# Petition for Writ of Certiorari — Fitzgerald v. Bayham

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition for Writ of Certiorari
- **Published:** January 1, 1996
- **Citation:** 516 U.S. 1075

## Text

i

Sr-sre

BLE D
DEC 21 1983

——_
+

a

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)

ii

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

ee

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)

10

iv
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

19

la

43a

44a

113a

120a

124a

v

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

vi

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

vt

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
24
24

A Ae Ty A a et DS A AO. oe

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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.

2

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

3

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

ee

4

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.

5

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 |

6

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

7

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-

8

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.

9

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.

10

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

11

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

12

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.

——&<«_

13

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.]

14

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”).

15

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.

i

16

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

17

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.

18

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.

19

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

20

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

21

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).

22

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.

23

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

24

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.

25

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

la

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.

2a
I

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-

3a

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.

II

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

4a

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

Sa

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

6a

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.

|

7a
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

8a

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

9a

IV

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-

1

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.”

Vv

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.

VI

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

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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] S

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386007_1423%3A1. Public record. Not legal advice.