Baker explains the malpractice insurance business:
Liability insurance goes through a boom-and-bust cycle. In the early years of the cycle, insurance companies take a pessimistic view of future losses and set aside more reserves than they need. Toward the end of the cycle, they take an increasingly optimistic view of future loses and don’t set aside enough reserves. As a result, they begin charging prices that are too low in relation to the risk. Because medical malpractice claims take so long to resolve and contain such a high percentage of high-value claims, the shortfalls in the reserves to pay medical malpractice claims accumulate over a number of years. When the insurance climate shifts back toward a pessimistic view of future losses, insurance companies need to increase their reserves, sometimes quite dramatically to make up for the underreserving of the past, and prices rise accordingly. This means the swings of the malpractice insurance cycle are more dramatic for medical malpractice insurance than for most other kinds of insurance.The key here is that the market is fairly unpredictable and susceptible to drastic price increases. Premiums increased substantially in 2002 as the insurance market realized it had undervalued the claims it would pay out, the stock bubble burst, and interest rates declined.
But doctors are poorly equipped to deal with price increases in malpractice insurance. That's because income and pricing for doctors is fairly inelastic -- their hands are tied at many levels -- hospitals, managed care organizations, and government payments. In these cycles, some doctors will have a difficult time affording malpractice insurance, especially small practices.
Besides doctor's inability to absorb premium increases, the current system doesn't do enough to prevent injury. The fact is, the vast majority of patients injured do not sue. Doctor's have a strong incentive to hide malpractice, and due to the complicated nature of medical practice, most families don't know if something went wrong. And some sue just to find out what really happened.
The malpractice insurance industry as it exists doesn't make sense. Business-wise, insurers must predict their costs up to 10 years before they're incurred and the industry is very susceptible to changes in medical practice, the market, and the number of lawsuits (which has remained fairly steady so far). For doctors, it causes pain when premiums increase and it fails to provide a sufficient incentive to reduce error. For patients, it discourages full compensation for injury. It's a bad deal all around.