Amicus Curiae Brief — Fitzgerald v. Bayham

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Supreme Court, & S. ie

(3) FILED

FEB § 1996

No. 95-984

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IN THE

Supreme Court of the Gnited States 3

OCTOBER TERM, 1995

STATE FARM MUTUAL AUTOMOBILE INSURANCE COMPANY,

Petitioner,

STATE OF NEW JERSEY, COMMISSIONER OF INSURANCE,

— Respondents.

On Petition for Writ of Certiorari to the

Superior Court of New Jersey, Appellate Division

BRIEF AMICI CURIAE OF THE AMERICAN

INSURANCE ASSOCIATION AND THE NATIONAL

- ASSOCIATION OF INDEPENDENT INSURERS IN

SUPPORT OF PETITIONER

CRAIG A. BERRINGTON *WILLIAM J. KILBERG

DAVID F. SNYDER THEODORE J. BOUTROUS, JR.

AMERICAN INSURANCE MARK SNYDERMAN

ASSOCIATION GIBSON, DUNN & CRUTCHER

1130 Connecticut Ave., N.W. 1050 Connecticut Ave., N.W.

Washington, D.C. 20036 Suite 900

(202) 828-7100 Washington, D.C. 20036

(202) 955-8500

MICHAEL P. DUNCAN

MONIKA LUSSNIG

NATIONAL ASSOCIATION OF

INDEPENDENT INSURERS

2600 River Road

Des Plaines, Illinois 60018

(847) 297-7800

*Counsel of Record

PRESS OF BYRON 8S. ADAMS, WASHINGTON, D.C. 1-800-347-8208

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TABLE OF CONTENTS

A. Substitution of an Average-Rate-of-

Return Rule for the Constitutionally

Mandated Cost-of-Capital Standard

Virtually Guarantees Confiscation..... 4

1. Loss of the Opportunity to

Recover Cost of Capital

Undermines the Financial

Stability of Insurance

Companies and the Security

That Policyholders Purchase... 4

a The New Jersey Court's

Average-Rate-of-Return Rule

Bears No Relation to the

Constitutionally Mandated

Fair Rate of Return and Will

Create a Downward Spiral

Toward Greater Confiscation... 7

B. In Justifying Its New Rule by the

Retroactive Nature of the Proceedings

Below, the New Jersey Court Has

_ Supplied a Road Map for

RNAse séabakbchckexashcidicsdands 9

SPIE si pcdasekai0iessticsesedscebuodspnvanencoas 12

TABLE OF AUTHORITIES

Cases:

Calfarm Ins. Co. v. Deukmejian, 48 Cal.3d

805, 771 P.2d 1247 (1989)........eeeeeeeeeeees

PPOYTTTTTTT TTT

Duquesne Light Co. v. Barasch, 488 U.S.

299 (1989) ......ccsecceceerececerteeeeeeeeeneeeees

Federal Power Comm'n v. Hope Natural

Gas Co., 320 U.S. 591 (1944) .......ceeeeeeees

First English Evangelical Lutheran Church v.

County of Los Angeles, 482 U.S. 304 (1987).

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

508 (9th Cir. 1990).........cseecereeeeeeeeeeeees

Jersey Cent. Power & Light Co. v. FERC,

810 F.2d 1168 (D.C. Cir. 1987) .........-+-++:

Lucas v. South Carolina, 112 S. Ct. 2886

Nationwide Mut. Life Ins. Co. v. Foster, 739

F. Supp. 962 (M.D.Pa. 1990) ....---.--+++ee005

Nollan v. California Coastal Comm'n, 483

U.S. 825 (1987).......cscseccceessceesececeeeenees

Southwestern Bell Tel. Co v. Public Serv.

Comm'n, 262 U.S. 276 (1923) .....-.+++e+2+0+

Page(s)

iil

State Farm Mut. Auto. Ins. Co. v. State of

New Jersey, 590 A.2d 191 (N.J. 1991)........ 10,11

20th Century Ins. Co. v. Garamendi, 8 Cal.4th

216, 878 P.2d 566 (1994), cert. dismissed,

115 S. Ct. 1085, cert. denied, 115 S. Ct.

REE vanckscenessestocncsenstsccesccsadccsese 4,10,12

United States v. Salerno, 481 U.S. 739 (1987) ....... 10

Statutes:

Cal. Ins. Code § 1861.01 (West 1996)................. 10

Haw. Rev. Stat. § 431.10C-202.5 (1995) ............. 10

I EG SEE cneccccnacscocdsesbenssnncsecceses 10

N.J. Stat. Ann. 17.33B-1 et seg. (West 1996) ........ 9

75 Pa. Cons. Stat. Ann. § 1799.7 (1995).............. 10

Tex. Ins. Code Ann. art. 5.131 (West 1996).......... 10

Other Authorities:

Richard A. Brealey & Stewart C. Myers, Principles

of Corporate Finance 13 (4th ed. 1991)....... 5

National Association of Insurance Commissioners,

Report on Profitability by Line by State in

EE SEED snc cclndadustuacanagnaetaces 8

INTEREST OF AMICI CURIAE*

The American Insurance Association “AIA" is a

national trade association, with headquarters in Washington,

D.C., representing more than 270 property and casualty

insurance companies in the United States. In 1994, AIA

member companies wrote $52.7 billion in insurance

premiums, $3.2 billion in New Jersey.

The National Association of Independent Insurers

("NAII") is a national trade association, with headquarters

in Des Plaines, Illinois, representing more than 570

property and casualty insurance companies in the United

States. In 1994, NAII member companies wrote $65.9

billion in insurance premiums, $1.68 billion in New Jersey.

Many AIA and NAII member companies are subject

to New Jersey automobile insurance rate regulation. AIA

member companies provided 21.7 percent of private

passenger automobile insurance coverage in New Jersey in

1994. NAII members companies provided 22 percent of

automobile insurance coverage in New Jersey that year.

AIA and NAII member companies also sell

insurance in every other state in the Union, all of which

regulate insurance rates. AIA and NAII file this brief amici

curiae because of their interest in preventing New Jersey

and other states from taking the property of member

companies through confiscatory insurance rate regulation.

Amici legitimately are concerned that, as New Jersey has

joined California in adopting an erroneous constitutional

standard, other states may join in a race to the bottom that

will threaten the survival of insurance companies.

*Counsel to the parties have consented to the filing of this brief.

Letters of consent have been filed with the Clerk.

SUMMARY OF ARGUMENT

This is a case of great and potentially destructive

import. The New Jersey court has provided both a rule that

allows states to drive down insurance rates with almost no

constitutional check, and the procedural mechanism through

which to achieve that result.

The New Jersey court discarded the cost-of-capital

standard in the constitutional analysis of rate regulation in

favor of a rule that looks only to the national average rate

of return. The opportunity to recover cost of capital is a

necessary element of a constitutionally adequate regulated

rate. The cost of capital describes the rate of return a

business must produce to attract capital in a competitive

market. If a business is not expected to uce a rate of

return at least comparable to that available from other

investments, capital will flow away from the business into

superior investments. An insurance company that cannot

recover its cost of capital will begin a cycle of lost capital

that will increase the riskiness of the firm and threaten its

financial integrity. This decline in capital imposes heavy

costs on policyholders because the insurance company's

ability to handle future losses is diminished.

The New Jersey court's substitute for cost of capital,

the national average rate of return for automobile insurance,

is constitutionally deficient. The nationwide average rate of

return ignores all of the local variables that determine a

firm's interest. At the same time, the

nati average is too narrowly focused to account for the

extreme volatility in the automobile insurance market.

Worst of all, the national average reflects regulated rate

reductions in other states. The New Jersey court's average-

rate-of-return rule will allow states to confiscate as long as

other states are doing the same.

The New Jersey court purported to limit application

of its new takings rule to retroactive review, in which the

takings determination is made after the challenged rate has

been in effect. This supposed limitation may actually

compound the problem. Retroactive relief is often critical

to the maintenance of minimal constitutional protections

from confiscatory insurance reform legislation; the.

possibility of retroactive relief is a linchpin of several state

regulatory schemes. The New Jersey rule grants

confiscatory authority to each such state, and is sure to

motivate similar practices throughout the Nation.

Moreover, retroactive relief will be mandated in numerous

cases in which an as applied takings challenge is resolved

after the effective date of the challenged rate. By tying its

new rule to retroactive proceedings, the New Jersey court

has provided a road map for confiscation.

ARGUMENT

In a series of recent cases, this Court has reaffirmed

the strong constitutional protection against the taking of

private property without just compensation. E.g., First

English Evangelical Lutheran Church v. County of Los

Angeles, 482 U.S. 304 (1987); Nollan v. California Coastal

Comm'n, 483 U.S. 825 (1987); Lucas v. South Carolina,

112 S. Ct. 2886 (1992), Dolan v. City of Tigard, 114 S.

Ct. 2309, 2320 (1994) ("We see no reason why the Takings

Clause of the Fifth Amendment, as much a part of the Bill

of Rights as the First Amendment or Fourth Amendment,

should be relegated to the status of a poor relation. . . ." ).

Those cases involved real property rights. No less

— magge and equally entitled to the protections of the

Fifth Amendment, is the property right of a regulated

business to earn a fair and adequate rate of return. See,

- D Light Co. v. Barasch, 488 U.S. 299, 308

(1989). The New Jersey court in this case ignored this right

through the establishment of a takings rule certain to

eviscerate any constitutional check on rate regulation.

Review and reversal in this case will allow this Court to

reestablish Fifth Amendment rights and clarify the

constitutional takings standard in rate regulation.

The New Jersey court held that the constitutional

review of a regulated rate need not consider the regulated

firm's cost of capital, even though recovery of cost of

Capital -is critical to the long-term survival of any business.

Rather, the court held, it is sufficient to determine

confiscation by looking to an arbitrarily-selected nationwide

average rate of return. The New Jersey court's new

standard applies whenever the constitutional review takes

place in a retrospective proceeding, that is, whenever the

regulated firm already has suffered loss of revenue from the

regulation. This decision is an invitation to confiscatory

ratemaking nationwide.

A. Substitution of an Average-Rate-of-Return

Rule for the Constitutionally Mandated

Cost-of-Capital Standard Virtually

Guarantees Confiscation

With the present decision, New Jersey--long a leader

in insurance regulation--joins California, another bellwether

state, in discarding the cost-of-capital standard in the

constitutional review of ratemaking. The New Jersey court

in this case expressly relied on 20th Century Ins. Co. v.

Garamendi, 8 Cal.4th 216, 878 P.2d 566 (1994), cert.

dismissed, 115 S. Ct. 1085, cert. denied, 115 S. Ct. 1106

(1995), where the California Supreme Court held that the

opportunity to recover cost of capital is not a necessary

element of a constitutionally adequate insurance rate. These

leading decisions form a dangerous and unconstitutional

trend.

1. Loss of the Opportunity to Recover

Cost of Capital Undermines the

Financial Stability of Insurance

Companies and the Security That

Policyholders Purchase

The effect of a state-regulated rate that precludes a

company from recovering its cost of capital is more than

just a cost of doing business in a regulated environment.

Such regulation goes beyond a diminution in profits;

recovery of the cost of capital is necessary to the continuing

viability of any business. For this reason, a regulated rate

that guarantees that a business will not be able to recover its

cost of capital is a taking:

The compensation which the Constitution

guarantees an opportunity to earn is the

reasonable cost of conducting the business.

Cost includes not only operating expenses,

but also ital charges. Capital charges

cover the allowance, by way of interest, for

the use of capital, whatever the nature of the

security issued therefor; the allowance for

risk incurred; and enough more to attract

capital.

Southwestern Bell Tel. Co. v. Public Serv. Comm'n, 262

U.S. 276, 291 (1923) (Brandeis, J. concurring). Accord

Federal Power Comm'n v. Hope Natural Gas Co., 320

U.S. 591, 603 (1944).

The opportunity to recover cost of capita! is part of

the Fifth Amendment's minimum constitutional guarantee to

any regulated firm. A state cannot prevent a legitimate

enterprise from attempting to stay in business; without the

opportunity to recover its cost of capital, no business can do

so. A regulated rate that prevents a firm from recovering

cost of capital is a taking, however, long before the firm is

driven to tcy. A firm that cannot recover its cost of

capital, by that fact alone, suffers "the sort of deep financial

hardship described in Hope.” Jersey Cent. Power & Light

Co. v. FERC, 810 F.2d 1168, 1181 n.3 (D.C. Cir. 1987)

(en banc).

An insurance company, like any other business, is

an investment. Those who supply capital to the firm do so

with the expectation that they will receive a return on their

investment. There is a market for such capital. The

decision to invest capital in any particular business will be

based on the expected rate of return and the risk involved.

The cost of capital describes the rate of return a

business must produce to attract capital in a competitive

market: The cost of capital, sometimes called the

. nity cost of capital,” is the expected rate of return

available from other investments with comparable risk.

Richard A. Brealey & Stewart C. Myers, Principles of

Corporate Finance 13 (4th ed. 1991). See also Hope, 320

U.S. at 603 ("the return to the equity owner should be

commensurate with returns on investments in other

enterprises having corresponding risks"). It is an

opportunity cost because the cost of capital is the

opportunity foregone by investing in one investment rather

than another. If a business is not expected to produce a rate

of return at least comparable to that available from other

investments with similar risk, capital will flow away from

that business into superior investments.

It is not enough that a business make a profit; the

rate of return must be sufficiently high to warrant the risk

that capital investors face or they will put their money

elsewhere. The riskier the business, the higher the rate of

return the business must produce to attract capital.

Insurance is by definition a risky business; future

uncertain events are an insurance company's stock in trade.

Insurance companies must make a profit comparable to

other risky investments. The New Jersey Court concluded

that State Farm's low 3.4 percent rate of return in 1990--

which the court acknowledged was the product of the state-

imposed surtaxes and assessments--was within the range of

constitutional fairness. Pet. App. 25a, 26a, 31a. Buta rate

of return limited by government regulation to 3.4 percent is

plainly insufficient in a market (in 1990) where investors

could earn more than twice that much by investing in risk-

free government securities. An insurance investor faces the

significant risk of losing capital to future unforeseen events

against which the company has insured, and must be

compensated accordingly. The cost of capital takes into

account the riskiness of the business. The regulatory

scheme New Jersey court approved ignores risk and ignores

the certainty that investors will move capital into safer

investments or into investments of comparable risk with a

higher rate of return. .

An insurance company's primary capital is the funds

that stand behind its ability to pay claims and meet the

demands of unexpected events. When catastrophes occur,

claims must be paid from this surplus. The insurance

company must replace that capital if it is to continue to

operate and support its policyholders. But if a state has

mandated that a company cannot charge rates sufficient to

cover the cost of capital, new capital may not be

forthcoming.

Even in the absence of unforeseen disasters, a

company unable to recover its cost of capital eventually will

find its capital going elsewhere. Mutual companies like

State Farm, which pay out profits in the form of dividends

to policyholders, will lose policies. Stock companies that

cannot cover their cost of capital will see the value of their

stock drop, making it far more difficult to raise capital

through loans and the issuance of new securities. A

company guaranteed not to make its cost of capital will

ae a cycle of lost capital that will significantly impair the

The decline in capital that results from a

confiscatory regulated rate imposes heavy costs on

policyholders as well as on the owners of insurance

companies (in the case of mutual companies, they are the

same). When an insurance company loses its surplus

capital, its ability to handle future losses is diminished. The

enterprise becomes riskier for policyholders, both in New

Jersey and in every other state in which the company writes

policies. In the insurance industry, this is fatal risk, for the

stability of the firm and its ability to stand behind its

policies is the protection that policyholders purchase. What

is taken in such a case is not only the property of the

insurance company, but the security of policyholders.

2. The New Jersey Court's Average-

Rate-of-Return Rule Bears No

Relation to the Constitutionally

Mandated Fair Rate of Return and

Will Create a Downward Spiral

Toward Greater Confiscation

As the prior discussion demonstrates, the cost of

capital measures in economically meaningful terms a firm's

ratemaking property interest. The New Jersey court

discarded this standard, concluding without any asserted

justification that the nationwide annual average rate of

return for private passenger automobile insurance

establishes a reasonable rate for constitutional purposes.

The New Jersey court's standard is woefully inadequate.

An as-applied takings analysis must adequately

incorporate the myriad factors that affect property values.

Yet the New Jersey court here concluded that it could assess

confiscation of a particular company's business in New

Jersey by looking at the average property of all insurance

companies nationwide. It is as if the New Jersey court held

that adequate compensation for condemnation of a home in

an upscale New Jersey suburb is the average price of homes

nationwide. Such a blunderbuss approach will capture the

particular property interest at stake only by sheer luck.

The nationwide average rate of return ignores all of

the local variables that determine a firm's protected

property interest. A national average does not reflect, for

example, the dramatic differences in automobile insurance

environments across the country. Between-state differences

in weather conditions, quality of roads, speed limits, traffic

law enforcement, age of drivers, and regulatory

environment all can and do affect automobile insurance

rates of return. These variables will be reflected in an

insurance company's cost of capital, but are washed away

in a national average.

While the national average rate of return is too crude

an instrument for proper takings analysis, it is also too

narrowly focused to account for the extreme volatility in the

automobile insurance market. A one-year average is a

snapshot; it does not reflect the rapid fluctuations in the

conditions for insurance that occur over time. For

example, the national average rate of return on net worth

for private passenger automobile insurance between 1985

and 1994 varied from a low of 4.5 percent in 1985 to 14.3

percent in 1992. National Association of Insurance

Commissioners, Report on Profitability by Line by State in

1994 § 4, p.8 (October 1995). A low average in any one

year could well reflect a particular event, like the recent

Blizzard of '96, that produces large liabilities for insurance

companies in particular states and pushes the national

average rate of return well below the cost of capital. A

regulated rate tied to the national average that forces an

insurance company in essence to absorb liabilities to which

it was not actually subject, is a taking.

Perhaps the most pernicious aspect of the New

Jersey court's average-rate-of-return rule is that it makes no

allowance for the fact that every state in the Union regulates

automobile insurance. The national average rate of return

therefore reflects regulated rate reductions in other states.

Each of these regulated rates is, of course, itself subject to

constitutional attack. Yet the New Jersey court has ruled

that a state may prevail against such an attack if it regulates

insurance rates, and therefore insurance company rates of

return, down to the same level as other states: "The

‘takings’ clause requires no remedy where the effect of

price regulation has been to reduce actual return to the

industry average.” Pet. App. 23a. In other words,

confiscation is allowed as long as everyone else is doing it.

Such reasoning, if adopted in other states, poses the real

danger of driving regulated insurance rates well below the

level of confiscation with no constitutional check.

B. In Justifying Its New Rule by the

Retroactive Nature of the

Below, the New Jersey Court Has Supplied

a Road Map for Confiscation

The New Jersey court purported to limit application

of its new takings rule to cases in which the takings

determination is made after the challenged rate has been

used. This limitation in no way diminishes the importance

of this case. To the contrary, the possibility of retroactive

relief is a linchpin of several state regulatory schemes; it is

the very feature that protects these regulatory statutes from

facial invalidity. The confiscatory authority the New Jersey

rule gives to these states will motivate similar practices

throughout the Nation. Moreover, retroactive relief will be

mandated in numerous cases in which an as-applied takings

challenge is resolved after the effective date of the

challenged rate.

The New Jersey Fair Automobile Reform Act, N.J.

Stat. Ann. 17:33B-1 et seg. (West 1996), which underlies

petitioner's takings challenge in the present case, is one of

several insurance reform statutes enacted by various states

in recent years. See, e.g., Cal. Ins. Code § 1861.01 (West

1996); Haw. Rev. Stat. § 431:10C-202.5 (1995); 1989

Nev. Stat. ch. 784, invalidated, Guaranty Nat'l Ins. Co. v.

Gates, 916 F.2d 508 (9th Cir. 1990); 75 Pa. Cons. Stat.

Ann. § 1799.7 (1995); Tex. Ins. Code Ann. art. 5.131

(West 1996). All of this reform has attempted to force a

reduction in insurance rates, generally through mandated

rollbacks. The New Jersey Act also attempts to maintain

low insurance rates for high-risk drivers through

unrecoverable surtaxes and assessments against insurance

companies. Not surprisingly, these blunt instruments have

brought takings challenges from the affected insurers. See,

e.g., Calfarm Ins. Co. v. Deukmejian, 48 Cal.3d 805, 771

P.2d 1247 (1989); State Farm Mut. Auto. Ins. Co. v. State

of New Jersey, 590 A.2d 191 (N.J. 1991); Guaranty Nat'l,

916 F.2d 508; Nationwide Mut. Life Ins. Co. v. Foster, 739

F. Supp. 962 (M.D.Pa. 1990).

Facial challenges are “the most difficult challenges

to mount successfully, since the challenger must establish

that no set of circumstances exists under which the [statute]

would be valid." United States v. Salerno, 481 U.S. 739,

745 (1987). Facial takings challenges to insurance reform

legislation, accordingly, have tended to fail, with courts

holding that the statute or regulations at issue allow an

individual insurer to obtain relief from confiscatory rates in

a later as-applied challenge. The purported relief often is to

be determined retroactively. Thus, a federal district court

noted that the Pennsylvania statute provided a

“constitutional safety valve" by which the Insurance

Commissioner could provide “retroactive relief in the future

if rates resulting from [the insurance reform statute] are

insufficient." Nationwide, 739 F. Supp. at 964. The

California Supreme Court struck a portion of California's

insurance rollback legislation, but allowed the rollbacks to

go forward with assurances that insurers would be protected

from confiscatory rates. Calfarm, 48 Cal.3d at 822. The

ensuing retroactive rate hearings resulted in the California

Supreme Court's rule that cost of capital is not a nag

element of takings review in a retroactive proceeding. 20t

Century, 8 Cal.4th at 292-97.

The present case is, of course, another example:

The New Jersey Supreme Court in 1991 rejected State

Farm's claim that the new surtaxes and assessments would

produce confiscation, dispatching State Farm to the

retroactive proceedings from which it now seeks review.

State Farm, 590 A.2d at 207. When State Farm

demonstrated in those proceedings that the surtaxes and

assessments produced precisely the effect State Farm had

predicted, the Insurance Commissioner and appellate court

changed the rules.

Retroactive relief is critical to the maintenance of

minimal constitutional protections from confiscatory

insurance reform legislation. If a court or administrator

refuses to t up-front relief in a takings challenge, the

regulated must be assured of the protections of the

Hope cost-of-capital standard when constitutional review

eventually takes place. The New Jersey Supreme Court in

1991 relied heavily on the cost-of-capital standard in

defense of the theoretical protections offered by the New

Jersey insurance reform statute. State Farm, 590 A.2d at

199, 206. The New Jersey appellate court then discarded

that standard in practice, effectively eliminating meaningful

constitutional review. Review by this Court is necessary to

maintain the constitutional standard in retroactive cases.

The prevalence of retroactive takings review extends

beyond challenges to insurance reform legislation. In any

case in which an insurance commissioner rejects an

insurer's filed rate in favor of a lower rate, the insurer may

have a takings challenge. If, as is the case in some states,

the insurer is forced to use the rate approved by the

commissioner, or an interim rate, during the pendency of

the takings challenge, the reviewing agency or court will be

faced with a retroactive determination. If the decision

maker determines that the insurer is entitled to a higher

non-confiscatory rate going forward, the insurer also will be _

entitled to relief for the period of the Rigo ogg taking"

while the ved or interim rate was in effect. See First

English, 483 U.S. 304 ("temporary" taking later found

unconstitutional requires compensation). The “retroactive

takings analyses" of the New Jersey court in the decision

below, and of the California court in 20th Century, will be

applicable in each such case.

The teaching of this case and of the 20th Century

decision is that a state may implement draconian insurance

reform, or any other reduction in insurance rates, with no

relief for insurers, by relegating insurers to retroactive

review where constitutional standards will not apply. State

legislatures considering insurance reform, and state

insurance commissioners promulgating regulations, surely

will heed the lesson.

CONCLUSION

For the foregoing reasons, the Court should grant

the petition for writ of certiorari and set the case for plenary

review.

February 5, 1996 Respectfully submitted,

Craig A. Berrington *William J. Kilberg

David F. Snyder Theodore J. Boutrous, Jr.

AMERICAN INSURANCE Mark Snyderman