Farm of its constitutional right to a fair return in 1990

and 1991, effectuating a taking of State Farm’s property.

Count three alleged a violation of State Farm’s constitu-

tional rights, claiming damages and relief under 42 U.S.C.

§ 1983. Appellant sought a refund of the 1990 and 1991

surtaxes and assessments or a credit against future pay-

ments; a declaration that the Commissioner’s prior prac-

tices and rulings deprived State Farm of due process and

just compensation; money damages, and attorneys fees,

under 42 U.S.C. § 1988.

Judge Levy denied Rate Counsel’s motion to intervene

and we denied rate counsel’s emergency motion to set

aside that order. In an order dated August 6, 1992, he

remanded the case to the OAL. In his opinion he found

it “inexplicable” that DOI and the ALJ would not con-

sider evidence of State Farm’s profitability in 1990 and

1991, since without that evidence no one could compute

State Farm’s rate of return for those years. Relying on

State Farm, supra, Judge Levy directed a hearing before

the OAL to determine “what the insurer’s rate of return

was for 1990 and for 1991 and what a fair rate of return

was for each of those years.” If the achieved rate was

not fair, then rates should be adjusted in a manner the

Commissioner deemed reasonable. The judge also in-

structed the ALJ to take evidence and make findings on

the reason for the delay in processing State Farm’s appli-

cation. Further review could be obtained either before

this court or the Chancery Division, depending on the

nature of the final action at the administrative level. On

August 21, 1992 we denied the motion of the State de-

fendants for leave to appeal, summary disposition and an

immediate stay of the order remanding the case to the

OAL.

The OAL processed the case on an expedited basis,

with ALJ McGill holding hearings on August 27 and 28

and September 1, 4, 15, and 16, 1992. The ALJ issued

his initial decision on October 9, 1992. Substantially

adopting Rate Counsel’s methodology, he concluded that

State Farm’s achieved rate of return on its automobile

business, even with payment of surtaxes and assessments;

was 3.4% in 1990 and 7.5% in 1991. He found this

return not only constitutionally adequate but at about the

midpoint in the range of reasonableness and slightly

higher on average “than the achieved rate of return of

4.8 percent for countrywide passenger automobile insur-

ance.” On the delay issue, the ALJ concluded that much

of the delay was due to State Farm’s resistance to dis-

covery.

The Commissioner issued his final decision on Novem-

ber 17, 1992. He did not agree with all of the findings

and conclusions of the ALJ, particularly some of the

details in computing State Farm’s actual rate of return

for the years in question. He did agree with the ALJ

that State Farm earned a fair and adequate return in

1990 and 1991, even with payment of the surtaxes and

assessments. He also agreed with the ALJ’s analysis of

the reasons for the delay in processing State Farm’s appli-

cation. Judge Levy in the Chancery Division held that

the Commissioner had issued a final decision and any

further review must be in this court. He dismissed the

Chancery Division complaint with prejudice on Decem-

ber 3, 1992.

State Farm filed this notice of appeal from the Com-

missioner’s final order and from Judge Levy’s December

3, 1992 order. On September 21, 1993 the Supreme

Court denied State Farm’s motion for direct certification.

III

State Farm is a mutual insurance company, authorized

to sell automobile insurance, property and casualty insur-

ance, and health insurance in New Jersey. Property-

casualty lines other than private passenger automobile in-

clude homeowners, commercial, marine, fire, and workers

compensation. About 75% of State Farm’s total New

Jersey property-casualty business is private passenger auto-

mobile insurance (PPA). State Farm is one of the major

private.passenger auto insurers in this State, ranking third

in 1988, behind Allstate and Prudential, and ahead of

New Jersey Manufacturers and Liberty Mutual.

Like all other automobile insurers, State Farm is subject

to a 5% surtax on private passenger automobile premiums

for the years 1990, 1991 and 1992. N.J.S.A. 17:33B-

49; State Farm, supra, 124 N.J. at 44. State Farm also

is subject to an assessment on all of its property-casualty

lines, payable to the Property Liability Insurance Guar-

anty Association (PLIGA), an assessment which totaled

2.7% of net premiums in 1990. N.J.S.A. 17:30A-8a

(9) & (10); State Farm, supra, 124 N.J. at 43-44. These

PLIGA assessments are levied for a period of eight years,

1990-97. As noted, the surtax and the assessments were

used to reduce the JUA’s deficit. Ibid.

Neither the surtaxes nor the assessments could be in-

cluded as normal expenses in the ratemaking process. /d.

at 44-45, citing N.J.S.A. 17:30A-16b (assessments) and

N.J.S.A. 17:33B-51 (surtaxes). However, the Fair Act

did say: “To provide a healthy and competitive automo-

bile insurance system in this State, automobile insurers are

entitled to earn an adequate rate of return through the

ratemaking process.” N.J.S.A. 17:33B-2g. The intent of

this section was “to make certain that any lessening of

insurers’ profits due to the surtaxes and assessments would

not preclude a constitutionally adequate rate of return.”

State Farm, supra, 124 N.J. at 61. Regulations adopted

by the Commissioner on January 25, 1991 (23 N.J.R.

514 (Feb. 19, 1991)), precluded a rate increase based on

payment of the assessments or surtaxes unless the Com-

missioner finds that “an increase in revenue is necessary

to ensure that the insurer earns a constitutionally adequate

return.” N.J.A.C. 11:3-16.11(d). If rate relief is deemed

necessary, “the Commissioner shall determine whether the

rate should be adjusted immediately or over time, as may

be appropriate.” N.J.A.C. 11:3-16.11(f).

The regulations do not specify the “constitutionally ade-

quate return,” nor do they inform insurers how the Com-

missioner might propose to compute the achieved return.

Rather, the Commissioner left it to the applicant to

“present in its filing a formula it believes appropriate for

determining the return required by relevant constitutional

principles, with supporting analysis and data fully ex-

plaining why such formula should be utilized.” N.J.A.C.

11:3-16.11(e).

All parties agreed that determining an insurer’s fair rate

of return in a retrospective proceeding presented a for-

midable task, because of the absence of any recognized

methodology for (1) defining a minimally acceptable rate

| of return, and (2) computing that return. State Farm,

| DOI and Rate Counsel all assembled highly-qualified

experts to submit reports and testify before the ALJ. Ap-

pearing for State Farm were Steven Lehmann, an actuary;

Dr. Irving Plotkin, an economist; Gary Ransom, an in-

vestment advisor; and Richard Stewart, among other things,

former president of the National Association of Insur-

ance Commissioners (NAIC). Testifying for DOI were

consultants and economists Blaine Nye and Bryan Sullivan

and Assistant Commissioner Martin Rosenberg. Rate

Counsel presented two experts, Allan Schwartz, president

of an actuarial consulting firm, and economist David

Parcell.

1h ne newt ener

Several important conceptual categories must first be

explained.

A. Fair Rate of Return

There was no dispute on certain underlying principles.

First, insurers are entitled to an opportunity for a fair

rate of return; they are not guaranteed that return. Sec-

ond, the actual return will vary from year to year, due

to a number of factors. Thus, one cannot simply examine

an earned rate of return and conclude that a company was

denied the opportunity to earn a fair rate of return. Third,

the fair rate of return in a prospective proceeding is one

needed to attract investors, often called by the experts

the cost of capital. Fourth, since cost of capital is a

prospective concept, it is difficult to determine what is a

fair rate of return in a retrospective proceeding. Ransom

for State Farm explained that “Fair rates of return from

an investor’s or insurance management’s point of view have

meaning only in a prospective sense” since the decision to

commit capital to such an enterprise “is triggered only by

the prospective returns that investors and management ex-

pect to earn in the future.” Schwartz explained for rate

counsel that “cost of capital is a prospective concept.” He

was unaware of any authority explaining “how to deter-

mine in a specific way what a retrospective fair rate of

return is.” *

One major aspect of disagreement was the fair rate of

return for the New Jersey automobile insurance industry

1 Cost of capital is a purely theoretical concept in State Farm’s -

case, since State Farm is a mutual company, which means it does

not seek to attract capital and needs no profit to attract capital.

The so-called Clifford hearings, which determined how to set rates

for automobile insurance, see In re Application of Ins. Rating Bd.,

68 N.J. 413 (1973), decided that for rate-making purposes, mutual

companies and stock-based companies should be treated in the same

way.

10a

for the years involved 1990 and 1991. State Farm’s

experts posited a rate return of between 16 and 19%,

premised on the theory that this high rate was necessary

because automobile insurance has historically been a risky

business in New Jersey; Lehmann said 16%, Plotkin said

19%; Ransom said between 17 and 19%. Several factors

made New Jersey uniquely risky: the difficult and burden-

some regulatory climate, involving a great deal of paper-

work and lengthy delays for rate increases; the require-

ment that New Jersey automobile insurers take on bad

risks; New Jersey’s long history of operating losses (ac-

cording to the Department of Insurance, insurers lost

money on private passenger autos in ten of the thirteen

years between 1976 and 1989, and during that thirteen-

year period, operating losses were more severe in New

Jersey than in any other state); the strict limitations on

profits imposed by the Excess Profits Law; the surtax and

assessment; enormous unfunded PIP claims and MTF

losses; and a biased, “heads I win—tails you lose” ad-

ministrative structure for rate increases. The November

1989 edition of the Insurance Reporter, DOI’s “official

newsletter,” recounted the long history of operating losses

on PPA. On the other hand, other property and casualty

lines, such as workers’ compensation, commercial auto or

homeowners, have in the past been more profitable in

New Jersey than in the nation as a whole.

Parcell, for Rate Counsel, who testified for the purpose

of establishing the cost of capital for each year between

1985 and 1991, focused not on the risks inherent in the

private passenger automobile side but analyzed all lines

of business. Using three different methodologies to esti-

mate rate of return for the property and casualty insurance

industry, he concluded that the cost of equity was about

13% for 1990 and 1991. As he understood the Commis-

sioner’s regulations, an insurer cannot recover unless it

shows confiscatory rates on all of its lines, and therefore

he looked at all lines.

ee re ne |

lla

The ALJ held that determining fair rate of return “re-

quires an all-lines analysis” and he agreed with Parcell’s

conclusion that, in a prospective proceeding, “the investors’

long-term expected or required return is in the area of

13.0 percent.” He added that 13% “is an approximation

of the center of the range of reasonableness for the fair

rate of return.” The Commissioner agreed with this con-

clusion. We note that 13% is very close to the rate of

return allowed by the Clifford formula. See N.J.A.C.

11:3-16.10. Under the Clifford formula, rates are fixed

so that an insurance company can earn a post-tax profit

of 3.5% of its premiums. Matter of Orders A-92-189 and

A-92-212, 274 N.J. Super. 385, 389 (App. Div. 1993),

affd o.b. 137 NJ. 93 (1994). To convert operating

profit to return on equity the standard formula, according

to DOI, is to multiply the operating profit percentage by

two and then increase the percentage by seven, to account

for investment income on insurers’ capital and surplus

funds. Insurance Reporter (November 1989). For pur-

poses of this appeal, State Farm does not dispute that 13%

is a fair rate of return.

The ALJ and the Commissioner proceeded to hold that

13% was not the minimally acceptable rate of return in

a retrospective proceeding. Schwartz, Nye and Sullivan all

thought that, because profits in the industry varied widely

from year to year, a fair rate of return can be considerably

less than 13%. Using a statistical device known as a

“confidence interval,” Schwartz concluded that a reasonable

rate of return in a retrospective proceeding could range

between 2.6% and 18.8%, while Nye said that an actual

one-year return of between —3.6% and 35.6% would in-

dicate a company earned a fair rate of return and Sullivan

thought that a return of between -—3.48% and 29.6%

could be a reasonable return. The Commissioner adopted

the ALJ’s finding that returns in the vicinity of —3.6%

to 2.6% represented the “low end of the range of reason-

12a

ableness” in a “retrospective analysis limited to one year

for private passenger automobile insurance.”

B. Actual or Achievable Rate of Return

While holding that an -all-lines analysis is more appro-

priate, the ALJ computed State Farm’s achieved rate of

return on its private passenger auto lines only. He

adopted Rate Counsel expert Schwartz’s analysis of State

Farm’s income and expenses on its private passenger auto-

mobile insurance for the years 1990 and 1991. The ALJ

concluded that for 1990 State Farm realized a 12.7%

rate of return without payment of the surtax and assess-

ment, and a 3.4% rate of return with payment of the

surtax and assessment. For 1991 the rate of return was

16.4% without payment, and 7.5% including the surtax

and assessment. Noting that the “average of these returns

is higher than the achieved rate of return of 4.8% for

countrywide private passenger automobile insurance,” the

ALJ concluded State Farm’s actual return was well within

the range of reasonableness. P

Having decided that State Farm had achieved a fair

rate of return for the two years in question, the ALJ

found it unnecessary to decide whether, as alleged by

DOI and Rate Counsel, State Farm’s profits were actually

higher because (1) State Farm over-reserved, thus inflat-

ing losses, and (2) State Farm was slow to implement

permitted rate increases, such as flex rate increases, thus

reducing its income. There was disputed evidence on both

items; DOI claimed that prompt implementation of per-

missible rate increases could have netted State Farm an

additional eight or nine million dollars in premiums and

also that State Farm had over-reserved. State Farm de-

nied this.

State Farm claimed a -12% rate of return for 1990;

the ALJ found a 3.4% rate of return. For 1991, State

Farm's calculation showed a —3.5% rate of return; the

ALJ found that the return was 7.5%. This difference

l3a

between the ALJ’s conclusion and State Farm’s claims is

largely attributable to three items: (1) loss adjustment

expenses (LAE); (2) Automobile Insurance Risk Ex-

change (AIRE) expenses, and (3) investment income on

policyholder funds. We summarize the factual dispute on

each item.

l. LAE.

For 1990 State Farm claimed about $6,000,000 more

in loss adjustment expenses than found by the ALJ; for

1991, the difference was about $10,000,000. State Farm

used the LAE from the excess profits report, explaining

that specific New Jersey loss adjustment expenses were

higher than in the nation as a whole because New Jersey

was a more expensive place to do business. Lehmann,

State Farm’s actuarial expert, claimed that Schwartz erred

in estimating State Farm’s LAE in New Jersey by using

a ratio of New Jersey losses to countrywide losses. He

should have used State Farm’s actual New Jersey LAE

shown in the excess profits report, since that reflects State

Farm’s actual performance in New Jersey. Over the past

several years State Farm’s LAE ratio was higher in New

Jersey than countrywide, because of differences in tort sys-

tems, their complexities, the amount of legal expenses in-

curred in adjusting claims, cost of purchasing land and

building for claims service centers, salaries for claims

managers and employees and vehicle storage costs. One

significant factor in State Farm’s higher LAE for New

Jersey is that claimants in New Jersey are more likely to

be represented by an attorney. In New Jersey about 61%,

have attorneys; nationwide about 45%. Where claim-

ants have attorneys, State Farm requires counsel. This

increases the LAE.

Schwartz, Rate Counsel’s expert, calculated LAE by

using a countrywide ratio because the higher level reported

for New Jersey “has not been explained or justified in any

way by State Farm.” Rate Counsel contended that losses

per automobile in New Jersey are among the highest in

l4a

the country and that higher loss adjustment expenses in

New Jersey relative to the countrywide data do not neces-

sarily explain the higher ratio of loss adjustment expenses

to losses. Schwartz had “no way of knowing . . . if the

reported New Jersey loss adjustment expenses reported by

State Farm are subject to any audits, controls or checks.”

Schwartz testified that he was not sure whether the num-

bers reported in the excess profits report are subject to

a verification or audit. The ALJ accepted Rate Counsel’s

position and the Commissioner agreed, saying that State

Farm had not met its burden of proof because only the

countrywide ratio was subject to audit and verification.

2. AIRE Expenses.

AIRE expenses are explained in an unpublished 1991

opinion of this court, as follows:

Private passenger automobile insureds must now

select one of two lawsuit thresholds, the verbal

threshold or the zero-dollar threshold. N.J.S.A.

39:6A-8. By selecting the verbal threshold, the in-

sured pays a lesser premium, but his right to sue for

noneconomic loss is significantly reduced. If the in-

sured selects the zero-dollar threshold, he pays a

higher premium, but does not surrender his right to

seek damages for pain and suffering. The dual

threshold system causes an inequity among insurance

companies. AIRE is designed to remedy this im-

balance by a system of assessments, based upon pre-

miums received from insureds selecting the zero-dollar

threshold, and by reimbursements, based upon an in-

surer’s total bodily injury claims. Insurers with

higher risk policyholders will receive more money

back from AIRE than insurers with lower risk policy-

holders. State Farm has been a net payer since 1984,

since it has paid more assessments to AIRE than it

has received reimbursements.

[In the Matter of the Commissioner of Insurance's

denial of State Farm Mutual Auto Insurance Com-

15a

pany’s Request for a Private Passenger Automobile

Rate Revision, No. A-4601-90T2 (App. Div. Decem-

ber 26, 1991) (slip op. at 3-4).]

There, this court held that AIRE expenses need not be

included in prospective ratemaking.

State Farm paid over $8,000,000 in AIRE expenses in

1990, and over $6,000,000 in 1991. State Farm included

AIRE expenses in computing its realized return because

they were an actual cost of doing business and reported

on the excess profits report. Rate Counsel’s expert

Schwartz declined to include AIRE expenses because, as

held by this court, they were not to be taken into account

in prospective ratemaking. The ALJ acknowledged that

State Farm had presented a strong argument for includ-

ing AIRE expenses, since they were in fact an actual

cost of doing business, but he excluded them because the

Commissioner “has specifically rejected the view that as-

sessments and reimbursements by AIRE should be re-

flected in rates.” The Commissioner agreed with the ALJ,

explaining that: “(1) it is too speculative as to whether

State Farm would continue to be a net payer; and (2)

to permit one insurer to adjust its rates on the basis of

AIRE assessments could well distort the industry-wide

mechanism.”

3. Investment Income on Policyholder-supplied

Funds.

This dispute focuses on a very technical problem, the

method for computing an insurer’s investment income on

policyholder-supplied funds. Rate Counsel’s computation

was about $4,000,000 higher for 1990 than State Farm’s,

and about $2,000,000 higher for 1991. However, Nye,

DOI’s economist, attributed a much greater sum to State

Farm, the difference being over $10,000,000 in 1990 and

almost $14,000,000 in 1991. The ALJ approved Rate

Counsel’s analysis but the Commissioner agreed with Nye.

State Farm used the figures from its excess profits report.

16a

State Farm condemned Nye’s approach because it included

net income from State Farm’s Canadian operations and

funds received from an affiliate.

The Commissioner made one other major policy deci-

sion, he included unrealized capital gains and losses in

computing fair return on a retrospective basis. State Farm

had a relatively small unrealized capital loss in 1990, the

effect of which would decrease its achieved return by

about 2%. It had an unrealized capital gain in 1991,

the effect of which would have increased the achieved

return by about 10%. The ALJ did not consider unre-

alized capital gains and losses because they are generally

not recognized for prospective ratemaking purposes and

because they tend to offset each other over time. But, he

cautioned, “if emphasis is to be placed on State Farm’s

actual experience in 1990 and 1991, these unrealized

capital gains could well be considered.” The Commis-

sioner concluded that they should be considered, reason-

ing the “ALJ’s statement that unrealized capital gain and

losses generally are not recognized for ratemaking pur-

poses is correct, but the present matter is outside the scope

of normal [prospective] ratemaking and all of State Farin’s

usual investment returns should be considered.”

State Farm contends that the surtaxes and assessments

deprived it of a fair rate of return for 1990 and 1991.

For purposes of argument on this appeal, State Farm ac-

cepts the conclusion of the Commissioner and the ALJ

that 13% is a fair rate of return and seems to accept, for

argument’s sake, the ALJ’s factual findings, which were

not questioned by the Commissioner, that its actual rate

of return on its private passenger auto lines was 3.4%

in 1990 and 7.5% in 1991. State Farm contends that

these findings perforce entitle it to relief and also urges

that the ALJ and the Commissioner erred in employing

the so-called “confidence intervals” to justify a lower rate

of return than 13%.

17a

DOI responds that the 13% figure applies only in a tra-

ditional ratemaking proceeding, where rates are set on a

prospective basis. An insurer’s failure to achieve that

rate in a particular year does not result in a constitutional

deprivation, since actual returns vary from year to year.

Ratemaking is not a guarantee against all vagaries of the

business cycle. DOI and Rate Counsel claim that in this

retrospective proceeding, State Farm failed to show denial

of a fair rate of return.

Our standard of review is clear. In State Farm, supra,

the Court concluded that, in enacting the Fair Act, the

Legislature “deliberately left to the Commissioner of In-

surance the determination of the precise constitutionally

required rate of return, as being within the area of ex-

pertise entrusted to the Department of Insurance in its long

exercise of the ratemaking function.” State Farm, supra,

124 N.J. at 61. Administrative action is upheld unless it

is arbitrary, unreasonable or capricious. Matter of Aetna

Casualty & Surety Co., 248 N.J. Super. 367, 376 (App.

Div.), certif. denied, 126 N.J. 385 (1991), cert. denied,

502 U.S. 1121, 112 S. Ct. 1244, 117 L. Ed. 2nd 476

(1992). Under that standard, a reviewing court asks itself

the following questions:

(1) whether the agency’s action violated the enabling

act’s express or implied legislative policy;

(2) whether there was substantial evidence on the

record to support the findings on which the agency

based its actions;

(3) whether in applying the legislative policies to the

facts, the agency clearly erred by reaching a con-

clusion that could not reasonably have been made

after weighing the relevant factors.

Williams v. Department of Human Services, 116 N.J. 102,

107 (1989); Public Service Electric & Gas Co. vy.

D.E.P.E., 101 N.J. 95, 103 (1985). “The burden is on

18a

the objector to overcome the presumption that agency

actions are valid and reasonable.” Matter of Aetna Casu-

alty & Surety Co., supra, 248 N.J. Super. at 376. More-

over, the “Commissioner’s expertise in the field of insur-

ance must be given great weight.” Ibid. Accord Matter

of Orders A-92-189 and A-92-212, 274 N.J. Super. 385,

398 (App. Div. 1993), aff'd o.b. 137 N.J. 93 (1994).

State Farm argues for a less deferential standard, con-

tending that this appeal presents purely legal issues which

are uniquely within the province of this court to decide.

See Mayflower Securities v. Bureau of Securities, 64 N.J.

85, 92-93 (1973). State Farm denies that resolution of

this matter hinges on any factual findings or that the

Commissioner’s expertise is involved when determining

State Farm’s constitutional rights. However, the Supreme

Court’s conclusion that the Legislature deliberately vested

in the Commissioner the initial determination of the re-

quired rate of return, as within his expertise, 124 N.J.

at 61, requires us to reject State Farm’s argument for a

virtually de novo review. See N.J. Bell Tel. Co. v. State,

162 N.J. Super. 60, 73 (App. Div. 1978).

“Whether a particular regulation of prices fails to per-

mit a just and reasonable return is a mixed fact-law

question.” Hutton Park Gardens v. West Orange Town

Council, 68 N.J. 543, 570 (1975). The party alleging

confiscation has the burden of proof. /bid. The federal

Supreme Court has declared it “obvious that reviewing

courts will require criteria more discriminating than justice

and arbitrariness if they are sensibly to appraise” a rate

order. Permian Basin Area Rate Cases, 390 U.S. 747,

790, 88 S. Ct. 1344, 20 L. Ed. 2d 312, 349 (1968). This

involves a three-fold inquiry:

First, it must determine whether the Commission’s

order, viewed in light of the relevant facts and of the

Commission’s broad regulatory duties, abused or ex-

ceeded its authority. Second, the court must examine

19a

the manner in which the Commission has employed

the methods of regulation which it has itself selected,

and must decide whether each of the order’s essential

elements is supported by substantial evidence. Third,

the court must determine whether the order may rea-

sonably be expected to maintain financial integrity,

attract necessary capital, and fairly compensate in-

vestors for the risks they have assumed, and yet

provide protection to the relevant public interests,

both existing and foreseeable.

[Permian Basin, supra, 390 U.S. at 791-92, 20 L. Ed.

2d at 350.]

Accord N.J. Bell Tel. Co., supra, 162 N.J. Super. at 73.

The court’s responsibility is not to supplant the

Commission’s balance of these interests with one

more nearly to its liking, but instead to assure itself

that the Commission has given reasoned consideration

to each of the pertinent factors. Judicial review of

the Commission’s order will therefore function ac-

curately and efficaciously only if the Commission in-

dicates fully and carefully the methods by which, and

the purposes of which, it has chosen to act, as well

as its assessment of the consequences of its orders for

the character and future development of the industry.

[Permian Basin, supra, 390 U.S. at 792, 20 L. Ed.

2d at 350.]

In State Farm, our Supreme Court endorsed the stand-

ards developed by the United States Supreme Court in a

series of cases dealing with government price regulation

of public utilities and by the Court in rent control cases.

State Farm, supra, 124 N.J. at 47. The basic rule is

tersely stated: “If the rate does not afford sufficient com-

pensation, the State has taken the use of utility property

without paying just compensation and so violated the Fifth

and Fourteenth Amendments.” Duquesne Light Co. v.

20a

Barasch, 488 U.S. 299, 308, 109 S. Ct. 609, 102 L. Ed.

2d 646, 657 (1989). “Sufficient compensation” has, since

1944, been defined as “enough revenue not only for op-

erating expenses but also for the capital costs of the

business.” Federal Power Commission v. Hope Natural

Gas Co., 320 U.S. 591, 603, 64 S. Ct. 281, 88 L. Ed.

333, 345 (1944).

By that standard the return to the equity owner

should be commensurate with the returns on invest-

ments in other enterprises having corresponding risks.

That return, moreover, should be sufficient to assure

confidence in the financial integrity of the enterprise,

so as to maintain its credit and to attract capital.

[Ibid.]

What that standard should be in any given case pre-

sents a vexing question. Neither “law nor economics has

yet devised generally accepted standards for the evalua-

tion of ratemaking orders.” Permian Basin Area Rate

Cases, supra, 390 U.S. at 790, 20 L. Ed. 2d at 349. Ac-

cord Duquesne Light Co., supra, 488 U.S. at 308, 102

L. Ed. 2d at 657. “The economic judgments required in

rate proceedings are often hopelessly complex and do not

admit of a single correct result.” /d., 488 U.S. at 314,

102 L. Ed. 2d at 661.

Given these complexities, courts have opted for a “bot-

tom line” approach. Thus:

It is not theory but the impact of the rate order

which counts. If the total effect of the rate order

cannot be said to be unjust and unreasonable, judi-

cial inquiry . . . is at an end. The fact that the

method employed to reach that result may contain

infirmities is not then important.

[Hope Natural Gas, supra, 320 U.S. at 602, 88 L.

Ed. at 345.]

2la

Accord Duquesne Light Co., supra, 488 U.S. at 310, 102

L. Ed. 2d at 658-59.

What this standard means in the context of insurance

rate regulation has been the subject of several opinions

in other jurisdictions. Generally, rates must be higher

than necessary to avoid insolvency—a scheme allowing a

rate increase only upon a showing of insolvency violates

the just and reasonable return standard. Calfarm Ins.

Co. v. Deukmejian, 771 P.2d 1247, 1254 (Cal. 1989).

Rates which merely allow an insurer to break even do

not permit a fair and reasonable return. Guaranty Na-

tional Ins. Co. v. Gates, 916 F.2d 508, 515 (9th Cir.

1990). It is impermissible to set rates so low that the

insurer must subsidize them with profits from other states.

Id. at 513-14; Calfarm, supra, 771 P.2d at 1254. Rates

cannot be set at a level below the fair rate of return to

make up for allegedly excessive profits in the past. [bid.

In rejecting an insurance commissioner’s claim that

insurers have the choice of submitting to confiscatory

rates or getting out of the insurance business, Massachu-

setts’s highest court held:

The Commonwealth’s admitted power to regulate

the insurance business and the rates which are

charged for insurance does not permit it to limit the

conduct of such business to those companies which

submit to whatever rates the commonwealth may fix,

even if they be confiscatory. The writing of insur-

ance is a lawful business and the commonwealth

may not impose unconstitutional conditions upon

the exercise of the right to engage therein.

While it is not constitutionally required to fix

rates which will guarantee a profit to all insurers, it

may not constitutionally fix rates which are so low

that if the insurers engage in business they may do

so only at a loss. The insurers are not required to

either submit to confiscatory rates or go out of busi-

22a

ness. They have a right to rates which are not con-

fiscatory, or which satisfy any higher applicable stat-

utory standard; and to a judicial review on the con-

stitutional statutory adequacy of such rates.

[Aetna Casualty & Sureiy Co. v. Commissioner of

Ins., 263 N.E.2d 698, 703 (Mass. 1970) (citations

omitted ).]

On the other hand, a recent California case suggests

that an insurer may have a legitimate interest in a fair

rate of return on capital but no absolute right thereto.

20th Century Ins. Co. v. Garamendi, 878 P.2d 566, 632

(Cal. 1994). An insurer’s interest in rates which provide

enough revenue for operating expenses and the capital

cost of doing business must be balanced against the inter-

ests of the public in lower prices for insurance. Id. at

635-36.

The analysis of the constitutional requirements for

price controls in 20th Century may indeed be at odds

with the standards announced by our Supreme Court. In

State Farm, supra, the Court stated that “the constitu-

tional requirement that a business be permitted a return

sufficient to assure its financial health does not necessarily

require any particular level of profit above what is ade-

quate to attract and retain invested capital.” 124 N.J. at

48 (emphasis supplied). See also Transcontinental Gas

v. Bernards Tp., 111 N.J. 507, 525 (1988) (rate of re-

turn should be sufficient to provide investors with a rea-

sonable return on capital). Put another way, “price con-

trols which do not permit an economically efficient opera-

tor to obtain a ‘just and reasonable return’ on his invest-

ment are deemed confiscatory.” Hutton Park Gardens v.

West Orange Town Council, supra, 68 N.J. at 568.

State Farm posits that its failure in 1990 and 1991 to

achieve a fair rate of return, 13%, as defined by the ALJ

and the Commissioner, automatically entitles it to relief.

We reject the argument given the finding by the ALJ

23a

that State Farm’s rate of return for PPA in New Jersey

for 1990 and 1991 approximated the actual PPA rate of

return for all insurers’ nationwide. The effect of the sur-

taxes and assessments was to reduce State Farm’s rate of

return on PPA to roughly the industry average for the

questioned years. The “takings” clause requires no rem-

edy where the effect of price regulation has been to reduce

actual return to the industry average.

The 13% figure advocated by rate counsel and ac-

cepted by the ALJ and Commissioner is the rate which

would be “fair” in a prospective ratemaking setting. One

of the major difficulties in this case, recognized by the

parties, the ALJ and the Commissioner, is the absence of

any precedent for determining fair rate of return in a

retrospective context. Normally, of course, ratemaking

is a legislative function and will only be exercised pro-

spectively. Petition of Elizabethtown Water Co., 107 N.J.

440, 452-53 (1987). In the insurance context, it requires

the insurer to “predict the future performance in order

to establish a premium that will generate the appropriate

rate of return.” Matter of Orders A-92-189 and A-92-

212, supra, 274 N.J. Super. at 390. By definition, retro-

active ratemaking occurs when a regulated company is

permitted to recover an additional charge for past losses,

or where the company is required to refund revenues al-

ready collected under previously established rates. Peti-

tion of Elizabethtown Water Co., supra, 107 N.J. at 448.

There is no constitutional proscription against retro-

active ratemaking but statutes are normally construed to

prohibit it because of the practical difficulties it entails.

Petition of Elizabethtown Water Co., supra, 107 N.J. at

450-54. We have recently concluded that the Commis-

sioner’s regulations authorize him to set higher rates pro-

spectively to offset past losses which caused returns to go

below the constitutionally required fair rate of return.

Matter of Commissioner of Insurance’s Decision on Lib-

erty Mutual Fire Ins. Co. Rate Filing, 266 N.J. Super.

24a

457, 467-68 (App. Div. 1993) (citing N.J.A.C. 11:3-

16.11(f)). Accord Nationwide Mutual Ins. Co. v. Foster,

739 F. Supp. 962, 964 (M.D. Pa. 1990). Neither DOI

nor Rate Counsel here challenges the right or the duty of

the Commissioner to engage in retroactive ratemaking to

offset the effect of the surtaxes and assessments which

have precluded a fair rate of return. The problem facing

the ALJ and the Commissioner was to determine what

was a fair rate of return in the context of this retrospective

proceeding.

State Farm’s argument that it is constitutionally entitled

to the difference between 13% and its realized return

suffers from two misconceptions: (1) 13% is the “fair”

rate of return in a retrospective proceeding, and (2) 13%

is the minimally acceptable rate of return. The highly

qualified experts presented said that 13% is a goal ina

prospective proceeding but many factors could explain a

return of less than 13% in any given year. No one sug-

gested that an insurer who earned less than a prospective

13% was constitutionally entitled to relief.

As to the second point, State Farm overlooks the princi-

ple that regulation may stringently limit return on invest-

ment, that investors’ interests must be balanced by con-

sumers’ interests, and that investors must anticipate that

profit levels can be capped or significantly reduced by

changes in government regulation. State Farm, supra,

124 N.J. at 48-50. Accord Permian Basin, supra, 390

U.S. at 769; 20 L. Ed. 2d at 337; Hope Natural Gas,

supra, 320 U.S. at 603, 88 L. Ed. at 345. Although the

experts took somewhat varying approaches in computing

rate of return, there is some correlation between the

target figure of 13% and average return in the industry.

Rate Counsel expert Schwartz determined fair rate of

return on a retrospective basis by examining actual re-

turns earned by property and casualty insurers over an

extended period of time, between 1973 and 1991. The

25a

methodology employed by Rate Counsel’s other expert,

Parcell, was considerably more complex but one major

component was examining historical returns in the prop-

erty and casualty industry to arrive at a fair rate of

return. The target rate of return was very close to the re-

turn permitted by the Clifford formula (see infra at 13) in

prospective ratemaking. Insurers cannot obtain rate relief

whenever their profits in a given year fall below the target

simply because they can prove some causal relationship

between a governmental policy and the reduced profit.

If an average return is around 13%, some insurers

must earn less than that average and some more. As

noted by the ALJ: “Obviously, an insurer cannot expect

to achieve an average return each year considering the

volatility and cyclicality of earnings in the insurance in-

dustry.” Accord Matter of Orders A-92-189 and A-92-

212, supra, 274 N.J. Super. at 390. The ALJ found that

the average return nationwide for private passenger auto-

mobile insurance in 1990 was 4.8%. This number finds

support in the record. The ALJ reached the conclusion

that State Farm was not entitled to relief because its

actual New Jersey returns were not significantly different

from nationwide returns, explaining:

With respect to the achieved rates of return of 12.7

percent for 1990 and 16.4 percent for 1991 exclud-

ing surtaxes and assessments, these returns are within

the range of reasonableness and average slightly

above the mid-point. The achieved rates of return

of 3.4 percent in 1990 and 7.5 percent in 1991 in-

cluding surtaxes and assessments are also within the

range of reasonableness for realized returns in spe-

cific years. It is particularly noteworthy that the

average of these returns is higher than the achieved

rate of return of 4.8 percent for countrywide private

passenger automobile insurance. In regard to the

mid-point of the range of reasonableness, an insurer

obviously cannot expect to achieve a rate of return

26a

equal to or above the long-term average return in

each and every year. Achieved returns below the

mid-point in some years are to be expected.

This conclusion finds support in the testimony of DOI

expert Nye, who said that if State Farm achieved approx-

imately the same rate of return as the industry as a whole

nationwide, then there is no “reason to conclude that any-

body is systematically fooling around with State Farm's

right to make a profit.” Since the actual returns were

roughly the same, “it doesn’t appear there was any inter-

ference with State Farm’s ability to earn a fair rate of

return in those years.”

State Farm contends that other factors caused notably

low returns in the property casualty industry for the year

1990 citing a report of DOI expert Sullivan who discussed

a Forbes Magazine article characterizing the year 1991

as a year the industry “would like to forget” because of

the “takeover of certain major life insurance companies, a

deteriorating market for commercial property and casualty

policies, and some portfolio adjustments which proved to

be poorly timed.” The relevance of this testimony as to

the fair rate of return for private passenger auto escapes

us. The cited circumstances would not impact on PPA.

According to Nye’s analysis, over a six-year period

countrywide, PPA earned significantly less than the prop-

erty casualty insurance industry as a whole. The six-

year countrywide average (1986-1991) for PPA was

7.3%, compared to 13.2% for the property casualty in-

dustry as a whole. Indeed, the 1989 results for PPA,

4.8%, were the same as those achieved in 1990.

Certain case precedent not available to the ALJ, the

Commissioner, or the parties at the time their briefs were

written in this case supports the use of historic returns as

a method of computing*a fair rate of return in a retro-

spective proceeding. 20th Century Ins. Co. v. Garamendi,

supra, 878 P.2d 566. Prior to 1988, California operated

27a

on an open-competition system, under which insurers

could allow the marketplace to dictate premiums for prop-

erty and casualty insurance. Id. at 580. See also Calfarm

Ins. Co. v. Deukmejian, supra, 771 P.2d at 1257. In

November 1988 California voters adopted Proposition

103, which authorized the commissioner of insurance to

set rates, and, of importance here, required premiums on

auto rates for the year 1989 (the rollback year) to be

20% lower than those in effect on November 8, 1987.

Id. at 1250. The rollback applied to all auto insurers

except those who the commissioner of insurance found

would be threatened with insolvency. /d. at 1250. Al-

though the California Supreme Court found this provision

facially unconstitutional, id. at 1253, it was severable

from the remainder of Proposition 103. /d. at 1256. In-

surers who believed the 20% reduction was confiscatory

could apply to the commissioner for relief, and could

charge higher premiums pending a hearing. /d. at 1258-

59. Accord Firemans’ Fund Ins. Co. v. Garamendi, 790

F. Supp. 938, 941 (N.D. Cal. 1992).

In response, 460 insurers filed over 4000 applications

for exemptions from the rollback requirements, as well as

over fifty lawsuits. Jd. at 941-42. The commissioner

adopted regulations which set the fair rate of return in a

retrospective proceeding at 10%. Id. at 944. Accord

20th Century, supra, 878 P.2d at 587. The insurer was

obligated to refund the amount of premium charged in

the rollback year that exceeded 80% of the 1987 rate

or such rate greater than 80% of the 1987 rate as was

minimally nonconfiscatory. /d. at 589.

California’s insurance commissioner settled on the 10%

rate of return by using historical averages, that is, the

commissioner calculated that between 1980 and 1989 the

property and casualty industry earned an average of a

10% return under both statutory accounting principles

and generally accepted accounting principles. /d. at 591.

Insurers challenged the constitutionality of both the ap-

28a

proach and the result. The Supreme Court held: “There

is certainly nothing confiscatory in the definition of 10%

as the lower boundary of the range of reasonable rates of

return.” Id. at 624. Applying the arbitrary, unreason-

able and capricious standard to both the commissioner’s

approach and the result, the court held that the commis-

sioner did not improperly exercise his discretion in using

historic averages to calculate a reasonable rate of return

in a retrospective proceeding. Id. at 623.

We find this aspect of the California Supreme Court's

opinion soundly reasoned: it provides the only precedent

available for setting a fair rate of return in a retrospective

proceeding.” We conclude that State Farm was not en-

titled to specific monetary relief in this rate hearing and

on this appeal because (1) computing rate of return on

a retroactive proceeding based on historical averages is

not unconstitutional; (2) government price regulations

may severely limit the return on investment, State Farm,

supra, 124 N.J. at 48; and (3) the actual impact of the

regulation controls. Duquesne Light, supra, 488 U.S. at

314, 102 L. Ed. 2d at 661. Simply put, on this record,

the impact of the government regulation here was to

reduce State Farm’s rate of return to about the return of

all PPA insurers for the country as a whole for the years

in question. We are satisfied that the final decision of

the Commissioner did not operate as a constitutional tak-

ing of State Farm’s property or deprive it of a fair rate

of return on property.

We next address State Farm’s contention that the Com-

missioner misused a statistical device known as “confi-

dence intervals” to reach the conclusion that a return

2 We do believe that the suggestion that insurers have no con-

stitutional right to a fair rate of return, 20th Century, supra,

878 P.2d at 632-33, is inconsistent with the standard announced

by the Court in State Farm, supra, 124 N.J. at 47-50.

29a

below zero in a particular year could be constitutionally

adequate. This was an attempt to determine a reasonable

range of fluctuation, or a standard deviation, from an

optimum or normative return, all of which was compli-

cated by the novel retroactivity analysis.

For example, Schwartz for Rate Counsel explained his

approach:

In order to determine a fair rate of return, on a

retrospective basis, we examined the actual return

earned by the property casualty insurance industry

over an extended period of time. This allows for a

determination to be made of the prospective fair rate

of return—by examining the average return. It will

also allow for a determination to be made of the

possible fluctuations around this prospective fair rate

of return—by examining the standard deviation of

the returns. These return values are shown in Exhibit

AIS-9.

From 1973 to 1991—a nineteen year period—the

property casualty insurance industry had an average

return of 10.7%. The standard deviation of the re-

turn was 4.9%. Based upon this, we determined that

a reasonable range for the actual rate of return—

on a retrospective basis—was 2.6% to 18.8%. This

range was based upon a common practice of using

a 90% confidence interval when performing statisti-

cal testing. Since State Farm’s actual profitability—

after consideration of the surtax and assessment—

was within this range, it can be concluded that State

Farm had the opportunity to earn a fair rate of re-

turn during 1990 and 1991. It is also interesting to

note that the property/casualty insurance industry’s

average rate of return during 1990 and 1991 com-

bined was 8.6%. State Farm’s New Jersey private

passenger automobile insurance profitability—even

without considering unrealized capital gains and ex-

cessive reserves—was 6.6%. This small difference

30a

in return is further evidence that State Farm had the

opportunity to earn a fair rate of return in 1990 and

1991.

Nye and Sullivan for DOI used somewhat more expansive

“confidence intervals,” —3.6% to +35.6% and ~3.48%

to +29.26%, respectively. The ALJ agreed with these

experts, reasoning:

Obviously, an insurer cannot expect to achieve »n

average return each year considering the volatility

and cyclicality of earnings in the insurance industry.

Under the circumstances, a range of reasonableness

is necessary for a retrospective analysis of returns in

the insurance industry. Based upon the presentations

of DOI and Rate Counsel, I accept returns in the

vicinity of —3.6 percent to 2.6 percent as the low

end of the range of reasonableness for a retrospective

analysis of one year.

The Commissioner adopted these findings.

Rate counsel offers what appears to be an accurate

definition of a “confidence interval,” explaining that it is

a “statistic which measures the probability that the re-

served results (e.g., retrospective actual rate of return)

will fall within a reasonable range around the expected

result (e.g., prospective fair rate of return).” It is a

device used when numerical calculations are derived from

samples rather than from a measurement of the entire

population. David W. Barnes & John M. Conley, Statisti-

cal Evidence in Litigation §3.14 at 106-07 (1986).

When calculations are derived from samples, “an element

of uncertainty is introduced and resulting estimates or

predictions are inherently less precise.” Ibid. A “con-

fidence interval” establishes a range above, below or

around the sample which tends to confirm the accuracy

of the number. 7d. at § 3.15 at 107. Accord DeLuca v.

Merrell Dow Pharmaceuticals, Inc., 911 F.2d 941, 948

(3rd Cir. 1990). It has a variety of uses in litigation, a

common case being where a plaintiff uses studies drawn

3la

from samples to establish that a drug caused a particular

injury. Ibid. See also Brock v. Merrell Dow Pharmaceu-

ticals, Inc., 874 F.2d 307, 311-13 (Sth Cir. 1989). Ina

recent death penalty case, where the Court undertook a

proportionality review and noted that a “confidence in-

terval simply designates the chance, expressed as a per-

centage, that a defendant’s case will fall within a certain

range of predicted probabilities of receiving a death sen-

tence.” State v. Martini, 139 N.J. 3, 43 (1994).

We agree with State Farm that there may be flaws in

the analysis expounded by the experts and adopted by the

Commissioner, some of which were recognized by the ex-

perts themselves. The Commissioner reasonably concluded

that an insurer who demonstrates a negative —3.6% rate

of return for one year does not necessarily establish that

the State regulatory scheme effected a taking of its prop-

erty, entitling the insurer to relief. Too many other factors

could have caused a low rate of return. The insurer bears

the burden of proving that the surtaxes and assessments

denied it a fair rate of return. See Hutton Park Gardens

v. West Orange Town Council, supra, 68 N.J. at 570.

Cf. State Farm, supra, 124 N.J. at 60 (Commissioner’s

regulations provide a procedure for separate rate-filings by

insurers “who can demonstrate that payment of the sur-

taxes and assessments has denied them a fair rate of re-

turn’”’).

In this case State Farm offered proof that it experienced

no unusual casualties or other factors which reduced its

rate of return on its automobile business and DOI and

Rate Counsel experts Schwartz, Nye and Sullivan all

conceded that they could find nothing in State Farm’s

experience in New Jersey, other than the surtaxes and

assessments, which would produce the low rate of return

which State Farm claimed was confiscatory. Notably, the

ALJ made no express finding that State Farm’s rate of

return was caused by factors other than the surtaxes and

assessments.

32a

In View of the agency’s conclusion based on substantial

evidence in the record that the achieved rate of return was

reasonable and not confiscatory, we find no basis for a

reversal or a remand simply because of the references to

“confidence intervals” in the opinions below. This statisti-

cal tool did not drive the analysis or command the conclu-

sion reached at the agency level. Any error in this respect

was essentially harmless and certainly not of constitutional

dimension.

VII

We need not reach the “all-lines” question, i.e., whether

State Farm could obtain relief if it proved that its return

in the private-passenger line was confiscatory but other-

wise achieved a fair return on an “all line, all years” basis.

Since State Farm did achieve a fair return on its personal

property auto lines, we eschew as unnecessary any deci-

sion on whether other profitable lines may be required,

constitutionally or statutorily, to subsidize auto line losses.

We should not reach such substantial questions unless ab-

solutely necessary to the disposition of the litigation before

us. O'Keefe v. Passaic Valley Water Commission, 132

N.J. 234, 240 (1993); Sacks Realty Co., Inc. v. Shore,

276 N.J. Super. 621, 625 (App. Div. 1994). See Matter

of Commissioner of Insurance, 256 N.J. Super. 158, 180

(App. Div. 1992), aff'd 132 N.J.209 (1993).

Vill

Finally, we address State Farm’s contention it was de-

nied procedural due process because the procedure failed

to provide any realistic opportunity for retrospective relief

and the agency failed to adopt standards in advance for

such relief.

As noted, infra at II, the regulations did not specify

precisely what constituted a “constitutionally adequate

return” nor did they inform insurers how the Commis-

sioner proposed to compute the achieved return. Rather,

the Commissioner left it to the applicant to present in its

33a

filing an appropriate formula for determining the return

required by relevant constitutional principles “with sup-

porting analysis and data fully explaining why such for-

mula should be utilized.” N.J.A.C. 11:3-16.11(e).°

ENA NE NRHA ET REGRESS Me RR

* The pertinent regulation called for exhaustive data. N.J.A.C.

11:3-16.11 states in full:

Rate filings reflecting assessments and surtaxes

(a) All insurers who submit a rate filing which reflects

assessments or surtaxes imposed pursuant to N.J.S.A. 17:30A-

8(a), and 17:33B-49, respectively shall submit such rate filing

independently of any prior approval rate filing submitted pur-

suant to N.J.A.C. 11:16.6.

(b) Any insurer desiring to modify its rates to reflect

assessments or surtaxes imposed pursuant to N.J.S.A. 17:30A-

8(9) and 17:33B-49, respectively shall provide the following

information in support of its application:

1. All of the data required for prior approval! filings sub-

mitted pursuant to N.J.A.C. 11:3-16.6;

2. A copy of the statutory property and casualty Annual

Statement, Exhibit of Premiums and Losses (page 14) for

New Jersey for each of the most recent 10 years. The insurer

shall also file information combining this data for each of

the most recent 10 years for all states and the District of

Columbia, if applicable, in which the insurer is authorized to

transact business; and shall provide a list of these jurisdic-

tions;

8. The following data for all of its insurance affiliates for

each of the most recent 10 years on a Statewide and country-

wide basis;

i. For property and casual, affiliates, Exhibit of Premiums

and Losses (page 14) of the statutory property and casualty

Annual Statement;

ii. For title insurance affiliates, Operations and Investment

Exhibit (page 4) and Schedule T—-Exhibit of Premiums Writ-

ten (Page 39) of the statutory title insurance Annual] State-

ment;

iii. For life and health affiliates, Liabilities, Surplus and

Other Funds (page 3); Analysis of Operations by Lines of

Business (page 5); and Exhibit 1 Part 1 and Part 2 (pages

7 and 7A) of the statutory life and health Annual] Statement;

and

34a

State Farm specifically contends that the Commissioner

denied its right to procedural due process by failing to

provide any meaningful backward-looking relief, because

iv. An estimate of the amount of business in other lines

that is produced by the synergistic effects of the insurer

writing private passenger automobile insurance in this State.

4. Certifications/representations by the insurer’s Chief

Financial Officer and President containing the information

set forth in Exhibit F in the Appendix incorporated herein

by reference;

5. A schedule of Key Performance Indicators (KPI's), as

set forth in Exhibit G in the Appendix incorporated herein

by reference, for the year of the rate filing and each of the

preceding two years;

6. For the current year and preceding two years, a schedule

of premiums, incurred losses and operating expenses by New

Jersey lines of business corresponding to line items one (1)

through twenty-two (22) of Part II of the IEE. In addition,

provide a schedule of operating expenses by classification cor-

responding to line items one (1) through twenty-two (22) of

Part I of the IEE. The aggregate of expenses reported by

line item must agree with the total operating expenses related

to New Jersey policies reported by line of business in Part II

of the IEE, (sum of lines four (4) through eight (8) ) ;

7. For each line item expenditure included in the schedule

required pursuant to (b)6 above, the following:

i. A description of all allocation methodologies used to allo-

cate corporate-wide costs (including worldwide, countrywide

and regionalwide costs) to New Jersey lines of business;

ii. A description of allocation methodologies used to allocate

operating expenses to New Jersey private passenger automobile

liability and physical damage lines of business and to all other

New Jersey lines of business;

iii. An explanation for any changes in allocation methodolo-

gies between years;

iv. For NJAFIUA/MTF servicing entities which are also

insurers, an explanation for differences between allocation

methodologies used to prepare the schedule required pursuant

to (b)6 above and the methodologies used to prepare Exhibit

P of the NJAFIUA/MTF reporting package; and

v. For each operating expense classification by each New

Jersey line of business, a schedule which shows the expenses

eT ee

35a

the Commissioner (1) initially ruled that ratemaking is

prospective only, and losses for prior years cannot be

recaptured and (2) failed to adopt standards for comput-

directly charged to a line of business; and indirect expenses

allocated to various lines of business using a reasonable allo-

cation methodology ;

8. For each New Jersey line of business (including private

passenger automobile), the following:

i. The number of named insureds;

ii. The number of employees directly dedicated to the line of

business ;

iii. The square feet of office space dedicated to the line of

business (excluding allocations of corporate or administrative

office space) ;

iv. The houra of data processing time charged;

v. The volume of exposures;

vi. The number of policies in force; and

vii. The number of claims reported during each of the three

years requested;

9. A report, based on a study and evaluation of the insurer’s

system of internal accounting control and signed by an inde-

pendent public accountant. The report shall state that in the

accountants’ opinion, the system of interna] accounting control

of the insurer in effect during the current year, taken as a

whole, was sufficient to meet the objectives of a system of

internal aceeunting control insofar as those objectives pertain

to the prevention or detection of errors or irregularities in

amounts that would be materia! in relation to the insurer’s

financial] statements ; :

10. A listing of all internal audits performed of the oper-

ations of the New Jersey private passenger automobile lines

of business during the current year, including the scope of

procedures performed;

11. Copies of all internal audit reports issued during the

current year pursuant to (b)10 above and management re-

sponses to al] internal audit findings, which are deemed to

be confidential pursuant to N.J.S.A. 17:23-6;

12. Access to source documents which, in the opinion of

the Commissioner, are necessary to support any and al] trans-

actions reported on the insurer’s statutory annual statement

filed with the Department or to support any other schedules

referred to herein;

36a

ing an insurer’s achieved return in a retrospective proceed-

ing. The proper remedy, says State Farm, was to require

the Commissioner to utilize its excess profits report for

18. An explanation why the insurer believes that the assess-

ment imposed by N.J.S.A. 17:30A-8(9) should be reflected in

the requested private passenger automobile rates since the

assessment, by statute, is classified as a loan; and

14. Any additional information specifically requested by the

Commissioner which may be necessary to evaluate the request

for rate relief.

the commissioner may, in his or her discretion, waive any of

the data filing requirements set forth in (b) above.

(d) The Commissioner shall not approve any increase in an

insurer’s rates on the basis that the insurer is required to pay

assessments pursuant to N.J.S.A. 17:30A-8(9), or surtaxes

pursuant to N.J.S.A. 17:38B-49, unless he or she shall find

that an increase in revenue is necessary to ensure that the

insurer earns a constitutionally adequate return. In making

that determination the Commissioner shall consider:

1. The insurer’s experience on all lines of its business

in New Jersey, and in the case of insurers operating in an

insurance holding company system, the experience of all of

the lines of business of all affiliated companies in New Jersey,

for a period of time over which an insurer could reasonably

plan to earn a target rate of return;

2. Whether the insurer and its affiliates, if any, are reason-

ably efficient in their operations, including claims handling,

subrogation and salvage, by comparison to insurers on a state-

wide and countrywide basis;

8. Whether the insurer and its affiliates, if any, have allo-

cated expenses to New Jersey operations in a fair and equitable

manner; and

4. The synergistic effect of mandated private passenger

automobile insurance on the sale of other lines of insurance

that the filer writes, including, but not limited to, higher

premium volumes, lower operating costs and lower acquisition

costs.

(e) Each filer shall present in its filing a formula it be-

lieves appropriate for determining the return required by rele-

37a

computing achieved return. State Farm accuses the Com-

missioner of adopting a biased methodology for the sole

purpose of enhancing its income and minimizing its ex-

penses, so as to artificially inflate its achieved return.

The Commissioner denies any such bias and claims

that sufficient credible evidence supports his findings on

each of the disputed income and expense items. He states

that had State Farm proven a denial of its right to a

reasonable return the remedy would have been higher

rates in the future. The Commissioner also disputes State

Farm’s reliance on the excess profits report, which the

Commissioner claims is an inappropriate way of com-

puting return on equity. Neither the Commissioner nor

Rate Counsel address State Farm’s lack of standards argu-

ment, other than an assertion by the Commissioner that

State Farm never objected below to a lack of standards.

As to the first contention, the regulations clearly pro-

vide that if relief is warranted, “the Commissioner shall

determine whether the rate should be adjusted immediately

or over time, as may be appropriate.” N.J.A.C. 11:3-

16.11(f). This court held that, by virtue of this regu-

lation, the “Commissioner himself has recognized that it

may be appropriate to level off the effect of earlier sur-

taxes and assessments, in rates applicable to persons who

are insured in years other than those in which the surtaxes

and assessments have been levied, in order to afford a

constitutionally adequate fair rate of return.” Liberty

Mutual Rate Filing, supra, 266 N.J. Super. at 468. This

vant constitutional principies, with supporting analysis and

data fully explaining why such formula should be utilized.

(f) The Commissioner may determine whether an insurer's

rates are, as a result of the payment of the surtaxes and

assessments, constitutionally adequate. In the event that

the Commissioner determines that rate relief is deemed to be

necessary, the Commissioner shali determine whether the rates

should be adjusted immediately or over time, as may be ap

propriate.

38a

regulation clearly enables the Commissioner to fulfill his

constitutional and statutory duty to provide relief if the

insurer establishes that, by reason of the surtaxes and

assessments, it was unable to achieve a fair rate of return.

Ibid.

The more meritorious issue here perhaps is the claimed

need for standards. State Farm complains that “without

advanced standards, the ‘hearing’ process was meaning-

less.” State Farm asserts that “procedural due process re-

quires government to tell regulated entities in a straight-

forward manner where and how to obtain relief, including

advance identification of the applicable substantive stand-

ards, both to permit the regulated entity to determine if

an application is warranted and to prevent government

from manipulating the process to deny relief.” State Farm

contends that the existing regulations, while requiring

voluminous information from insurers seeking relief, pro-

vide “no identification as to how that information is to

be used and no methodology to retrospectively compute

actual returns.” bid.

The Commissioner asserts, without any particular elab-

oration, that “standards were clearly articulated.” The

Commissioner also claims that State Farm never objected

to the lack of standards. This is not so. As noted by the

ALJ early in the proceedings, on December 5, 1990,

State Farm, complaining about the volume of informa-

tion required, contended that the Commissioner violated

due process by failing to disclose the standards by which

he would determine whether State Farm earned a fair and

reasonable return.

Principles of due process demand that agencies articu-

late in as much detail as possible the standards that guide

discretionary decision-making. Lower Main Street Asso-

ciates v. N.J. Housing and Mortgage Finance Agency,

114 N.J. 226, 235 (1989). As noted therein, the Court

has “on several occasions invalidated the actions of ad-

39a

ministrative agencies where there was a significant failure

to provide either statutory or regulatory standards that

would inform the public and guide the agency in discharg-

ing its authorized function.” /bid. Interested parties need

to know the factors which an agency will deem relevant

and which might influence its ultimate decision. Crema v.

N.J. Dept. of Environmental Protection, 94 N.J. 286,

302 (1983). Lack of specific standards “results in con-

fusion” to those affected and to the agency itself. State,

Department of Environmental Protection v. Stavola, 103

N.J. 425, 438 (1986).

The Commissioner’s regulations do require massive

amounts of data, N.J.A.C. 11:3-16.11(b), a subject of

considerable complaint from insurers when the regulations

were initially adopted. See 23 N.J.R. 516 (February 19,

199i). According to Lehmann, State Farm’s actuary,

New Jersey has by far the most cumbersome and burden-

some rate-filing requirements in the country, partly be-

cause DOI requires information not kept in the ordinary

course of business, such as the number of employees di-

rectly dedicated to each line of insurance, the square

feet of office space dedicated to that line and the hours

of data processing time charged by line of business. To

supply the information for its March 1990 application for

a regular rate increase amounted to over 4100 pages,

which took State Farm five months to assemble. It filed

an additional 6000 pages for the surtax and assessment

filing. But the regulations do not specify how the Com-

missioner will use this data. They merely state that the

Commissioner will “consider” the insurer’s experience on

all lines of New Jersey business, whether the insurer and

its affiliates are reasonably efficient, whether they have

allocated expenses to New Jersey in a fair and equitable

manner, and the “synergistic effect of mandated private

passenger automobile insurance on the sale of other lines

of insurance.” N.J.A.C. 11:3-16.11(d). The regulations

leave it to the insurer to devise a “formula it believes

40a

appropriate for determining the return required by rele-

vant constitutional principles, with supporting analysis and

date fully explaining why such formula should be utilized.”

NJ.A.C. 11:3-16.11(e). At that point, the Commis-

sioner “may determine whether an insurer’s rates are, as

a result of the payment of the surtaxes and assessments,

constitutionally adequate.” N.J.A.C. 11:3-16.11(f).

In upholding the facial constitutionality of the anti-

pass-through provisions of the Fair Act, the Supreme

Court acknowledged “uncertainty” about whether the reg-

ulations would enable the Commissioner to “fulfill his

duty under the statute to assure that insurers receive a

constitutionally fair rate of return.” State Farm, supra,

124 N.J. at 62-63. The concurring opinion went further,

expressing “grave doubts about the ability of the Com-

missioner of Insurance, under present regulations, to guar-

antee insurance companies a constitutionally-adequate rate

of return.” 124 N.J. at 66-67 (Garibaldi, J., concurring).

We do not think the Commissioner has provided meaning-

ful standards.

In this unique situation, however, we decline to reverse

and remand for a new hearing to be held after the Com-

missioner adopts new regulations setting forth more pre-

cise standards and methodologies for applications for ret-

rospective rate increases. We are satisfied that State Farm

received fair treatment and achieved a fair rate of return

for 1990 and 1991, notwithstanding the assessments and

surtax. State Farm was permitted to present all pertinent

data and to urge any methodology it chose upon the

agency. No avenue of argument or theory was fore-

closed. This was an unprecedented hearing. No tradi-

tional regulatory guidelines were available. Adoption of

new regulations would have consumed considerable time

and no doubt resulted in controversies similar to those

which arose at the hearing and on the appeal here. In-

deed, the regulations would probably have been challenged

4la

on appeal to this court. Calculating an insurer’s profitabil-

ity is a complex process best resolved by the agency en-

trusted with regulating insurance companies. See State

Farm, supra, 124 N.J. at 61. We are satisfied that the

parties each had a chance to urge the formula and meth-

odology of its choice upon the ALJ and the agency and

that State Farm received a fair hearing on its contentions.

In this unique situation the constitution was satisfied.

Remaining is State Farm’s claim that the Commissioner

deliberately inflated its income and minimized its ex-

penses in order to deny it relief. The argument reflects

the sense of hostility and distrust many insurers have

expressed toward the former Commissioner, a situation

that prior cases have noted leads to a great deal of litiga-

tion and an unwillingness to compromise. See Matter of

Commissioner of Insurance, supra, 132 N.J. at 233; Mat-

ter of Aetna Casualty & Surety Co., supra, 248 NJ.

Super. at 388.

State Farm is not entirely correct in asserting that the

Commissioner ruled against it on every issue. Both the

ALJ and the Commissioner accepted State Farm’s claim

for a $36.2 million UCJF reserve in 1990, over objection

by DOI staff. The Commissioner also overruled DOI’s

objection and agreed with State Farm on the issue of the

applicable tax rates. We cannot on this record attribute

a deliberate bias on the part of the Commissioner to skew

his analysis for the purpose of denying relief to State

Farm. On the other hand, the Commissioner did make it

difficult for insurers generally to succeed in an as-applied

challenge.

‘The adoption of detailed standards through the rule-

making process in which the regulated industry will have

an ample opportunity to participate would go far toward

dispelling the sense that the Commissioner has acted or

will act in less than a fair and impartial manner. There

were some inconsistencies in the Commissioner’s meth-

42a

odology. For example, he refused to consider State Farm’s

substantial AIRE payments, even though they are con-

tained in the excess profits report, because it was specula-

tive whether State Farm would continue to be a net payer

in the future. He also ruled that State Farm had to

account for unrealized capital gains and losses, items not

contained in the excess profits report—not enough to

constitutionally flaw the process perhaps, but nonetheless

questionable.

For future purposes, the DOI should develop more spe-

cific regulations for methods and standards for determin-

ing both fair and achieved rates of return retrospectively.

Policy making through adjudication, rather than rulemak-

ing, should be avoided when possible. In re Solid Waste

Utility Customer Lists, 106 N.J. 508, 519 (1987); see

Metromedia, Inc. v. Director, Div. of Taxation, 97 N.J.

313 (1984); Matter of Farmers’ Mutual Fire Assurance

Association, supra, 256 N.J. Super. 607.

Affirmed.

43a

APPENDIX B

[Filed Sep. 27, 1995]

SUPREME COURT OF NEW JERSEY

C-125 September Term 1995

40,501

STATE FARM MUTUAL AUTOMOBILE

INSURANCE COMPANY,

Plaintiff-Petitioner,

Vv.

STATE OF NEW JERSEY, SAMUEL FORTUNATO, et al.,

Defendants-Respondents.

ON PETITION FOR CERTIFICATION

To the Appellate Division, Superior Court:

A petition for certification of the judgment in

A-2042-92 having been submitted to this Court, and

the Court having considered the same;

It is ORDERED that the petition for certification is

denied, with costs.

WITNESS, the Honorable Robert N. Wilentz, Chief

Justice, at Trenton, this 26th day of September, 1995.

/s/ Stephen Townsend

Clerk of the Supreme Court

44a

APPENDIX C

Order No. A92-319

STATE OF NEW JERSEY

DEPARTMENT OF INSURANCE

OAL Docket No.: INS 6227-92

Agency Docket No.: Company 90-610(R) and

90-1056(R)

IN THE MATTER OF THE PRIVATE PASSENGER AUTOMO-

BILE RATE FILINGS ON BEHALF OF STATE FARM Mv-

TUAL AUTOMOBILE INSURANCE CONCERNING FAIR ACT

SURTAXES AND ASSESSMENTS

FINAL DECISION AND ORDER

This matter comes before the Commissioner of Insur-

ance (“Commissioner”) pursuant to N.J.S.A. 17:29A-1

et seq., N.J.S.A. 52:14B-1 et seq. and all powers ex-

pressed or implied therein.

This matter is a proceeding on remand from the Su-

perior Court of New Jersey, Chancery Division, Mercer

County, of two filings by State Farm Mutual Automobile

Insurance Company (“State Farm”) to increase rates for

private passenger automobile insurance to reflect surtaxes

and assessments imposed pursuant to the Fair Automobile

Insurance Reform Act of 1990, (“the FAIR Act”)

N.J.S.A. 17:33B-1 et seq.

On May 11, 1990 State Farm applied for a rate in-

crease of 5% to reflect a 5% surcharge on private pas-

senger auto premiums. This rate filing was initially con-

45a

solidated with State Farm’s pending prior approval rate

filing and requests for additional information were made

by the Department. On August 24, 1990 State Farm

applied for a similar rate increase concerning the Prop-

erty Liability Insurance Guaranty Association (“PLIGA”)

assessment pursuant to N.J.S.A. 17:30A-8a(9) proposing

a 2.7% increase on all auto policies for eight years (DOI

Docket #90-1006).

By letter dated October 29, 1990, the Commissioner

advised State Farm that the requested rate increase for

surtaxes would no longer be consolidated with the prior

approval filing but would be considered in a separate

proceeding with the requested rate imcrease for assess-

ments. Addi‘ onally, State Farm was advised that regu-

lations would be promulgated shortly and set forth in

detail the data that would be required in order to review

the surtax and assessment rate requests. State Farm re-

sponded to the Commissioner’s letter of October 29, 1990

by letter dated December 5, 1990, providing some infor-

mation and objecting to other data requests. Thereafter,

the DOI and State Farm engaged in a series of cor-

respondence by which the DOI requested additional data

and State Farm resisted supplying it.

The matter was transmitted to the OAL on June 28,

1991 as the result of a stipulation which required the

transmittal of State Farm’s surtax and assessment filings

to the OAL with information to be provided through dis-

covery. After the transmittal to the OAL, telephone con-

ference was held on August 1, 1991, and counsel were

directed to submit pre-hearing memoranda. Hearings were

scheduled to commence on February 24, 1992. During a

telephone conference on September 25, 1991, a discovery

schedule was established with requests to be made by

October 9, 1991, and responses to be provided by October

29, 1991. A schedule was also established for expert

reports and pre-filed testimony (See Initial Decision at 5).

46a

A discovery dispute arose in which all parties sought

to compel more specific answers to interrogatories. The

discovery orders were issued on January 2, 1992, with

State Farm to respond within 10 days of receipt of the

orders and DOI and Rate Counsel to respond after receipt

of State Farm’s responses. By letter dated January 13,

1992, State Farm filed with the Commissioner of Insur-

ance an interlocutory appeal which was denied by order

dated January 23, 1992. In late January, the hearings

scheduled to commence in February were adjourned at

the request of all counsel, and a new schedule was estab-

lished with hearings to commence on June 22, 1992.

The parties exchanged some discovery beginning ap-

proximately January 31, 1992 and initial and reply expert

reports were exchanged in March, 1992 and, April 1992,

respectively. The date for pre-filed direct testimony was

postponed at the request of State Farm and DOI for set-

tlement negotiations. A settlement agreement providing

for withdrawal of State Farm’s surtax and assessment fil-

ings was submitted by letter dated May 19, i992. The

settlement was approved by Initial Decision-Settlement

dated May 29, 1992 (See Initial Decision at 7 and 8).

On May 29, 1992, State Farm instituted a law suit in

Superior Court of New Jersey, Chancery Division, Mercer

County claiming that the FAIR Act and DOI’s regula-

tions specific to rate filings (N.J.A.C. 11:3-16.11) were

unconstitutional as applied to State Farm. The remand

order was issued on August 6, 1992, which directed the

Office of Administrative Law (“OAL”) tc determine

what State Farm’s rates of return were for 1990 and

1991, and what a fair rate of return was for each of those

two years. If the achieved rate of return was not fair, rate

relief was to be ordered. The court also directed that

findings be made regarding the reason for the delay in the

resolution of the filing. The Department transmitted the

remanded matter to the Office of Administrative Law

47a

(“OAL”) for hearing on August 13, 1992. Six days of

hearings were conducted commencing on August 27, 1992

and concluding on September 16, 1992. The matter was

heard by Administrative Law Judge Richard McGill

(“ALJ”). The record was closed on September 25, 1992.

The case was decided on October 9, 1992 and the Initial

Decision was filed October 15, 1992. State Farm, the

Public Advocate, the Division of Rate Counsel (“Rate

Counsel”) and DOI staff filed exceptions to the Initial

Decision on October 22, 1992. State Farm and the DOI

filed responses to the exceptions by October 28, 1992.

DISCUSSION

The major issues raised by the exceptions submitted by

the parties are: (1) The ALJ’s determination of a fair

rate of return for State Farm during 1990 and 1991; (2)

The calculation of State Farm’s actual rate of return for

1990 and 1991 as defined by the following sub-issues:

(A) The ALJ’s conclusion that State Farm’s data had

not been tested for reasonableness; (B) The ALJ’s con-

clusion that State Farm’s $36.2 million UCJF reserve in

1990 should not be deducted from losses in calculating

profitability; (C) The ALJ’s rejection of State Farm’s

specific New Jersey loss adjustment expenses; (D) The

ALJ’s exclusion of State Farm’s net payments to AIRE;

(E) The ALJ’s conclusion concerning the calculation of

equity in Unearned Premium Reserves; (F) The ALJ's

decision on investment income on Policyholder—Supplied

Funds; (G) The ALJ’s determination that not all of State

Farm’s auto reserves in 1991 should be used in the calcu-

lation of investment income; (H) The ALJ’s calculation

of tax rates for the purposes of this proceeding; (I) The

ALJ’s conclusion that he is not recognizing capital gains

and losses; and (J) The ALJ’s failure to address the

issue of whether State Farm failed to establish the spe-

cific effect of its payments of FAIR Act surtaxes and

assessments. (3) The ALJ’s determination as to why this

48a

proceeding was delayed. These issues are discussed below.

After independently reviewing the record and the sub-

mission of the parties I adopt the ALJ’s Initial Decision

with the modification listed below.

Before addressing the major issues raised by the excep-

tions, it is important to reiterate the point addressed by

the ALJ (Initial Decision at 11) that this matter differs

from an ordinary rate case in several important respects.

First, ratemaking is normally prospective in nature. In

prospective ratemaking, experience for a recent period is

analyzed to determine the adequacy of rates for the fu-

ture. The approach taken by the parties in this proceed-

ing differs in that rate relief appears to be dependent on

what an anticipated adequate rate of return was during

two specific past calendar years.

Second, the ALJ states that insurance ratemaking is

normally based on certain generally recognized and ac-

cepted ratesetting methodologies such as the loss ratio

method, which is embodied in N.J.A.C. 11:3-16.10 for

prior approval filings and by incorporation in N.J.A.C.

11:3-16.11 for surtax and assessment filings. The man-

dated approach involves a comparison between what the

insurer’s rate of return was for 1990 and for 1991 and

what a fair rate of return was for each of those years.

This is not ordinarily made in automobile insurance rate-

making, and as a result, there does not appear to be any

generally recognized and accepted methodology to make

this comparison.

The ALJ further states that in view of the lack of a

generally recognized and accepted methodology, it is not

surprising that the parties have proposed widely disparate

methods. The difficulty is that there are myriad ways

to make the mandated comparison, and at the same time,

there are no particular guidelines or standards for re-

solving methodological differences between the parties.

49a

Thus, this proceeding involves complexities that are not

ordinarily present in a rate case.

Thirdly the ALJ states that, it should be recognized

that the regulations, N.J.A.C. 11:3-16.6 through N.J.A.C.

11:3-16.11, set forth detailed data filing requirements. In

the remand order, the Court required that “all usual data”

be pre-filed. The ALJ notes that data is usually sub-

mitted in accordance with N.J.A.C. 11:3-16.6 to 16.10

for prior approval filings and N.J.A.C. 11:3-16.11(a)

and (b) for surtax and assessment filings. However, as

discussed further below, State Farm did not submit the

data required by those regulations but rather relied on its

excess profits report, which is unusual for a rate

proceeding.

It is important to note that the sole and limited pur-

pose of the Excess Profit Report is to compare actual

performance with the performance predicted in State

Farm’s last approved rate filing in order to determine if

an insurer had an excess profit.

I. What constitutes a fair rate of return

First, State Farm states that the ALJ found that the

constitutional rate of return was an after tax 13% return

on equity. State Farm takes exception to the ALJ’s re-

jection of its testimony because State Farm asserts that

there was little analysis of objective data. State Farm

argues that the ALJ rejected unrefuted evidence simply

because the evidence was not capable of being plugged

into a formula that could be used in any state (See State

Farm exception at 24).

State Farm states that given the tremendous risk asso-

ciated with New Jersey private passenger automobile in-

surance it is appropriate and even conservative to use

16% as the appropriate cost of capital (See State Farm’s

exceptions at 29).

50a

Additionally, State Farm asserts that in establishing

the fair rate of return, investors are concerned solely

with true expected results, not theoretical results (See

State Farm’s exceptions at 30).

The DOI took exceptions to the ALJ’s conclusion that

“the DOI’s expert utilized an array of data . . . without

identifying a fair rate of return for State Farm” (Initial

Decision at 19). DOI asserts that its expert did identify

a fair rate of return for State Farm using the comparable

risk (See DOI’s exception at 2 and 4).

The DOI asserts that State Farm misrepresents the

ALJ’s conclusions regarding a fair rate of return, by

ignoring the distinction between the cost of capital, which

is a prospective concept, and a retrospective analysis of

achieved rates of return. Additionally, the DOI staff

states that the 13% figure used by the ALJ is a number

which reflects an expected rate of return (i.e., the rate of

return investors may expect, at the beginning of the year,

to earn during the subsequent year.) (See DOI’s reply to

exceptions at 6 and 7).

State Farm states that the DOI’s expert did not use

the comparable risk methodology to determine the ex-

pected cost of capital. State Farm argues that the DOI’s

expert simply opined that State Farm’s actual New Jersey

private passenger auto and all lines returns were com-

parable to country-wide returns for the industry from

1986-1991. State Farm asserts that this is not a fair rate

of return analysis and that comparing State Farm’s results

to an industry average is improper, because the industry

may have inadequate or excessive earnings for the period

in question (See State Farm’s reply to exceptions at 2).

State Farm takes exception to the confidence intervals

used by the ALJ. State Farm asserts that the ALJ’s inter-

vals do not provide a “range of reasonableness” such that

the lower end of the range represents the bare bones

Sla

minimum constitutional rate of return (i.e., the absolute

minimum rate that will attract investors) (See State

Farm’s exceptions at 31).

The DOI asserts that the ALJ properly considered

Statistical data and country-wide industry returns in de-

termining a fair rate of return (See DOI’s reply to ex-

ceptions at 10).

Finally, State Farm argues that the issue of whether

it has been denied a fair rate of return should be deter-

mined solely on the actual returns for 1990 and 1991

(See State Farm’s reply to exceptions at 13).

I find State Farm’s argument unpersuasive. The con-

stitutional adequacy of State Farm’s actual returns, in

1990 and 1991 requires an analysis of returns over sev-

eral years, on all property casualty lines of business

written in New Jersey. Therefore, I reject State Farm’s

argument.

The ALJ appropriately stated the applicable constitu-

tional standards which were recently reviewed by our

Supreme Court in State Farm v. State, 124 N.J. 32(1991).

As set forth therein, the landmark case under the United

States Constitution is FPC v. Hope Natural Gas Co., 320

U.S. 591, 64 S.Ct. 281, 88 L.Ed. 333 (1944), where

the United States Supreme Court stated (Initial Decision

at 12):

From the investor or company point of view it is

important that there be enough revenue not only for

operating expenses but also for the capital costs of

the business. These include service on the debt and

dividends on the stock... . By that standard the

return to the equity owner should be commensurate

with returns on investments in other enterprises hav-

ing corresponding risks. That return, moreover,

should be sufficient to assure confidence in the finan-

cial integrity of the enterprise, so as to maintain its

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credit and to attract capital. . . . [Id., 320 US. at

603, 64 S.Ct. at 288, 88 L.Ed. at 345.]

The ALJ further noted (Initial Decision at 13) that

the New Jersey Supreme Court has accepted the com-

parable risk method as an appropriate method for use

in this jurisdiction. As the New Jersey Supreme Court

stated in State Farm v. State, supra, 124 N.J. at 48:

. . . to avoid confiscatory results under the taking

clause, “the return should be one which is generally

commensurate with returns on investments in other

enterprises having comparable risks.”

The ALJ also cites Duquesne Light Co. v. Barasch,

488 U.S. 299, 109 S.Ct. 609, 102 L.Ed. 2d 646 (1989),

for stating the point at which rates become confiscatory.

The ALJ noted that . . . a wide range of returns can be

expected in the insurance industry. Thus, the task in

evaluating returns for a given past year is not simply to

determine the center of the range of reasonableness but

rather to identify the outer bounds of the range of reason-

ableness (Initial Decision at 13 and 14).

The ALJ correctly stated that:

The right to a constitutionally adequate rate of

return does not generally extend to individual serv-

ices provided by regulated entities, but rather applies

to the enterprise as a whole. In Fort Smith Light &

T. Co. v. Bourland, 267 U.S. 330, 332, 45 S.Ct.

249, 69 L.Ed. 631, 633 (1925), the United States

Supreme Court held that a street railway company

“may be compelled to continue the service of a

branch or part of a line, although the operation in-

volves a loss.” Further, the city railway company

could not abandoned an unprofitable line unless,

among other things, “the system, as a whole, was not

earning a fair return upon the value of the property

used and useful in the business.”

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Additionally, the ALJ (Initial Decision at 16) notes that

courts have recognized that:

. . a State may constitutionally require the provider

of a vital public service to provide that service to

a part of its market, which, standing alone, is profit-

able. (Citation omitted). [Matter of Plan of Orderly

Withdrawal, 248, N.J. Super. 616, 637 (App. Div.

1991), affd. 129 N.J. 389 (1992)].

The ALJ concludes that a multi-line insurer’s con-

stitutional right to a fair rate of return pertains to the

enterprise as a whole as defined by jurisdictional rate-

setting and does not extend to each individual line of

insurance. Second, multi-line insurers will be treated as

a single entity for purposes of achieving the objectives of

the FAIR Act (Initial Decision at 16).

I concur with the ALJ that an analysis of a fair rate

of return requires several years of data, on an all lines

basis, utilizing a comparable risk method as the pro-

cedure for analysis. As noted by the ALJ, the consti-

tution does not require approval of rates that guarantee

that an insurer will make a profit in all lines for all years.

I find that it is appropriate to consider the insurer’s ex-

perience on all lines of its business for a period of time

over which it could plan to earn a reasonable rate of

return. A two year span (1990-1991) is not a long enough

time period to determine whether an insurer has earned

a reasonable rate of return.

I adopt the interim conclusions of the ALJ that 13.0%

is an approximation of the center of the range of reason-

ableness for a fair rate of return on a long term basis

for private passenger automobile insurance (Initial De-

cision at 19). I also adopt the ALJ’s finding that returns

in the vicinity of —3.6% to 2.6% as the low end of the

range of reasonableness a retrospective analysis limited

to one year for private passenger automobile insurance

(Initial Decision at 20). In considering a short time

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frame, such as a single year, it is to be expected that there

are a wide range of acceptable results considering the

volatility and cyclicality of earnings in the insurance in-

dustry.

II. Calculation of State Farm’s achieved rate of return

In concluding that State Farm did not establish a con-

fiscation of its property that would require rate relief, the

ALJ was faced with deciding several sub-issues concerning

the calculation of State Farm’s rate of return in 1990 and

1991. The disputes among the parties on these sub-issues

were thoroughly argued and briefed before the ALJ, and

the parties again raised many of these arguments in their

exceptions. Although the ALJ’s resolution of these sub-

issues individually was not critical to his ultimate con-

clusion, it is appropriate that this decision address them

and set forth the items on which I agree and disag

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