TORT LIABILITY COSTS
For Small Business
MAY 2007
In many ways, small businesses are the lifeblood of the U.S. economy. They generate the majority of new jobs, employ over half of those workers who are in the private sector, and they are a wellspring of innovation, from which new products and services and even new industries grow. In 2004, the U.S. Chamber Institute for Legal Reform commissioned NERA Economic Consulting to quantify the cost of tort litigation to small businesses. That study has been widely cited by policy analysts and policy makers. In the interest of providing data that is current, ILR has commissioned an update on small business tort costs from NERA Economic Consulting. (Note: the 2004 study, using the most recent available data, was based on 2002 figures; this update is based on 2005 data.) The results show that small businesses continue to bear a significant share of tort costs.
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The annual tort liability price tag for small businesses has grown from $87 billion in 2002 to $98 billion in 2005, an increase of 13 percent. For purposes of this study, small businesses are defined as those with less than $10 million in annual revenues and at least one employee in addition to the owner. Small businesses bear 69 percent of business tort liability costs but take in only 19 percent of business revenues. This is up from 2002, when small businesses paid 67 percent of tort liability costs on 19 percent of revenues. The cost of the tort system to individual small businesses is $20 per $1,000 of revenue. In other words, a small company with $1 million in annual revenues will pay, on average, $20,000 in annual tort related costs. Small businesses pay $20 billion of their tort costs out of pocket, as opposed to through insurance. This is up from $18 billion in 2002. Very small businesses, those with less than $1 million in revenues, pay $31 billion in tort liability costs, but take in only 6 percent of business revenues. This amount is unchanged since 2002, reflecting a decrease in the proportion of liability costs borne by these businesses from 24 percent to 21 percent, and a corresponding increase in the share borne by larger small businesses.
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TORT LIABILITY COSTS FOR SMALL BUSINESSES
Written by Judyth W. Pendell
Senior Fellow, AEI-Brookings Joint Center for Regulatory Studies
Liability cost analysis conducted by Paul J. Hinton
Vice President, NERA Economic Consulting
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Introduction
In many ways, small businesses are the lifeblood of the U.S. economy. According to the U.S. Small Business Administration, they employ over half of all private sector employees and pay more than 45 percent of the total U.S. private payroll. Over the past decade, small businesses annually have generated 60 to 80 percent of the net new jobs and have created more than 50 percent of the non-farm private domestic product (GDP). Small businesses support a large portion of the technical expertise in this
a decade. They have described a continuing emergence and growth of innovative small companies on the heels of the post World War II economy in which large firms dominated, as they continue to dominate in Western Europe and Japan. Of course, large, well-established firms play important roles today through mass production and incremental improvements in “radical innovative breakthroughs.” But, it often takes the entrepreneurial small businesses to generate the “radical” innovation.
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The leaders of small businesses inspire country. They employ 41 percent of all the highest level of public confidence. A high tech workers, including scientists, engineers, and computer workers.
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February 2007 Harris poll examined the level of U.S. adults’ confidence in the lead-
Many small businesses are on the front lines of innovation. As our economy evolves into an ever more entrepreneurial form of capitalism, they become more and more central to economic growth. The Ewing Marion Kauffman Foundation has been supporting basic research into innovation and entrepreneurship for over
ers of 16 major institutions. Harris interviewed over 1,000 respondents representing a cross section of the U.S. adult population. Small business leaders emerged in first place, with 54 percent of respondents saying they have a “great deal” of confidence in the leaders of small business. (The military followed in second place with
1 U.S. Small Business Administration, “FAQs: Frequently Asked Questions” available online at: http://app1.sba.gov/faqs/faqindex.cfm?areaID=24 2 Ewing Marion Kauffman, “On the Road to an Entrepreneurial Economy: A Research and Policy Guide,” pp. 4-5, February 26, 2007. 3 Harris Interactive, “Confidence in Leaders of Major Institutions”, The Harris Poll #19, February 27, 2007.
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46 percent and major educational institutions came in third with 37 percent.)
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ment. These programs provide support such as assistance with financing or training in business management. Some offer special forms of tax treatment and debt relief. They reflect a broad consensus that small businesses are valuable to the economy and are to be nurtured.
In recognition of the importance small businesses play in the health of the U.S. economy, policymakers have enacted, over many years, programs that protect and encourage small business develop-
Estimated Distribution of the Number of U.S. Businesses in 2005
3M
2.5M
2M
1.5M
1M
500K
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Although considerable attention has been paid to the regulatory burdens that small businesses bear, there has been little focus on the costs the liability system imposes. Although some liability costs represent legitimate lawsuits by parties
who have been injured by the activities of the businesses they sue and who seek to recover reasonable compensation for their injuries, there is unquestionably a great deal of waste and excess in the civil justice system. This may take the
Estimated Distribution of the Size of U.S. Businesses in 2005
$12T
$10T
$8T
$6T
$4T
$2T
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Liability Costs
2005 Estimates of Number and Size of Businesses1
Business Category < $1 Million $1M to $4.9 Million $5M to $9.9M < $10M $10M to $50M > $50M Overall Number of Businesses 4,723,364 952,197 145,092 5,820,653 128,913 32,545 5,982,111 Revenues $1.472T $2.256T $1.140T $4.868T $2.979T $18.401T $26.248T Percent of Revenues 6% 9% 4% 19% 11% 70% 100%
Estimated 2005 Business Liability Costs
Insured Costs2 $20.5B $46.8B $10.4B $77.7B $11.8B $5.7B $95.2B Self Insured or Uninsured3 $10.1 $7.1 $2.9 $20.2 $8.8 $18.7 $47.7 Total
Insured Costs + Self or Uninsured
% of Total Costs 21% 38% 9% 69% 14% 17% 100%
Liability Costs per $1K of Revenues
(Total ÷ Revenues) x 1,000
$30.7 $53.9 $13.4 $97.9 $20.6 $24.4 $142.9
$20.84 $23.88 $11.74 $20.11 $6.91 $1.33 $5.44
Sources: Marsh Commercial Business Center, San Antonio, account data; Marsh Global Placement data (BASYS); MarketStance data; A.M. Best “Best’s Aggregates & Averages,” 2006; 2002 Economic Census: Enterprise Statistics; Tillinghast-Towers Perrin, “U.S. Tort Costs: 2006 Update.” 1. The aggregate number of businesses in 2005 was estimated from US Census payroll statistics by increasing the published 2004 value at the growth rate observed between 2003 and 2004. The aggregate revenues were estimated using US Economic Census data on 2002 Sales and Receipts (i.e. revenues) increased at the growth rate observed in GDP. The distribution of the number of businesses and revenues by revenue category was held constant based on the distributions observed in the most recent US Economic Census (2002). In this analysis, businesses are defined as enterprises with payroll. There were 801,000 non-employer businesses in 2004 (based on US Census payroll data) that were excluded by this definition. 2. The insured costs by revenue category are estimated by NERA using data from Marsh, Inc. on insurance purchases by particular businesses. Aggregate values are scaled to match aggregate premiums reported by A.M. Best for 2006 (adjusted to exclude Canadian exposure.) 3. Uninsured costs are estimated as a multiple of the insured liability costs. Insured liability costs are estimated by multiplying premiums by the combined ratio reported by A.M. Best for 2005. The distribution of premiums by revenue category is estimated by NERA using data from Marsh, Inc. on insurance purchases by businesses of different sizes. Premiums are scaled to match the aggregate values reported by A. M. Best for 2005. The percent of costs uninsured is obtained from MarketStance. Values are scaled to match aggregate uninsured cost estimates reported by Tillinghast.
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form of frivolous or meritless claims, coercive pressure to settle, excessive damage verdicts, and the often exorbitant cost of defending against a lawsuit, to name just some of the forces that drive the waste and excess. These costs are a drag on the businesses that bear them. As a first step in understanding the impact of the costs of the tort system on small businesses, the Institute for Legal Reform at the U.S. Chamber commissioned in 2004 a study of such tort costs from NERA Economic Consulting. This 2007 report is an update of that study.
were businesses with annual revenues of $10 million or less. The 1992 Census reported 4.6 million business entities with 4.5 million—or 98 percent— having annual revenues of $10 million or less. NERA estimates that in 2005 there were 6.0 million business entities with 5.8 million—or 97 percent— having annual revenues of $10 million or less. The small business cost estimate conducted by NERA is based primarily on three data sources:
Tillinghast “2006 Update on U.S. Tort Cost Trends”—Since 1985
Tillinghast, an actuarial consulting
Tort Liability Costs for Small Business
For purposes of this study, small businesses are defined as those with $10 million or less in annual revenues and with at least one employee in addition to the owner. The majority of business entities are in this size bracket. According to the 2002 Census, of the total 5.7 million U.S. business entities with payroll, 5.5 million—or 97 percent—
firm, has published an annual estimate of insured and self-insured tort costs. The Tillinghast estimate of total tort costs in 2005 is $261 billion, with $143 billion falling on businesses. These costs do not include medical malpractice, personal liability, or workers compensation. They also do not include indirect costs, such as those incurred to avoid litigation, and court costs, such as filing fees. They do
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include: amounts paid or expected to be paid (incurred losses) to third parties, defense costs, and insurance company administrative expenses.
MarketStance—Estimates of costs not
covered by insurance were obtained from MarketStance, a market research firm specializing in insurance. Small business tort liability costs have the following components:
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Marsh, Inc.—A major insurance brokerage firm, Marsh, Inc. had proprietary data on actual liability insurance pur-
Settlements, awards, and defense costs paid directly by uninsured businesses;
chases by businesses.
Small business share of tort liability costs*
* Size of Businesses in Revenues (2005 revenues estimated by increasing 2002 values at the rate of GDP growth)
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Liability insurance premiums and costs incurred by insurance companies on behalf of policyholders;
NERA’s findings for 2005 tort costs to small businesses are as follows:
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The tort liability price tag for small businesses in America was $98 billion.
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Liability insurance deductibles; Damages excluded from insurance policies;
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Small businesses bore 69 percent of business tort liability costs, but took in only 19 percent of business revenues.
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Damages exceeding policy limits; and
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Punitive damages in states where they cannot be insured.
The cost of the tort system to individual small businesses was $20.11 per $1,000 of revenue.
Liability Cost Study, 2002 vs. 2005
Revenue Categories
< $1M $1M to $4.9M $5M to $9.9M < $10M $10M to $49.9M > $50M Overall 2002
Total Business Revenues
$1,237 $1,896 $958 $4,091 $2,504 $15,467 $22,063 2005 $1,472 $2,256 $1,140 $4,868 $2,979 $18,401 $26,248
Total Liability Cost
$30 $44 $12 $87 $17 $25 $129 $31 $54 $13 $98 $21 $24 $143 24% 34% 10%
Percent of Total Costs
21% 38% 9% 69% 14% 17% 100%
Liability Cost per $1,000 Revenues
$24.50 $23.14 $12.88 $21.15 $6.89 $1.61 $5.83 $20.84 $23.88 $11.74 $20.11 $6.91 $1.33 $5.44
67% 13% 19% 100%
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Small businesses paid $20 billion of their tort costs out of pocket as opposed to through insurance.
These findings compare to the 2002 data in the previous small business tort cost study as follows:
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Very small businesses (those under $1 million in revenues) paid $31 billion, or 21 percent of tort liability costs, but took in only 6 percent of business revenues.
The total tort liability costs for small businesses has increased 13 percent since 2002, from $87 billion to $98 billion.
Percent of Tort Liability Cost Borne by Businesses of Equal or Lesser Size: 2005 vs. 2002*
< $100K $100K$250K
$100K- $250K- $500K- $1M$500K $500K $1M $2.5M
$1M$5M
$2.5M- $5M$5M $10M
$10M$25M
$10M- $25M- $50M- $100M- $250M- $500M$50M $50M $100M $250M $500M $1B
$1B- > $2.5B $2.5B
* Size of Businesses in Revenues (2005 revenues estimated by increasing 2002 values at the rate of GDP growth)
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In 2002, small businesses bore 67 percent of business tort liability but took in 19 percent of revenues. In 2005, the portion of tort liability costs increased to 69 percent on 19 percent of business revenues.
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Out of pocket tort costs to small businesses in 2002 were $18 billion. Those have increased to $20 billion.
It is interesting to note on Tables 4 and 5 that, if we add the tort costs borne by medium sized businesses (those from $10 million to $49.9 million) to those borne by small businesses, together they bear 83 percent of all tort liability costs.
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The cost to individual small businesses was $21.15 per $1,000 in 2002. It decreased to $20.11 per $1,000 in 2005.
Tort Liability Cost by Size of Business, 2005 vs. 2002
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Most small businesses buy liability insurance to protect themselves from lawsuits. Although only half of the smallest businesses, those under $100,000 in revenues, buy insurance, an average of 95 percent of businesses buy insurance if they are over $100,000 and under $10 million in
revenues. The data don’t provide any detail on the amount or type of liability coverage purchased, i.e., we don’t know the specific coverages, policy limits, deductibles, or exclusions. We can see, however, the extent to which companies are entirely self-insured.
Average Tort Liability Cost by Size of Business, 2005 vs. 2002
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Estimated Proportion of Businesses Buying Insurance
Revenue Categories
< $100K $100K - $499K $500K - $999K $1M - $4.9M $5M - $9.9M $10M - $49.9M $50M - $99.9M $100M - $249M $250M - $499M $500M - $999M $1B - $2.5B > $2.5B
Conclusion
Small businesses play a central role in the health of the U.S. economy and Americans have a stake in protecting
Insured Proportion
0.50
them from the wasteful and excessive 0.92 0.98 reforms at the state and federal level 0.97 0.94 0.85 0.66 0.54 0.53 0.45 0.42 .44 should be considered and passed into law. costs that are part of the tort litigation system. Meaningful, common sense
Source: Insured proportion from MarketStance
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Technical Appendix
Explanation of the Analysis Performed for this Study Business liability costs are
estimated using data on actual insurance purchases for customers of Marsh, Inc. (“Marsh”) combined with estimates of the fraction of costs that are uninsured from MarketStance. U.S. census data are used to scale up the average costs for the sample of businesses to estimate the costs for the U.S. economy as a whole.
using samples of insurance customers from Marsh. These samples of data correspond to separate brokerage operations of Marsh that focus on small businesses and larger businesses. The proportion of all businesses that buy liability insurance (either general liability or specialized liability lines) is assumed to equal the proportion of liability costs that are insured (estimated by MarketStance.) The proportion of businesses that buy umbrella or automobile lines is estimated as a fraction of the proportion buying liability
Estimating Liability Costs Average insurance costs per $1,000 in business revenues for businesses of different sizes are
lines. The appropriate fractions are estimated using Marsh account data by comparing multiplied by the aggregate revenues of the number of businesses in each size cateall businesses of the same size in the U.S. gory that buy umbrella or automobile lines economy and the estimated proportion of to the number that buy liability lines (either businesses buying liability, general liability or specialized liability lines). umbrella/excess and commercial automobile lines of insurance. These aggregate values are scaled by a calibration factor such that the total premium cost equals the value reported by A.M. Best for premiums earned in 2005. The actual costs of insurance to busicost of paying losses and administering nesses of different sizes were analyzed Total insurance costs are calculated by adjusting premiums earned by the combined ratio for the corresponding lines reported by A.M. Best for 2005. The combined ratio is a standard financial ratio used by insurers to express the
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policies as a percent of the premium revenue they earn. By adjusting liability premium data by the combined ratio, we estimate total insured costs associated with liability losses. The total liability costs consist of insurance costs and costs associated with uninsured and self-insured out-of-pocket costs. The proportion of liability costs that are uninsured or self-insured by businesses themselves is estimated by MarketStance for businesses in different revenue size categories.
s General Liability; s Builders Risk; s Directors & Officers Liability; s Employment Practices Liability; s Fiduciary Liability; s Liquor Liability; s Professional Errors & Omission; s Professional Liability.
Combining Insurance Data from Different Samples Small business data
were obtained from the Marsh Commerical Business Center in San
Lines of Insurance analyzed in this study Insurance lines used in this analysis consist of commercial liability lines (the components of which are described below), liability umbrella or excess liability, commercial automobile lines and liability components of packaged products including commercial multi-peril and business owners policies. Commercial liability lines include many specialized lines. For the purposes of this study, we used the largest lines that together constituted 90 percent of commercial liability total premiums. These lines consist of:
Antonio (“San Antonio data”). These data consist of a sample of packaged and mono-line policies serviced through its Marsh Commercial Business Center. The data for larger businesses consist of Marsh’s global placement clients of Marsh’s Casualty practice and its Finpro practice, which places Directors & Officers Liability, Professional Services Firm Indemnity, Error & Omissions and other professional liability lines. These data reside in Marsh’s BASYS database. See below for a description of how these samples were combined.
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When this study was conducted using 2002 data, Marsh’s middle-market clients were largely served through its Tampa operation, which has since been restructured. The middle market clients differ in risk profile from Marsh’s global placement clients. In the absence of data for these middle-market clients, we estimated their average premium costs as a multiple of either the smaller San Antonio accounts or the larger global placement accounts (BASYS data) based on the observed relationship in the 2002 data. Specifically, for the revenue segments from $100 to $999 thousand, we calculated the proportion of average premium cost per $1,000 in revenue for the 2002 San Antonio data to the 2002 Tampa data, and applied that proportion to the 2006 San Antonio data. For the revenue segments from $1 to $250 million, we calculated the proportion of average premium cost per $1,000 in revenue for the 2002 BASYS data to the 2002 Tampa data, and applied that proportion to the 2006 BASYS data.
Data from the San Antonio sample, the estimated middle-market sample, and the global placement database are combined to create weighted average estimates of insurance costs for each size category. The San Antonio accounts consist principally of businesses’ with between 10 and 25 employees. Typical businesses accounts are estimated to have less than $500 thousand in revenues although some accounts have revenues as high as $2.5 million. These accounts mainly buy packaged policies. The majority of the smallest accounts buy Business Owners Policies (BOP) which typically combine property, general liability and auto cover. The San Antonio data includes aggregate statistics for approximately 8,300 accounts. About 7,000 smaller accounts are serviced by The Hartford and have average premiums of about $3,000. About 1,300 accounts, which are serviced by Marsh, have average premiums of about $10,000 (excluding workers compensation premiums). We assume for accounts that buy packaged policies
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that the same fraction of premiums is attributable to each line (liability, auto, umbrella and property) as for those accounts purchasing mono-line policies. The middle-market accounts consist principally of businesses with between $500 thousand and $50 million. The 2002 sample consisted of over 3,000 open accounts with average premiums of $60,000 (median $36,000). Global Placement accounts consist principally of businesses with more than $1 million in revenues. These more than 8,000 accounts have average liability premiums of $400,000. For businesses with revenue less than $100 thousand, values are calculated using packaged account data from San Antonio data. For businesses with revenues between $100 thousand and $999 thousand, values are calculated as the weighted average of non-packaged account data from San Antonio sample and the corresponding size accounts from the estimated middle-market data. For business with revenues between $1 mil-
lion and $250 million, values are calculated as the weighted average of estimated middle-market data and Global Placement data. For businesses with revenues greater that $250 million, values are calculated using the Global Placement data.
Aggregate U.S. Insurance Premiums
A.M. Best publishes Best’s Aggregates & Averages Property/ Casualty United States & Canada each year, in which aggregate premiums are calculated from insurance companies’ regulatory filings (see Exhibit of Premiums and Losses). Lines of insurance (as classified by A.M. Best) that are relevant to this study are 1) the liability portion of Commercial multiple peril lines, 2) Products liability lines, 3) Other liability lines, and 4) other commercial auto liability lines excluding no-fault lines. Other liability lines includes general liability, and includes the other specialized lines analyzed using the Marsh data i.e. pollution legal liability; directors & officers liability; professional services firm indemnity; error & omissions; employment practices liability; fiduciary liability.
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Tillinghast-Towers Perrin publishes “Update on U.S. Tort Cost Trends” each year in which it estimates total costs of the U.S. tort system. We use Tillinghast, along with the A.M. Best, to scale the costs reported by the Marsh clients to match these aggregate national estimates.
The 2002 Census reports data on number of businesses of different size measured in terms of their sales and receipts (i.e., revenues). We use these data to create aggregate estimates of tort costs based on the costs of insurance to businesses with different levels of revenues. The aggregate number of businesses in 2005 was estimated from US Census payroll statistics by increasing the pub-
Estimating Businesses’ Revenues in the U.S. Economy We use data from the
U.S. Economic Census for year 2002.
Study of 2002 Business Revenues
Revenue Categories
< $100K $100K - $499K $500K - $999K $1M - $4.9M $5M - $9.9M $10M - $50M > $50M Total Business Revenues
Estimation of 2002 Study
$129 $1,025 $850 $2,605 $1,347 $3,331 $14,590 $23,876
Actual Census Data
$64 $597 $576 $1,896 $958 $2,504 $15,467 $22,063
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lished 2004 value at the growth rate observed between 2003 and 2004. The aggregate revenues were estimated using US Economic Census data on 2002 Sales and Receipts (i.e. revenues) increased at the growth rate observed in GDP. The distribution of the number of businesses and revenues by revenue category was held constant based on the distributions observed in the most recent US Economic Census (2002). In this analysis, businesses are defined as enterprises with payroll. There were 801,000 non-employer businesses in 2004 (based on US Census payroll data) that were excluded by this definition.
Census at the time. The 2002 Economic Census data is now available and reveals where our estimates of the size of each of the revenue categories was inaccurate. We have revised the business revenues in our 2002 study to reflect the Economic Census values. We use these revised 2002 revenue estimates in comparing our 2002 results to our 2005 results. Consequently the 2002 results reported in this study will not match the values in the original study. The table below presents our original estimates of business revenues by revenue category for the 2002 study and the actual data from the 2002 Economic Census. The figures below are in billions of dollars.
Revisions to the 2002 Study When this
study was conducted using 2002 data, the 2002 United States Economic Census had not yet been completed. For this reason, we had to base our estimates of 2002 business revenues on aggregate data for all business reported for 2001, and data on the distribution of companies by revenue category in 1992, which was the most recently released Economic
Limitations of the Study The data
sources used for this analysis imposed limitations. The validity of the study results depends on the following assumptions that:
s The distribution of the number of
businesses and of sales and receipts by enterprise for 2002 is representative of the current distribution;
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s The number of businesses grew
bility or specialized liability lines) is proportional to the liability costs that are insured as estimated by MarketStance;
s The proportion of Marsh accounts
between 2004 and 2005 at the same rate as reported in US Census payroll data between 2003 and 2004;
s Between 2002 and 2005, busi-
ness revenues in each revenue category have increased at the rate of GDP growth;
s Marsh account data consist of a
buying specific lines and the associated costs for businesses within each size category (after calibration) is representative of typical insurance purchases;
s MarketStance estimates of unin-
representative mix of accounts of different sizes;
s From 2002 to 2006, the data for
sured/self-insured costs for businesses of different employee size categories accurately represent the uninsured/self-insured costs of businesses with corresponding average revenues;
s Costs associated with first party
Marsh’s middle-market clients remained in a constant proportion to the data for Marsh’s brokerage operations that deal with smaller companies for the revenue segments from $100 to $999 thousand, and larger companies for the revenue segments from $1 million to $250 million;
s The fraction of businesses that buy
losses do not represent a material proportion of the liability costs covered by the liability insurance lines included in the study.
liability insurance (either general lia-
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About the Authors
Paul J. Hinton is a Vice President of NERA Economic Consulting. He directs projects in
the economics of product liability, mass torts, regulation, antitrust, commercial damages and securities litigation. He has testified as an expert witness in civil litigation and in legislative committee. Hinton received his B.A. in engineering science from Oxford University and his Masters in Public Policy from the John F. Kennedy School of Government at Harvard University.
Judyth W. Pendell is a senior fellow at the AEI-Brookings Joint Center for Regulatory
Studies and a consultant to several organizations, including the Institute for Legal Reform. She previously was director of the Center for Legal Policy at the Manhattan Institute and a visiting fellow at the Institute for Civil Justice at RAND. In 1996 she left Aetna, where she was a vice president in the department of Law and Regulatory Affairs, following 15 years of public policy work for that company. Pendell obtained a B.A. from Vassar College and an M.B.A. from Yale School of Management.
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