State Farm Lloyds v. Julia Rathgeber, in Her Official Capacity as Commissioner of Insurance Texas Department of Insurance And Office of Public Insurance Counsel

TEXAS COURT OF APPEALS, THIRD DISTRICT, AT AUSTIN

NO. 03-11-00322-CV

State Farm Lloyds, Appellant

v.

Julia Rathgeber, in her official capacity as Commissioner of Insurance;1 Texas Department
of Insurance; and Office of Public Insurance Counsel, Appellees

FROM THE DISTRICT COURT OF TRAVIS COUNTY, 201ST JUDICIAL DISTRICT
NO. D-1-GN-09-004048, HONORABLE TIM SULAK, JUDGE PRESIDING

OPINION

State Farm Lloyds appeals a district court judgment affirming a final order of the

Commissioner of Insurance determining that it had charged consumers homeowners insurance

premiums that were excessive for several years during the 2000s and ordering refunds with interest.

We will affirm the Commissioner’s order with respect to the first year at issue, but must reverse as

to the remaining years and remand for further proceedings. We also hold that there was reversible

error in the Commissioner’s award of interest on refunds he determined to be due.

1
We have substituted Ms. Rathgeber as successor to Mike Geeslin, who issued the order on
appeal. See Tex. R. App. P. 7.2(a) (requiring substitution of state officer’s successor when named
state officer ceases to hold office before final disposition of appeal).
 BACKGROUND

This appeal arises from the proceedings on remand this Court required in Geeslin

v. State Farm Lloyds (State Farm Lloyds I),2 and we will refer the reader to that opinion

for a comprehensive explanation of statutory context and procedural prologue. On remand, the

Texas Department of Insurance (TDI) noticed a “re-hearing” to determine whether the Commissioner

should affirm the reduction TDI had ordered in the “initial rate” State Farm Lloyds had filed under

former art. 5.26–1 of the Insurance Code,3 or require a greater or lesser reduction instead.4 The

Office of Public Insurance Counsel (OPIC) intervened. The hearing was ultimately conducted over

several days in 2009, and the record was closed in November of that year.

The State Farm Lloyds “rate” in dispute at the hearing referred to “the cost of

insurance per exposure unit . . . with an adjustment to account for the treatment of expenses, profit,

and individual insurer variation in loss experience, and before any application of individual

risk variations.”5 Former art. 5.26–1 required that the “initial rate” filed by State Farm Lloyds

and ultimately approved by TDI be “just, reasonable, adequate, not excessive, and not unfairly

discriminatory for the risks to which it applies.”6 These requirements, simply put, mean that an

2
255 S.W.3d 786 (Tex. App.—Austin 2008, no pet.).
3
Act of June 2, 2003, 78th Leg., R.S., ch. 206, § 4.01, 2003 Tex. Gen. Laws 907, 921
(“former art. 5.26–1”).
4
See former art. 5.26–1, § 4; State Farm Lloyds I, 255 S.W.3d at 800-01.
5
See Act of June 2, 2003, 78th Leg., R.S., ch. 206, §§ 1.01, 2(7), 2003 Tex. Gen. Laws
907–8 (“former art. 5.142”) (defining “rate”); former art. 5.26–1, § 1(b) (incorporating definitions
from former art. 5.142).
6
Former art. 5.26–1, § 2(b) (“Initial Rate Filing”); see also former art. 5.142, § 3
(requirements applicable to initial filed rates calculated by the insurer). Specific considerations in
setting this “rate” were to include “past and present loss experience”; “the insurer’s historical

2
insurer charges consumers a price sufficient to recover both its projected expenses of assuming risks

under its policy and a profit yielding a “reasonable” rate of return on its capital, but not a profit

“unreasonably” higher than this.7 The requirements also operate against a constitutional backdrop.

This Court has held—most recently in State Farm Lloyds I—that government-set rates are deemed

to effect an unconstitutional taking of an insurer’s property if the insurer cannot recover both its

projected “operating expenses” and a “reasonable rate of return” on its capital.8

In advocating their views of a reasonable rate that would comply with these statutory

and constitutional requirements, the parties, generally speaking, followed a common methodology

in which they calculated an “indicated” rate comprised of the sum of several specified categories of

premium, exposure, loss, and expense experience”; “catastrophe hazards within this state”;
“operating income”; “investment income”; and “a reasonable margin for profit.” Id. § 3(b).
7
See former art. 5.142, § 2(b) (defining “excessive,” “inadequate,” and “unfairly
discriminatory”); State Farm Lloyds I, 255 S.W.3d at 801 (construing “just, reasonable, adequate,
not excessive, and not unfairly discriminatory for the risks to which it applies” to mean that “the rate
must allow for a ‘reasonable profit’ but not one that is ‘unreasonably high in relationship to the
insurance coverage provided’”) (quoting former art. 5.142, §§ 2(b)(1–3), 3(d); former art. 5.26–1,
§ 2(b)); see also American Alliance Ins. Co. v. Board. of Ins. Comm’rs, 126 S.W.2d 741, 744
(Tex. Civ. App.—Austin 1939, writ ref’d) (reasoning that “unreasonable, unjust, excessive, or
inadequate” in context of insurance ratemaking implies “a duty both to the insuring public and the
insurance carriers” to promulgate rates “which shall be as low to the insured as is consistent with a
reasonable return to the insurer”).
8
State Farm Lloyds I, 255 S.W.3d at 795 (“A government-set rate must allow a regulated
company to not only recover its operating expenses, but also to realize reasonable returns on its
investments sufficient to assure confidence in the continued financial integrity of the enterprise. A
rate that does not allow for a reasonable rate of return is confiscatory and unconstitutional.” (citing
Duquesne Light Co. v. Barasch, 488 U.S. 299, 307 (1989); Jersey Cent. Power & Light Co.
v. Federal Energy Regulatory Comm’n, 810 F.2d 1168, 1181 (D.C. Cir. 1987); Railroad Comm’n
v. Houston Natural Gas Corp., 289 S.W.2d 559, 572 (Tex. 1956)); see also American Alliance,
126 S.W.2d at 742 (holding that fire insurance rates “must be reasonable and nonconfiscatory . . .
[t]hat is, the rate prescribed, whether maximum or fixed, must be sufficient to yield a reasonable
net capital return, after deducting all necessary and proper expenses . . . . Otherwise, the rate is
confiscatory and violative of the stated constitutional inhibitions.”).

3
projected expenses per exposure unit (e.g., estimated payments or losses related to hurricanes), plus

an additional “underwriting profit” provision calculated so as to ensure that State Farm Lloyds

obtained an overall profit (including net income from both premiums and investments) sufficient

to provide a rate of return on its capital equivalent to that which it could obtain in alternative

investments of equivalent risk (i.e., a return compensating it for the “opportunity cost” of

its capital).9 The indicated rate would then be compared to the premium State Farm Lloyds was

projected to earn per exposure unit under the filed initial rate it had charged its customers. If the

indicated rate was less than State Farm Lloyds’s projected premiums, its initial rate would be deemed

excessive. Conversely, if the indicated rate equaled or exceeded the projected premiums, a

rate reduction would be considered confiscatory. Although generally following the same method

for calculating the indicated rate and any required reduction, the parties differed with respect to the

cost or expense elements that should be included in the indicated rate and their amount.

The issues were further framed by an unusual procedural posture on remand. As

explained in State Farm Lloyds I, former art. 5.26–1 (a component of the 78th Legislature’s

watershed S.B. 14) had governed the first of three phases through which the Legislature imposed rate

regulation on what had become a largely unregulated Texas homeowners insurance market.10 Under

9
See Actuarial Standards Board, Actuarial Standard of Practice: Documentation and
Disclosure in Property and Casualty Insurance Ratemaking and Loss Reserving, at 9 (1989)
(superseded 1991) (incorporating “Statement of Principles Regarding Property and Casualty
Insurance Ratemaking” adopted by the Board of Directors of the Casualty Actuarial Society in 1988)
(currently available at http://www.actuarialstandardsboard.org/pdf/superseded/asop9_1989.PDF)
(hereinafter “ASOP 9”); Actuarial Standards Board, Actuarial Standard of Practice No. 30:
Treatment of Profit and Contingency Provisions and the Cost of Capital in
Property/Casualty Insurance Ratemaking, at §§ 1.1, 2, 3.1 (1997) (currently available
at http://www.actuarialstandardsboard.org/pdf/asops/asop030_057.pdf) (hereinafter “ASOP 30”).
10
See State Farm Lloyds I, 255 S.W.3d at 792.

4
former art. 5.26–1, effective June 11, 2003 through August 31, 2004, insurers were required to file

their initial regulated rates within 20 days of the statute’s effective date and implement them.11 After

this initial filing, former art. 5.142, effective June 11, 2003, through November 30, 2004, provided

temporary rate-regulation procedures.12 Under former art. 5.142, insurers were required to file

their rates with TDI and await the Commissioner’s approval before implementing them.13 Then,

beginning on December 1, 2004, a permanent file-and-use regime, governed by former art. 5.13–2

of the Insurance Code (now codified as chapter 2251 of that code)14 took effect whereby insurers file

their rates with TDI and implement them, subject to the Commissioner’s power to disapprove the

rates before they go into effect or disapprove further use of the rates after they go into effect.15 In

State Farm Lloyds’s case, TDI had ordered, and the Commissioner had affirmed, a 12% reduction

in the insurer’s initial filed rate. This reduction, all other things being equal, would have taken effect

on September 7, 2003. However, in former art. 5.26–1, the Legislature had allowed an insurer who

sought judicial review of a rate-reduction order, as State Farm Lloyds had, the option of charging

its filed rate while litigation was pending,16 subject to mandatory refunds of “the difference in

overcharged premium to each policyholder, plus interest,” if “on final appeal the court upholds the

11
See id. (citing former art. 5.26–1, § 2(a)).
12
See id. (citing former art. 5.142).
13
See id. (citing former art. 5.142, § 5).
14
See Act of June 2, 2003, 78th Leg., R.S., ch. 206, § 6.04, sec. 3(a)(5), 2003 Tex. Gen.
Laws 907, 926 (currently codified at Tex. Ins. Code §§ 2251.00–.252 ) (“former Art. 5.13–2”).
15
See State Farm Lloyds I, 255 S.W.3d at 792 (citing former art. 5.13–2, §§ 5, 7).
16
See former art. 5.26–1, § 5(b).

5
commissioner’s determination that the insurer’s rates are excessive.”17 State Farm had availed itself

of this option and continued charging its initial filed rate (which we will term its “implemented

rate”), notwithstanding the Commissioner’s opposition to it, pending litigation over its validity.

As events turned out, the first round of litigation over State Farm Lloyds’s

implemented rate had not concluded until 2008, when this Court issued its State Farm Lloyds I

decision. In remanding the case to the Commissioner for further proceedings despite former

art. 5.26–1’s expiration on September 1, 2004, this Court observed that the Legislature had provided

that the expiration “‘does not affect an action or proceeding against an insurer subject to that law for

failure to comply with that law before its expiration, regardless of when the action or proceeding was

commenced, and that law is continued in effect for that purpose.’”18 In the meantime, however,

State Farm Lloyds’s implemented rate has remained in effect not only as its operative initial rate

under former art. 5.26–1, but also as the insurer’s operative rate under former art. 5.142, which had

contained parallel provisions authorizing the insurer to charge its desired rate pending appeal, subject

to refunds with interest if the rate was later found excessive.19 State Farm Lloyds had similarly

continued charging the implemented rate as the file-and-use regime began on December 1, 2004, and

would ultimately do so, despite TDI’s attempts to restrict the insurer from continuing to charge the

rate and the insurer’s efforts to obtain rate increases,20 until mid-2008, when the Commissioner

17
Id. § 6.
18
See State Farm Lloyds I, 255 S.W.3d at 805 (quoting former art. 5.26–1, § 7).
19
See former art. 5.142, §§ 13(b), 14; State Farm Lloyds v. Geeslin, 267 S.W.3d 438,
443–46 (Tex. App.—Austin 2008, no pet.) (State Farm Lloyds III).
20
See Texas Dep’t of Ins. v. State Farm Lloyds, 260 S.W.3d 233, 238–49
(Tex. App.—Austin 2008, no pet.) (State Farm Lloyds II); State Farm Lloyds III, 267 S.W.3d
at 441–47.

6
finally approved increased rates effective on June 1 for new business and August 1 for renewal

business. Consequently, the dispute on remand concerned whether State Farm Lloyds, through

its implemented rate, had overcharged its policyholders not only between September 7, 2003,

and August 31, 2004, the period in which former art. 5.26–1 had been in effect, but whether

it had continued to do so for several years thereafter. The statutory standards governing the

“excessiveness” of State Farm’s “rate” after September 1, 2004, were essentially identical to those

applicable under former art. 5.26–1.21

But while the hearing on remand thus concerned whether State Farm Lloyds

had overcharged its customers in the past, the Commissioner emphasized that “ratemaking is a

prospective endeavor,” alluding to the longstanding principles barring retroactive ratemaking,

the making of “a retrospective inquiry to determine whether a prior rate was reasonable and

imposing a surcharge when rates were too low or a refund when rates are too high.”22 He likewise

observed that both the relevant Insurance Code provisions23 and actuarial principles24 contemplated

21
See former art. 5.142, §§ 2, 3(d); former art. 5.13–2, §§ 1, 3.
22
State v. Public Util. Comm’n, 883 S.W.2d 190, 199 (Tex. 1994). These principles derive
in part from the view that ratemaking is in the nature of a legislative act, having only prospective
effect, as opposed to being an adjudication of rights in a controversy that has previously arisen. See
Railroad Comm’n v. Houston Natural Gas Corp., 289 S.W.2d 559, 562–63 (Tex. 1956); see also
Central Power & Light Co. v. Public Util. Comm’n, 36 S.W.3d 547, 554 (Tex. App.—Austin 2000,
pet. denied) (citing City of Alvin v. Public Util. Comm’n, 876 S.W.2d 346, 362 (Tex. App.—Austin
1993), judgment vacated w.r.m. sub nom. Public Util. Comm’n v. Texas–N.M. Elec. Co., 893 S.W.2d
450 (Tex. 1994)).
23
See former art. 5.142, § 2(b) (defining an “excessive” rate as one “likely to produce a long-
term profit that is unreasonably high” and an “inadequate” rate as one “insufficient to sustain
projected losses and expenses”); accord former art. 5.13–2, § 3(b)(a)–(b) (same).
24
See ASOP 9, at 6 (“A rate is an estimate of the expected value of future costs.”).

7
prospective ratemaking based on estimates of future costs, and he additionally deemed it “unfair to

judge the reasonableness of any of the parties’ estimates of future costs based on information that

was unknowable” at the time the estimates were made.” (Emphases in original.) Thus, the proper

ratemaking inquiry on remand, as the Commissioner reasoned, centered not on real-life events

that had occurred while the implemented rate was in effect, viewed in hindsight—as he put it,

“retrospective evidence . . . has no business in a rate hearing”—but on the rate or rates the

Commissioner should have set prospectively from the perspective of a time preceding the period

or periods in which the rate was used. To that end, the Commissioner focused the inquiry on

information known or “knowable” as of early September 2003, the date of the original hearing.25

However, the Commissioner did conclude that evidence of State Farm Lloyds’s financial

condition as of the time of the rehearing would be relevant to assessing the impact of any refunds

he might order.

A related question concerned the time intervals for the rate or rates the Commissioner

would determine—not only the period in which former art. 5.26–1 had been in effect, and for which

the cost estimates underlying State Farm Lloyds’s implemented rate had been made, but almost

four years thereafter, far longer than the typical one-year term of a homeowner’s insurance policy.

The Commissioner ultimately focused the inquiry primarily on determining the rate that should have

applied during an “initial term” between September 7, 2003 and August 31, 2004, corresponding

roughly to the period in which former art. 5.26–1 had been in effect and for which the implemented

25
See, e.g., Southwestern Bell Tel. Co. v. Public Util. Comm’n, 615 S.W.2d 947, 954–55
(Tex. Civ. App.—Austin 1981, no writ) (distinguishing retrospective ratemaking from administrative
proceedings on remand to set rates prospectively from date of the original agency order that had been
reversed on appeal).

8
rate had been designed. Then, utilizing his initial-term indicated rate as a starting point, the

Commissioner considered the extent to which adjustments or modifications to the indicated rate

should be made during the “subsequent period” between September 1, 2004 and July 31, 2008.

A further development impacting the hearing’s procedural posture had been the 2004

discovery of an error in State Farm Lloyds’s original premium projections under the implemented

rate that had caused it to significantly overstate the figure. TDI had also relied on the same premium

projections, and the error had correspondingly skewed upward the amount of rate reduction it

determined necessary to conform State Farm’s Lloyds’s implemented rate with the agency’s view

of the proper indicated rate. The Commissioner deemed this error to be “knowable” at the time of

the first hearing, and TDI agreed that its calculations should be revised and abandoned its advocacy

of the original 12% rate reduction. Accordingly, the Commissioner found that TDI’s original 12%

reduction would “produce a confiscatory rate” and, as such, that State Farm Lloyds had met its initial

burden under former art. 5.26–1 (as modified by State Farm Lloyds I) to show by clear and

convincing evidence that TDI’s rate would not be “just, reasonable, [and] adequate . . . for the risks

to which it applies.”26 And with that burden being met, the Commissioner reasoned, the relevant

“issue for determination” became simply “the development of rates chargeable by SFL [State Farm

Lloyds] which are just and reasonable and neither confiscatory nor excessive for the risks to

which they apply.” In the Commissioner’s view, “[n]either [TDI] Staff nor SFL bore the burden of

production or persuasion on this issue.”

After correcting for the erroneous premium projections, TDI determined that

State Farm Lloyds’s implemented rate had been excessive by over 9% through June 2004. OPIC,

26
Former art. 5.26–1, § 4; see State Farm Lloyds I, 255 S.W.3d at 800–01.

9
on the other hand, did not correct for the error and urged rate reductions in line with TDI’s original

position. In contrast, State Farm Lloyds insisted that the Commissioner adopt its implemented rate

in lieu of any reduction because its costs had actually justified a 12% rate increase over its

implemented rate, had it opted to seek one.27 Although there were other areas of divergence in

the parties’ respective calculations of the indicated rate, this appeal would ultimately center on two.

The first, presenting what the Commissioner would term the most “vexing and

difficult” issue in the proceeding, concerned a provision State Farm Lloyds had included in its rate

to aid its recovery from large financial losses it had incurred a few years earlier. Between 2000 and

2002, State Farm Lloyds had incurred almost $2 million in underwriting losses from unanticipated

mold claims and a multitude of non-hurricane catastrophes (e.g., tornadoes, hailstorms, and ice

storms).28 The aggregate losses had dwarfed the preexisting amount of State Farm Lloyds’s surplus,

the cash reserves that insurers are required to maintain beyond the amounts reserved for incurred and

expected claims, which serve as a “cushion” against losses not anticipated in the existing rate. By

statute, State Farm Lloyds was required to maintain a minimum surplus equaling one-third of its total

premiums—33¢ for every $1 of premium, or a 3:1 premium-to-surplus ratio—or else be deemed

“statutorily insolvent” and potentially subject to supervision or conservatorship.29 Amid its losses,

27
To be clear, State Farm Lloyds was not seeking an increase from its implemented rate
(nor could it do so retroactively), but only to oppose any reduction in its implemented rate. See
State Farm Lloyds I, 255 S.W.3d at 792 (noting that the insurer had filed its then-current rate as its
“initial rate” under former art. 5.26–1).
28
“Catastrophe” in this context refers, according to the Commissioner, to “large and
fortuitous occurrences that cause widespread property damage,” such as a hurricane or “large
hailstorm in a major metropolitan area.”
29
See Tex. Ins. Code §§ 441.051(1) (circumstances constituting insolvency), 822.205
(requiring surplus); see generally id. §§ 441.001–.351 (“Supervision and Conservatorship”).

10
there is no dispute that State Farm Lloyds would have been rendered statutorily insolvent absent

large cash infusions, and thus it had turned to an affiliate, State Farm Mutual Automobile Insurance

Company (State Farm Mutual), and obtained three advances—in November 2001, February 2002,

and September 2002—in amounts totaling over one billion dollars. When State Farm Lloyds filed

its initial rate in June 2003, its surplus was just below $467 million, giving it a premium-to-surplus

ratio of roughly 2.8:1.

The advances from State Farm Mutual had formed the consideration for a

$1.05 billion “consolidated surplus debenture” that State Farm Lloyds had issued to State Farm

Mutual. The parties agree that the terms of this instrument distinguish it as a “surplus note,”a type

of financial instrument that evidently has been used in the insurance industry for decades30 and has

specifically been addressed by TDI rule.31 As the term suggests, a “surplus note” is in the nature of

a debt instrument, but the interests of the creditor are subordinated in a manner permitting

the proceeds to be initially treated for accounting purposes as unencumbered surplus, similar

to equity capital. In the case of State Farm Lloyds’s surplus note, it reflects that the insurer owes

State Farm Mutual a principal amount of $1.05 billion, plus interest accruing at 7% per annum,

compounded and payable semiannually, with a maturity date of December 31, 2016. However,

tracking requirements from TDI’s rules,32 the instrument conditions State Farm Lloyds’s payment

obligation on the existence of surplus exceeding specified threshold amounts—principal is to be

30
See, e.g., Harlan v. United States, 409 F.2d 904, 906–07 (5th Cir. 1969).
31
See 28 Tex. Admin. Code § 7.7 (2014) (TDI, Subordinated Indebtedness, Surplus
Debentures, Surplus Notes, Premium Income Notes, Bonds, or Debentures, and Other Contingent
Evidences of Indebtedness).
32
See id. § 7.7(c), (e), (f); see also id. § 7.7(a)(3) (defining “surplus note”).

11
repaid only out of “excess surplus funds” that exceed $900 million, while semi-annual interest

payments are to be made only from surplus, if any, that exceeds $700 million. Similarly, only if and

to the extent these payment obligations actually arise is any offsetting liability recognized.33 Of final

note, TDI’s rules require that the Commissioner give prior approval to any surplus notes before

issuance,34 and State Farm Lloyds obtained such approval here.

State Farm Lloyds had included in its rate indication a “surplus note” provision in the

amount of 9% of premium. This amount, as explained by the insurer’s witnesses during the hearing,

was intended to (1) capture the annual costs of repaying the principal on the surplus note, plus

interest, amortized over a 15-year term,35 plus (2) provide additional funds to increase State Farm

Lloyds’s surplus (net of the funds going toward the surplus-note payments) at a rate so as to equal

the amount of the company’s projected annual premiums (i.e., 1:1 premium-to-surplus ratio) within

nine years. Both TDI and OPIC opposed the inclusion of the surplus-note provision in the rate,

urging that State Farm Lloyds was entitled to recover only the opportunity cost of the surplus-note

proceeds, not additional sums to recapitalize the company, and that the company’s rate would already

ensure it this recovery through the rate of return secured by the underwriting-profit provision. In

addition to its surplus-note provision, State Farm Lloyds had included an underwriting-profit

provision in its rate, equal to 5% of premiums, determining that this amount would provide it a

33
See id. § 7.7(f)(1).
34
See id. § 7.7(b)(1).
35
However, because the liability for and timing of the payments themselves were tied to
minimum surplus levels, State Farm Lloyds was not projected to actually make any payments of
interest or principal during the initial period, nor for some time thereafter. Rather, the schedule
reflected the amortized cost of paying the required principal and interest over the course of the 15-
year term as surplus levels increased past the threshold minimums.

12
rate of return on its capital equivalent to alternative investments of similar risk. TDI had agreed

that this underwriting-profit figure was appropriate for recovering State Farm Lloyds’s costs of

capital—including any recoverable costs related to the surplus note. In contrast, State Farm Lloyds

insisted that the costs of amortizing the surplus-note principal and “rebuilding” the company’s

surplus, as it sought to recover through the surplus-note provision, were instead in the nature of

expenses of providing homeowner’s insurance in the volatile Texas market, akin to projected

payments on claims, and were appropriately compensated in the rate separately and apart from its

costs of capital recovered through underwriting profit and rate of return.

The second material disputed rate component was a “contingencies” provision,

equal to 2% of premium, that State Farm Lloyds had included in its rate. The Commissioner heard

evidence, and the parties appear generally to agree, that a “contingencies” provision, like

underwriting profit, is an accepted means by which ratemakers account for the cost of capital in light

of risk.36 Underwriting profit is said to account for the undifferentiated risk that an insurer’s actual

expenses will turn out to vary from the estimates that the rate is designed to recover within any given

period.37 But where deviations between an insurer’s estimated and actual expenses can be shown

to persist systematically over time and be incapable of being eliminated by changing other

components of the ratemaking process, it is considered appropriate to include in the rate an

additional contingencies provision to compensate for the expected range of unanticipated losses.38

36
See ASOP 30, at § 1.1 (observing that both underwriting provisions and contingency
provisions “provide for the cost of capital”).
37
See id. at § 3.7 (recommending inclusion of contingency provision), App. 1 at 6–7
(discussing role of contingency provision).
38
See id. at § 3.7.

13
Thus, to summarize the difference between the two types of provisions, a contingency provision

seeks to recover an expected range of losses and is thus not expected to be realized as profit, while

an underwriting-profit provision yields an expected profit that accounts for variability in results.39

In attempting to establish the requisite systematic deviations between estimated and

actual expenses, State Farm Lloyds relied in part on evidence of past court decisions that had

effectively broadened coverage beyond what was contemplated in its rate structure. Initially, both

TDI and OPIC opposed inclusion of a contingencies provision. Although TDI eventually acceded

to the provision, OPIC maintained that State Farm Lloyds had failed to demonstrate any pattern

of deviations that had not been addressed by intervening regulatory changes. It emphasized, for

example, that the Commissioner in 2002 had approved new homeowners-policy forms that

unequivocally excluded mold coverage.

The Commissioner determined that neither State Farm Lloyds’s 9% surplus-note

provision nor its 2% contingencies provision should be included in the insurer’s rate. Regarding the

former, the Commissioner agreed with TDI and OPIC that State Farm Lloyds was entitled to recover

only the cost of the surplus-note proceeds that would already be compensated through a reasonable

return on capital ensured through the underwriting-profit provision. Consequently, he reasoned that

“[a]llowing a separate provision for a write-down or amortization of SFL’s surplus note and related

interest would be tantamount to allowing two returns on capital in the ratemaking formula.” The

Commissioner similarly concluded that “[i]t is unreasonable to include principal and interest

payments on the surplus note as an expense in SFL’s rates” and that doing so “in addition to rate

provisions which already contemplate SFL’s expected future costs, including its cost of capital, will

39
See id.

14
produce excessive rates.” As for the contingencies provision, the Commissioner found that “[t]he

evidence does not support a conclusion that there is a systematic variation between expected costs

and actual costs.” Accordingly, he concluded that “[i]nclusion of a contingency provision over and

above a reasonable underwriting profit provision which reflects the risks of SFL writing homeowners

insurance in Texas in 2003 will produce excessive rates.”

But while deciding that these specific rate provisions were unwarranted and

inappropriate, the Commissioner determined that the underlying evidence was nonetheless probative

of risk that had not yet been sufficiently accounted for in State Farm Lloyds’s calculation

of underwriting profit. Although stopping short of finding that a “systematic variation between

expected costs and actual costs” actually existed so as to warrant a contingencies provision, the

Commissioner found that there “may be” such a variation (emphasis in original), that this

“conclusion . . . implies risk,” and that “this risk can be considered and addressed in deriving

an appropriate underwriting profit . . . provision.” Similarly, with respect to the surplus-note

obligation, the Commissioner found that:

While the inclusion of the separate 9.0% surplus note provision in the ratemaking
formula would be unreasonable, it is reasonable to consider the existence of
the surplus note, and the need for both the principal and related interest to be
paid by December 31, 2016, in considering the reasonableness of the underwriting
profit provision. Specifically, the Commissioner finds it is reasonable to consider
the existence of the surplus note, and SFL’s obligation to timely repay it when
determining: (1) the level of risk faced by SFL in writing homeowners insurance in
2003; (2) an appropriate premium to surplus ratio [as explained below, a method of
weighing risk] or cost of capital; and (3) an appropriate underwriting profit provision.

The Commissioner additionally found that the analysis should also consider another “indication

of risk” that had been “brought forth in the record”: “[t]he fact that SFL is a single-state insurer

15
deriving almost its entire premium from a single line of insurance which includes catastrophe

coverage in a catastrophe-prone state.” And while the Commissioner acknowledged evidence that

“SFL is making significant provision for catastrophe reinsurance” (i.e., shifting the risk of such

losses to the reinsurer)—in fact, the Commissioner ultimately approved including a rate component

to fund such coverage—he also found that “some catastrophe exposure” faced by State Farm Lloyds

“is not fully covered by reinsurance.”40

In light of these indicators of additional risk he had identified, the Commissioner, to

summarize his analysis, recalculated underwriting profit using the same basic methodology that

State Farm Lloyds had utilized, but with greater weighting of risk in the equation. Based on this

analysis, the Commissioner concluded that an appropriate underwriting profit for State Farm Lloyds

during the initial period was 8.5% of premium—in other words, an underwriting profit 3.5% higher

than the company itself had sought, and 1.5% higher than the combined total of the company’s

underwriting-profit and contingencies provisions.

Despite this increase in the underwriting-profit component of the Commissioner’s

rate indication, State Farm Lloyds’s implemented rate remained excessive by comparison. In

accordance with the difference, the Commissioner concluded that a “rate reduction of –6.2% . . .

produces rates that are both just and reasonable and neither excessive nor confiscatory for the period

September 7, 2003, through August 31, 2004.” He then turned to the “subsequent period” between

September 1, 2004 and July 31, 2008.

40
Elaborating, the Commissioner credited testimony that “since many exposures are not
covered by the catastrophic insurance coverage and since in Texas, many catastrophes are too small
to exceed the reinsurance deductible (or ‘attachment point’), the coverage is incomplete.”

16
 The Commissioner rejected arguments by OPIC that he should merely extend the

initial-period rate indication unchanged through the subsequent period, finding that “[t]here is no

evidence in the record to suggest that SFL’s rates remained at the same level of excessiveness for

the entire period” and that, to the contrary, the “evidence . . . suggest[s] the level of excessiveness

of SFL’s rates declined over time.” To account for these changes, the Commissioner, relying on the

same data set of September 2003 information from which the initial rate had been derived, projected

trends of increases in several cost components of the rate (which would tend to justify a higher rate)

into the subsequent period to determine a single rate for that entire period. But while determining

these cost elements prospectively from the perspective of September 2003, the Commissioner also

reduced the underwriting-profit component of the rate based on events that had occurred much later.

In 2006 and 2007, State Farm Lloyds’s non-hurricane catastrophe losses had turned

out to be significantly lower than the projections built into its implemented rate, causing the insurer’s

surplus to increase to an extent that it had been able to pay both accrued interest on the surplus

note and large amounts of principal. Finding that “[d]uring the subsequent period SFL [had]

repaid approximately $400 million, or more than one-third, of the surplus note principal,” the

Commissioner deemed it “reasonable to consider the repayment of $400 million of surplus note

principal during the subsequent period when evaluating the risk associated with the repayment of the

$1.05 billion surplus note.” On that basis, he determined that a “reasonable underwriting profit

provision used to determine the rate in the subsequent period is 8.0%,” a reduction of one-half of

one percent from the underwriting profit in the ordered rate for the initial period. Incorporating the

lower underwriting profit into the flat rate the Commissioner had calculated for the subsequent

17
period yielded an indicated rate that was 3.4% lower than State Farm Lloyds’s implemented rate

throughout the entire subsequent period.

In light of his determinations that State Farm Lloyds’s implemented rate had been

excessive during both the initial and subsequent periods, the Commissioner ordered that the insurer

refund the difference to its policyholders. He estimated the gross amount of these refunds to be

$256.7 million, plus accrued interest of approximately $53.0 million. The Commissioner found,

however, that the insurer could provide these refunds in the form of credits to policyholders during

the initial or subsequent period who renewed their coverage.

State Farm Lloyds timely sought judicial review of the Commissioner’s final

order in the district court below.41 On evidence consisting solely of the administrative record,

the district court affirmed the Commissioner’s order in full. State Farm Lloyds then perfected

this appeal.

ANALYSIS

State Farm Lloyds brings six points of error on appeal. Collectively, the points

challenge, based on an assortment of evidentiary and constitutional grounds, (1) the Commissioner’s

refusal to include the surplus-note provision in State Farm Lloyds’s rate; (2) the Commissioner’s

refusal to include the 2% contingencies provision in the rate; (3) the Commissioner’s determination

of the underwriting-profit component of the rate for the initial period; (4) the rate the Commissioner

41
See former art. 5.26–1, § 5(a) (“Not later than the 10th day after the date of receipt of the
commissioner’s order under Section 4 of this article, an insurer may file a petition for judicial review
in a district court of Travis County.”).

18
imposed for the “subsequent period;” (5) the refunds ordered by the Commissioner; and (6) interest

awarded by the Commissioner on amounts he held to be due.

Standard of review

The parties agree that judicial review is governed by the familiar standard set forth

in section 2001.174 of the Administrative Procedure Act (APA):

[A] court may not substitute its judgment for that of the agency as to the weight of
the evidence on questions committed to agency discretion but:

(1) may affirm the decision of the agency in whole or in part; and

(2) shall reverse or remand the case for further proceedings if substantial rights
of the appellant have been prejudiced because the administrative findings,
inferences, conclusions, or decisions are:

(A) in violation of a constitutional or statutory provision;

(B) in excess of the agency’s statutory authority;

(C) made through unlawful procedure;

(D) affected by other error of law;

(E) not reasonably supported by substantial evidence considering
the reliable and probative evidence in the record as a whole;
or

(F) arbitrary or capricious or characterized by abuse of discretion
or clearly unwarranted exercise of discretion.42

42
Tex. Gov’t Code § 2001.174; former art. 5.16–1, § 5(a); see also former art. 5.142, § 13;
Tex. Ins. Code § 2254.004(d).

19
Essentially, this is a rational-basis test to determine, as a matter of law, whether an agency’s

order finds reasonable support in the record.43 “The test is not whether the agency made the correct

conclusion in our view, but whether some reasonable basis exists in the record for the agency’s

action.”44 We apply this analysis without deference to the district court’s judgment.45 We presume

that the agency’s findings, inferences, conclusions, and decisions are supported by substantial

evidence, and the burden is on the contestant to demonstrate otherwise.46

Substantial-evidence analysis entails two component inquiries: (1) whether the

agency made findings of underlying facts that logically support the ultimate facts and legal

conclusions establishing the legal authority for the agency’s decision or action and, in turn,

(2) whether the findings of underlying fact are reasonably supported by evidence.47 The second

inquiry, which has been termed the “crux” of substantial-evidence review,48 is highly deferential

to the agency’s determination: “substantial evidence” in this sense “does not mean a large or

considerable amount of evidence”—in fact, the evidence may even preponderate against the agency’s

finding—but requires only “such relevant evidence as a reasonable mind might accept as adequate

43
See Texas Health Facilities Comm’n v. Charter Med.-Dallas, Inc., 665 S.W.2d 446,
452–53 (Tex. 1984).
44
Slay v. Texas Comm’n on Envtl. Quality, 351 S.W.3d 532, 549 (Tex. App.—Austin 2011,
pet. denied).
45
See Texas Dep’t of Pub. Safety v. Alford, 209 S.W.3d 101, 103 (Tex. 2006) (per curiam).
46
See Slay, 351 S.W.3d at 549.
47
See Vista Med. Ctr. Hosp. v. Texas Mut. Ins. Co, 416 S.W.3d 11, 26–27
(Tex. App.—Austin 2013, no pet.) (citing Charter Med.-Dallas, 665 S.W.2d at 453).
48
See Granek v. Texas State Bd. of Med. Exam’rs, 172 S.W.3d 761, 778 (Tex. App.—Austin
2005, no pet.) (citing John E. Powers, Agency Adjudications 163 (1990)).

20
to support a [finding] of fact.”49 Likewise, we “may not substitute [our] judgment for the judgment

of the state agency on the weight of the evidence on questions committed to agency discretion.”50

In contrast, the first inquiry, concerning the extent to which the underlying facts found by the

agency logically support its ultimate decision or action, may entail questions of law that we

review de novo.51

State Farm Lloyds’s points of error implicate both deferential aspects of substantial-

evidence review and issues that we must examine de novo. Foremost among the latter are

State Farm Lloyds’s arguments grounded in constitutional takings principles, which substantially

overlap and interrelate with their non-constitutional grounds.52 Although these principles derive

from both the Texas and federal constitutions,53 the parties have not suggested any material

substantive difference between these provisions as they impact this case, so we will assume there

49
Slay, 351 S.W.3d at 549.
50
Tex. Gov’t Code § 2001.174(1).
51
See Railroad Comm’n v. Texas Citizens for a Safe Future & Clean Water, 336 S.W.3d
619, 624 (Tex. 2011); Montgomery Indep. Sch. Dist. v. Davis, 34 S.W.3d 559, 565 (Tex. 2000)
(citing Charter Med.-Dallas, 665 S.W.3d at 453); City of El Paso v. Public Util. Comm’n,
344 S.W.3d 609, 619 (Tex. App.—Austin 2011, no pet.); Buddy Gregg Motor Homes, Inc. v. Motor
Vehicle Bd., 156 S.W.3d 91, 99 (Tex. App.—Austin 2004, pet. denied).
52
To this extent, we make an exception to the general rule that we reach constitutional issues
only after exhausting non-constitutional grounds. See AEP Tex. Commercial & Indus. Retail Ltd.
P’ship v. Public Util. Comm’n, 436 S.W.3d 890, 907 (Tex. App.—Austin 2014, no pet.) (citing
In re B.L.D., 113 S.W.3d 340, 349 (Tex. 2003) (“As a rule, we only decide constitutional questions
when we cannot resolve issues on nonconstitutional grounds.”)).
53
The prohibitions against confiscatory government-imposed rates derive from Article I,
Section 17 of the Texas Constitution, see Tex. Const. art. I, § 17(a) (“No person’s property shall be
taken . . . for or applied to public use without adequate compensation being made . . . . “), and the
Fifth Amendment to the United States Constitution, see U.S. Const. amend. V (“private property
[shall not] be taken for public use, without just compensation”), as applied to the states through the
Fourteenth Amendment.

21
are none.54 Similarly, in invoking competing views of these principles and their application here,

both sides have relied primarily on jurisprudence from the United States Supreme Court applying

the Takings Clause of the federal constitution, with much emphasis on its seminal Hope Natural

Gas decision.55

Under these authorities, the United States Supreme Court has explained, “[t]he

guiding principle has been that the Constitution protects [regulated entities] from being limited to

a charge for their property serving the public which is so ‘unjust’ as to be confiscatory,” a charge that

is “‘so unjust as to destroy [the] value of the property for all the purposes for which it was acquired,’

and in so doing ‘practically deprive[s] the owner of property without due process of law.’”56 But

above this constitutional floor, a rate “may reduce the value of the property which is being regulated”

54
See Sheffield Dev. Co. v. City of Glenn Heights, 140 S.W.3d 660, 669 (Tex. 2004)
(characterizing the counterpart Texas and federal constitutional takings protections as
“comparable”); City of Corpus Christi v. Public Util. Comm’n, 51 S.W.3d 231, 242 (Tex. 2001)
(observing that federal case law is instructive on whether rates constitute an unconstitutional taking
of regulated entity’s property under the Texas Constitution); see also Bentley v. Bunton, 94 S.W.3d
561, 577–78 (Tex. 2002) (noting that where parties do not argue that differences in state and federal
constitutional guarantees are material to a case, and none is apparent, “we will limit our analysis to
the First Amendment and simply assume that its concerns are congruent with those of article I,
section 8”).
55
See Federal Power Comm’n v. Hope Natural Gas Co., 320 U.S. 591 (1944). Although
relying on these principles in State Farm Lloyds I to partly invalidate former art. 5.26–1, this Court
did not have occasion to explore their parameters in detail. Instead, as State Farm Lloyds observes,
the State Farm Lloyds I analysis “was based on a straightforward syllogism” that followed from
the requirement that a government-set rate afford a regulated entity a reasonable rate of return on
its capital—“rates can be confiscatory without necessarily leading to insolvency.” See State Farm
Lloyds I, 255 S.W.3d at 594–95. Beyond its recognition of the basic constitutional concepts and that
they apply to insurance rate regulation, State Farm Lloyds I provides us little guidance here.
56
Duquesne, 488 U.S. at 307–08 (quoting Federal Power Comm’n v. Natural Gas Pipeline
Co. of Am., 315 U.S. 575, 585 (1942); Covington & Lexington Tpk. Rd. Co. v. Sandford, 164 U.S.
578, 597 (1896)).

22
or “limit stringently the return recovered on investment.”57 “All that is protected against, in a

constitutional sense, is that the rates fixed by the [government] be higher than a confiscatory level.”58

Starting with Hope, the Supreme Court began focusing this inquiry not on the precise

methodology through which a rate is formulated, but on a rate order’s “end result”:

It is not theory but the impact of the rate order that counts. If the total effect of the
rate order cannot be said to be unjust and unreasonable, judicial inquiry . . . is at an
end. The fact that the method employed to reach that result may contain infirmities
is not then important.59

Thus, as far as constitutional takings principles are concerned, a governmental ratemaker “[i]s

not bound to the use of any single formula or combination of formulae in determining rates.”60

Hope further explained that evaluating the justness and reasonableness of a rate’s

“end result” entails “a balancing of the investor and the consumer interests.”61 In that analysis:

57
Federal Power Comm’n v. Texaco, Inc., 417 U.S. 380, 391–92 (1974) (citing In re
Permian Basin Area Rate Cases, 390 U.S. 747, 769 (1968); Hope, 320 U.S. at 601).
58
Id. (citing Natural Gas Pipeline, 315 U.S. at 585).
59
Hope, 320 U.S. at 602 (internal citations omitted).
60
Id. In the same vein, the Supreme Court would later observe:

The economic judgments required in rate proceedings are often
hopelessly complex and do not admit of a single correct result. The
Constitution is not designed to arbitrate these economic niceties.
Errors to the detriment of one party may well be cancelled out by
countervailing errors or allowances in another part of the rate
proceeding. The Constitution protects the [regulated entity] from the
net effect of the rate order on its property.

Duquesne, 488 U.S. at 307.
61
320 U.S. at 603.

23
 [T]he investor interest has a legitimate concern with the financial integrity of
the company whose rates are being regulated. From the investor or company point
of view it is important that there be enough revenue not only for operating expenses
but also for the capital costs of the business. These include service on the debt and
dividends on the stock. By that standard, the return to the equity owner should be
commensurate with returns on investments 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.62

In short, courts consider “whether the order may reasonably be expected to maintain financial

integrity, attract necessary capital, and fairly compensate investors for the risks they have assumed,

and yet provide appropriate protection for the relevant public interests.”63 A rate whose end result

effects a reasonable balancing of insurer and investor interests relative to ratepayer or broader public

interests “cannot properly be attacked as confiscatory.”64

In reviewing whether the Commissioner’s order effected a reasonable balancing of

these interests, we give deference under the substantial-evidence standard to his findings regarding

“initial questions of historical fact,” but review de novo his “second-order analysis [of] appl[ying]

th[e] historical facts to the legal standards.”65

62
Id. (internal citations omitted).
63
Permian Basin, 390 U.S. at 792.
64
Id. at 770 (citing Hope, 320 U.S. at 603); see also Jersey Cent., 810 F.2d at 1189 (Starr,
J., concurring) (suggesting that “confiscatory” “is a short-hand way of saying that an unreasonable
balance has been struck in the regulation process so as unreasonably to favor ratepayer interests at
the substantial expense of investor interests”).
65
See City of Dallas v. Stewart, 361 S.W.3d 562, 568 (Tex. 2012). Stewart concerned an
administrative determination that private property was a nuisance, a determination tantamount to
holding that constitutional takings protections were inapplicable. See id. at 569. While granting that
judicial scrutiny of the agency’s findings of “historical facts” (e.g., “whether or not the structure had
foundation damage”) could be limited to assessing whether there was reasonable support by
substantial evidence, the Texas Supreme Court held that due process required de novo review of the

24
Surplus note

We will begin with the single most pivotal question in this rate appeal, and the one

on which State Farm Lloyds places the greatest emphasis—the validity of the Commissioner’s

decision not to include the 9% “surplus note” provision in the ordered rate. State Farm Lloyds

challenges this determination principally through its first two points of error.

Interest

In its first point of error, State Farm Lloyds insists that without the surplus-note

provision, the ordered rate, in both the initial and subsequent periods, is confiscatory and

unconstitutional because it fails to account for the interest it owes on the surplus note. This is so,

State Farm Lloyds reasons, because interest on the surplus note is properly considered an “operating

expense” distinct from the costs of capital compensated through rate of return on capital and

underwriting profit, and must be compensated as such in the rate.66 To support this premise,

agency’s construction and application of the property owner’s substantive rights under the takings
clause (e.g., “Did the damage to the structure make it a threat to public health or safety such that the
government may deprive a citizen of her ownership in the structure?”). Id. at 578–79 & n.24. The
court reasoned that such de novo review was required because agencies lacked delegated power to
construe constitutional provisions and any legislative attempt to delegate them such power “‘would
raise serious and grave issues of a separation of powers violation.’” Id. at 568 (quoting Ronald L.
Beal, Texas Administrative Procedure & Practice § 9.3.1[c] (2011)); see also id. at 577 (further
emphasizing the “subordinate status” of administrative agencies “in our system of government” and
“the ‘legitimacy deficit’ inherent in administrative adjudication”) (quoting Henry P. Monaghan,
Constitutional Fact Review, 85 Colum. L. Rev. 229, 239 (1985)). As State Farm Lloyds emphasizes,
its constitutional challenges are grounded in the same substantive constitutional rights as in Stewart,
and that case, consequently, guides our review of those aspects of the Commissioner’s order. Cf.
Permian Basin, 390 U.S. at 792 (indicating that reviewing court should “not . . . supplant the
[ratemaker]’s balance of these interests with one more nearly to its liking, but instead [merely] assure
itself that the [ratemaker] has given reasoned consideration to each of the pertinent factors”).
66
See State Farm Lloyds I, 255 S.W.3d at 795 (“A government-set rate must allow a
regulated company to not only recover its operating expenses, but also to realize reasonable returns

25
State Farm Lloyds points to TDI’s rule governing surplus notes, which requires accounting

recognition of interest payments as “liabilities” when they come due67 and accounting principles,

generally incorporated into TDI’s rules,68 requiring that interest “shall be expensed in the statements

of operation when approved for payment.”69 State Farm Lloyds also emphasizes Texas Supreme

Court decisions involving utility ratemaking that, in its view, approve or contemplate recovery of

interest or other “carrying costs” on debt as specific components of the rate separate from a return

on capital.70 In response, TDI and OPIC continue to maintain that, as the Commissioner found,

State Farm Lloyds is seeking to double-recover a cost of capital for which it is already being

compensated in the rate.

To address State Farm Lloyds’s assertions, we begin by noting that the Hope court

characterized “service on the debt” as a component of the “the capital costs of the business,” as

opposed to “operating expenses,”71 and that interest on debt is commonly accounted for through the

on its investments sufficient to assure confidence in the continued financial integrity of the
enterprise.”).
67
See 28 Tex. Admin. Code § 7.7(f)(1) (“[T]he terms for payment of . . . interest shall result
in the reflection of a financial statement liability.”).
68
See id. § 7.18 (2014) (TDI, National Association of Insurance Commissioners Accounting
Practices and Procedures Manual) (adopting all Statements of Statutory Accounting Principles,
except to the extent they contradict the Insurance Code or TDI rules).
69
See National Association of Insurance Commissioners, Accounting Practices &
Procedures Manual of 2005, Statements of Statutory Accounting Principles No. 41, par. 5, at 41–3.
70
See Texas Indus. Energy Consumers v. CenterPoint Energy Houston Elec., LLC,
324 S.W.3d 95, 97 (Tex. 2010); CenterPoint Energy, Inc. v. Public Util. Comm’n, 143 S.W.3d 81,
83 (Tex. 2004).
71
See Hope, 320 U.S. at 603.

26
rate of return on capital in other ratemaking contexts.72 The Commissioner heard evidence that the

same is true in insurance ratemaking—interest on an insurer’s debt is considered to be a cost of

capital that is properly and customarily compensated through the rate of return secured through

underwriting profit, not as a type of operating expense. We cannot conclude the Commissioner’s

decision to address State Farm Lloyds’s surplus-note interest the same way is without reasonable

support in the evidence.

But the more critical feature of Hope, as it relates to State Farm Lloyds’s ultimate

constitutional complaint, is the Supreme Court’s emphasis on the “total effect of the rate order,”

not the “theory” or “method employed,” in determining a rate’s constitutionality.73 Under Hope,

whether the ordered rate addressed interest on the surplus note as an “operating expense,” a “cost

of capital” addressed through underwriting profit and rate of return, or through some other means,

is singularly of little constitutional significance. What matters is whether the rate, in its ultimate

effect, sufficiently accounted for the cost in some fashion.

To the extent State Farm Lloyds contends that the ordered rate fails altogether to

account for interest on the surplus note, it overlooks that the reasonable cost of capital contemplated

by the insurer’s own underwriting-profit model, later utilized by the Commissioner, would include

the cost of the surplus-note proceeds. That is, the ordered rate provided State Farm Lloyds a return

72
See, e.g., Central Power & Light, 36 S.W.3d at 553 (describing how costs of gas utility’s
capital, including debt capital, are determined in calculating the rate of return) (citing Southern
Union Gas Co. v. Railroad Comm’n, 692 S.W.2d 137, 141 (Tex. App.—Austin 1985, writ ref’d
n.r.e.)); Texas Water Comm’n v. Lakeshore Util. Co., Inc., 877 S.W.2d 814, 819, n.6
(Tex. App.—Austin 1994, writ denied) (noting that “utility’s interest payments on long-term debt
are used to compute the utility’s rate of return”) (citing Southern Union, 692 S.W.2d at 141)).
73
See Hope, 320 U.S. at 602.

27
on its capital, including the surplus-note proceeds, calculated so as to approximate the returns the

funds would have garnered in alternative investments of similar risk. TDI’s witnesses testified that

these earnings are the cost or value of State Farm Lloyds’s capital in economic effect, and for

ratemaking purposes, inasmuch as they represent the rate of return that must be paid to investors to

risk their funds in the enterprise.

While the Commissioner did not attempt to distinguish or specifically account for the

actual amount of State Farm Lloyds’s interest obligations under the surplus note in determining the

rate of return on the proceeds74—in effect, he “costed” all of State Farm Lloyds’s capital as if it were

equity75—TDI presented expert testimony that this was the norm in insurance ratemaking. Further

support for the Commissioner’s approach is found in the evidence that the surplus note, while a debt

instrument, also had attributes of equity—the debt obligations are subordinated so as to ensure that

the proceeds can be used to supply minimum levels of surplus first. Yet even if there were any error

in failing to differentiate surplus-note interest from its other costs of capital, State Farm Lloyds has

not demonstrated any harm from the Commissioner’s approach.

To the contrary, according to projections prepared by one of State Farm Lloyds’s own

experts, Dr. David Appel, the 5% underwriting profit originally advocated by the insurer and TDI

would generate earnings sufficient to cover the same amortized costs of repaying the surplus note

that the insurer had built into its surplus-note provision—including both interest and principal—plus

74
Cf., e.g., Southern Union Gas, 692 S.W.2d at 141 (distinguishing different methods for
“costing” long-term debt capital, common stock capital, and preferred stock capital within
determination of gas utility’s rate of return, and explaining that the cost of long-term debt capital is
simply “the interest rate contractually agreed upon by the investor and the [regulated entity]”).
75
See id.

28
grow additional surplus at a rate of at least 4% annually through 2008. Appel also prepared a similar

set of projections that assumed a 7.8% underwriting profit, which generated surplus growth of at

least 9% annually above the amortized costs of repaying the surplus note through the same period.

The rate ultimately ordered by the Commissioner, as noted, provided State Farm Lloyds an even

higher underwriting profit in both the initial and subsequent periods.

This evidence reasonably supports the Commissioner’s findings that the ordered rate

fully accounts for interest on the surplus note (and, indeed, also principal) through the return on

capital secured through underwriting profit. It would follow that allowing a separate provision

to recover interest would, as the Commissioner found, amount to a double-recovery and render

the rate excessive. In light of these findings and their evidentiary support, we cannot conclude that

the Commissioner’s refusal to separately provide for recovery of surplus-note interest renders

the ordered rate unreasonable or confiscatory. Accordingly, we overrule State Farm Lloyds’s first

point of error.

Recapitalization

In its second point of error, State Farm Lloyds asserts that the ordered rate, in both

the initial and subsequent periods, “failed to adequately and measurably provide for [its] principal

payments on the surplus note.” By this, significantly, State Farm Lloyds does not mean that

the ordered rate failed to provide it sufficient earnings to repay principal owed on the surplus

note—again, Appel’s projections tended to show that the rate would cover the annualized amortized

principal and interest on the note even with a lower underwriting profit than the Commissioner

ultimately ordered. Instead, the insurer’s contention is that the rate must also enable it to build

additional surplus at a rate that would increase its total surplus (net of amounts reserved for surplus-

29
note payments) to a 1:1 premium-to-surplus ratio within nine years. Unless the rate enables it to

do both, State Farm Lloyds insists, it would be forced to operate with “depleted” levels of surplus

for an inordinately prolonged period of time, and run the risk in the meantime that further

catastrophes would derail its repayment of the surplus note. Such developments, it adds, would

undermine confidence in its financial integrity and prevent it from attracting future investment to an

unreasonable and unconstitutional degree.76

This was the real point of Appel’s projections, as State Farm Lloyds emphasizes.

According to Appel’s calculations, a rate with a 5% underwriting profit and no surplus-note

provision would require 21 years (2024) to grow State Farm Lloyds’s surplus, net of surplus-note

payments, to reach a 1:1 premium-to-surplus ratio. With a 7.8% underwriting profit, according to

Appel, such “recapitalization” would take 17 years (2020).

The Commissioner was unpersuaded that State Farm Lloyds was entitled to recover

any costs related to the surplus note beyond the aforementioned return on its capital secured

through underwriting profit. Assuming the rate provided State Farm Lloyds returns on its

76
State Farm Lloyds summarizes its contentions as follows:

Regardless of how “capital costs” might ordinarily be treated for accounting or
ratemaking purposes, and regardless of whether an insurer’s replenishing surplus
depleted by catastrophes can properly be considered an “investment in capital” in the
traditional sense (a company investing in an asset to turn a profit), the fundamental
point is this: unless the rates set for the insurer allow it simultaneously to (1) rebuild
and maintain its surplus at prudent levels, and (2) timely pay off both interest and
principal on its surplus note, the financial integrity of the insurer will be crippled.
Without rates allowing for both (1) and (2), the insurer will not be able to “operate
successfully” (because it will have surplus below prudent levels) and it will not be
able to “maintain its credit” and attract capital” (because lenders don’t renew loans
to deadbeat clients).

Reply br. at 20–21 (citing Hope, 320 U.S. at 603).

30
capital commensurate with those to be earned in alternative investments of similar risk, as the

Commissioner observed in his order, there would be incentives for investors to provide capital

to State Farm Lloyds going forward.77 The Commissioner was similarly skeptical that there was

any immediate financial compulsion to provide State Farm Lloyds anything more. Although

acknowledging that having a 1:1 premium-to-surplus ratio would be “ideal,”78 the Commissioner

cited Appel’s projections indicating that the ordered rate (and even a rate providing a lower

underwriting profit) would enable the insurer to gradually rebuild its surplus to that 1:1 level

while amortizing the surplus note, albeit at a slower pace than would be possible with the surplus-

note provision. In light of this evidence, the upshot of State Farm Lloyds’s arguments, as the

Commissioner saw it, was that he should “establish a rate so [the] insurer can expect to grow its

surplus to a pre-determined level over a specified period of time over and above its cost of capital.”

He rejected that notion, emphasizing the Supreme Court’s holdings that “[a]ll that is protected

against, in a constitutional sense, is that the rates . . . be higher than a confiscatory level.”79 He

similarly viewed the surplus-note provision as an unjustified attempt by State Farm Lloyds not only

77
See Hope, 320 U.S. at 603 (“[T]he return to the equity owner should be commensurate
with returns on investments having corresponding risks.”).
78
State Farm Lloyds suggests that the Commissioner conceded in his order that nothing short
of a 1:1 premium-to-surplus ratio would be “prudent” in its insurance operations. This is not entirely
accurate. The Commissioner did accept a characterization by Appel that a 1:1 premium-to-surplus
ratio was “minimally prudent,” but this was only with respect to the hypothetical, risk-adjusted level
of capital that was utilized in calculating underwriting profit. See infra at 40–41. The Commissioner
explicitly rejected the 1:1 ratio as a requirement or minimum benchmark in assessing State Farm
Lloyds’s financial condition. Order at 101 & n.276.
79
Texaco, 417 U.S. at 391–92.

31
to recoup its legitimate costs of providing insurance to its then-current policyholders, but also to

effectively shift its past losses to them as well.

On the other hand, the Commissioner was given some pause by evidence that

State Farm Lloyds’s premium-to-surplus ratio in 2003 was relatively low, noting a concession by

TDI’s expert that the insurer’s premium-to-surplus ratio was only 2.35:1 around the time of the

original hearing. Until State Farm Lloyds regained more solid financial footing, the Commissioner

acknowledged, further unanticipated catastrophes would have had potentially “severe” repercussions

for the insurer’s ability to fund repayment of the surplus note, obtain additional capital, and

ultimately maintain financial viability. But the Commissioner remained unconvinced that he should

approve the surplus-note provision for these reasons, a provision that, in his view, purported to

provide State Farm Lloyds extraordinary returns above its cost of capital. Rather, the Commissioner

viewed these considerations as going to the cost of capital itself, more specifically risk—the potential

that State Farm Lloyds’s actual costs would vary from the expected costs anticipated in its rate—that

is factored into determination of the reasonable return on its capital and underwriting profit.

Additionally, the Commissioner determined that the parties themselves had not sufficiently

accounted for these and other considerations bearing on risk when determining cost of capital

and underwriting profit. To determine the appropriate rate, then, the Commissioner recalculated

underwriting profit with greater weighting of risk and determined that State Farm Lloyds should

receive a substantially higher underwriting profit of 8.5% of premium during the initial period and

8.0% in the subsequent period. Thus, the net effect of these rulings was to provide State Farm

Lloyds an additional 3.0% to 3.5% of premium on top of the 5% it had sought as underwriting profit

32
during the initial period, but not the full 9% of premium it had sought in the form of the surplus-note

provision.

As State Farm Lloyds recognizes, our ultimate consideration in addressing its

constitutional challenge to the ordered rate is whether the “end result” represents a reasonable

balancing between the interests of the insurer and its investors (chiefly State Farm Mutual) on one

hand, and those of its policyholders and the broader public interest on the other. With respect to

State Farm Lloyds’s second issue, that inquiry focuses on whether the Commissioner’s refusal to

permit State Farm Lloyds recovery of the full 9% of premium it sought through the surplus-note

provision caused the ordered rate to unreasonably disfavor its financial and investor interests relative

to those of ratepayers and the public. On the company and investor side of the equation, a rate that

provided State Farm Lloyds returns reflecting the opportunity cost of its capital would, as the

Commissioner observed, tend to attract funds from economically rational investors, at least in theory.

Moreover, as TDI and OPIC emphasize on appeal, the Commissioner heard evidence that if the

expense and earnings estimates anticipated in the rate held true, State Farm Lloyds would be able

to cover the annualized amortized costs of the surplus note and gradually grow its surplus. And

while the Commissioner acknowledged the potentially troubling consequences if actual events did

not turn out that way, especially during the initial term, he took account of this risk through a

substantial increase in the underwriting profit provided in the rate.

On the other side of the equation, furthermore, were concerns that a higher rate would

effectively force State Farm Lloyds’s then-current policyholders to bear the costs of the company’s

past losses. The Supreme Court has long held that a “company may not insist as a matter of

constitutional right that past losses may be made up by rates to be applied in the present and

33
future.”80 On the other hand, State Farm Lloyds insists that the surplus-note provision would actually

benefit, not harm, its ratepayers, and should accordingly be weighed favorably in the constitutional

balance. Because accelerated rebuilding of its surplus would tend to reduce the risk of future

financial perils, State Farm Lloyds urges, its current ratepayers should appropriately bear these along

with other costs of providing them insurance. More broadly, State Farm Lloyds insists that if its

rate fails to include the surplus-note provision, it and other insurers will be discouraged from seeking

this sort of extraordinary financing to survive future perilous times, opting instead to simply

withdraw from the market,81 and that future investment to aid financially strapped insurers in such

circumstances will likewise be chilled. These outcomes, State Farm Lloyds argues, would in turn

not only harm Texas consumers (especially if a large homeowners insurer like itself were to leave

the market), but thwart the regulated private-market approach to homeowners insurance that the

Legislature has heretofore generally preferred over more government-intensive policy alternatives.

We echo the Commissioner’s assessment that these are “vexing” and “difficult”

questions of insurance regulation, economic theory, and public policy. But resolution of such issues

within our governmental framework is vested first in the Commissioner or the Legislature, and it is

80
Bluefield Waterworks & Improvement Co. v. Public Serv. Comm’n, 262 U.S. 679, 694
(1923); see also Market St. Ry. Co. v. Railroad Comm’n of State of Cal., 324 U.S. 548, 567 (1945)
(“The due process clause has been applied to prevent governmental destruction of existing economic
values. It has not and cannot be applied to . . . restore values that have been lost by the operation of
economic forces.”); Galveston Elec. Co. v. City of Galveston, 258 U.S. 388, 395 (1922) (rate cannot
be held confiscatory merely on the basis that it is insufficient to enable the company to recoup
prior losses).
81
State Farm Lloyds offers the cautionary example of an affiliate, then the largest
homeowners insurer in Florida, who elected to withdraw from that market after it “was denied
adequate rates after unanticipated surplus-draining hurricane losses [reduced] its surplus . . . to
dangerously low levels despite a multi-million dollar surplus-note loan from State Farm Mutual.”

34
only at the margins of the other Branches’ lawful powers that the Judiciary properly has a say. We

are unpersuaded that the Commissioner, in refusing to afford State Farm Lloyds recovery of the full

9% of premium it sought through the surplus-note provision, has effected such an unreasonable

balancing among the interests of State Farm Lloyds, its investors, ratepayers, and the public as to

violate the constitutional norms.82 Consequently, we cannot conclude this decision renders the rate

confiscatory. Accordingly, we overrule State Farm Lloyd’s second point of error.

Contingencies

In its third point of error, State Farm Lloyds challenges the Commissioner’s refusal

to include the 2% contingencies provision in the rates for the initial and subsequent periods.

Alternatively, it urges that to the extent the Commissioner effectively included a contingencies

provision in the increased underwriting profit he awarded, he deprived it of a reasonable rate of

return on its capital because contingencies are in the nature of anticipated expenses rather than

anticipated profit. The predicate for both arguments is that the Commissioner’s failure to find

the required systematic variation between State Farm Lloyds’s projected and actual expenses

was arbitrary and not supported by substantial evidence. This is so, according to the insurer, because

it presented “uncontradicted” and “unimpeached” evidence establishing the required systematic

shortfalls.

Even accepting State Farm Lloyds’s view of the record, the Commissioner was not

obligated to accept or credit the insurer’s evidence regarding the contingencies provision as long as

82
See, e.g., Permian Basin, 390 U.S. at 770 (“ . . . any rate selected . . . from the broad zone
of reasonableness permitted by the Act cannot properly be attacked as confiscatory”).

35
he provided an explanation or findings that would establish a reasonable basis for his doing so.83

And, although State Farm Lloyds asserts otherwise, the Commissioner made underlying findings

demonstrating a reasonable basis for his rejection of the carrier’s evidence of systemic variations.

Among other facts, the Commissioner pointed to a significant intervening change in the ratemaking

process—in 2002, he had approved the use of policy forms that unequivocally excluded most mold

losses from basic coverage, thereby addressing a key driver of the adverse court decisions that

State Farm Lloyds had cited as proof of a systemic pattern of unforeseen losses. In the face of such

facts, State Farm Lloyds’s argument goes ultimately to the weight the Commissioner ascribed to its

evidence, and we cannot conclude he acted unreasonably or exceeded his discretion in that regard.84

We overrule State Farm Lloyds’s third point of error.

Underwriting profit

We next consider State Farm Lloyds’s challenge to the Commissioner’s determination

of underwriting profit in the initial period, a component of its fifth point of error. In addition to

being an independent ground for reversal, our preceding analysis of State Farm Lloyds’s arguments

83
See CenterPoint Energy Entex v. Railroad Comm’n, 213 S.W.3d 364, 373
(Tex. App.—Austin 2006, no pet.) (“An agency may accept or reject the testimony of witnesses. An
agency is not obliged to accept opinion testimony from an expert—even if it is the sole evidence
on the issue. But an agency must provide a basis for its rejection of uncontradicted, unimpeached
testimony that is neither inherently improbable or conclusory. The [agency] can reject such
uncontradicted evidence if it explains or makes findings that permit courts to review the
reasonableness of that rejection, but a failure to explain can result in reversal.”) (internal citations
omitted).
84
See, e.g., Pioneer Natural Res. USA, Inc. v. Public Util. Comm’n, 303 S.W.3d 363,
367–68 (Tex. App.—Austin 2009, no pet.) (agency “‘is the sole judge of the weight to be accorded
the testimony of each witness . . .’”) (quoting Central Power & Light, 36 S.W.3d at 561).

36
regarding the surplus note rested, in part, on the assumption that the underwriting-profit provision

in the ordered rate had sufficiently secured it a rate of return consistent with its cost of capital.

State Farm Lloyds argues that the Commissioner’s determination of underwriting

profit is not supported by substantial evidence because “he used a method that no witness proposed

and no record evidence supports as an acceptable method for determining the profit provision.” It

thus invokes the principle that substantial-evidence review, however deferential its factual aspects

may be, still requires that an agency decision find ultimate support in evidence or facts officially

noticed, and mere “agency expertise cannot be a substitute for proof.”85 It follows from this

principle, as State Farm Lloyds emphasizes, that an agency’s methodology for calculating a rate or

a rate component must find ultimate support in the evidence, facts judicially noticed, or an agency

rule.86 But this does not necessarily mean that there must be explicit testimony or evidence of a

particular methodology or calculation—in a given case, for example, the evidence might well enable

the agency to reasonably infer an appropriate method that combines elements presented by different

witnesses but no single witness.87 Similarly, even where no single witness testifies that the

85
Railroad Comm’n v. Lone Star Gas Co., 618 S.W.2d 121, 124–25 (Tex. Civ.
App.—Austin 1981, no writ).
86
See Railroad Comm’n v. Moran Util. Co., 728 S.W.2d 764, 766–67 (Tex. 1987); Central
Power & Light, 36 S.W.3d at 557–58; Lone Star Gas, 618 S.W.2d at 124–25.
87
See Pioneer, 303 S.W.3d at 367–70 (although no witness testified specifically that 35%
of utility’s computer system should be considered used and useful and included in its rate base,
agency could reasonably infer that calculation from evidence that (1) 70% of the system’s cost was
allocable to its regulated operations and (2) 50% of the system had been used and useful during the
test year; observing that “even where no evidence suggests a specific figure explicitly, the [agency]
may infer that figure if it is supported by the body of evidence on that issue”); see also Central
Power & Light, 36 S.W.3d at 547 (observing that because an agency “may accept or reject in whole
or in part the testimony of the various witnesses who testify . . . [i]t follows . . . that substantial

37
calculation should yield a specific figure, competing testimony may present a range of reasonable

options from which the agency has discretion to choose.88

The primary focus of State Farm Lloyds’s argument is that the Commissioner

took account of the surplus-note obligation and the possibility of contingencies as factors probative

of risk that should bear upon underwriting profit rather than viewing them as justifications for the

specific rate provisions it had advocated. In State Farm Lloyds’s view, the evidence afforded the

Commissioner only one alternative for addressing these issues—adopt the solution advocated by

its experts and include the 9% surplus-note provision and 2% contingencies provision in the rate.

State Farm Lloyds overlooks that TDI and OPIC’s experts advocated an alternative method for

addressing the surplus-note obligation and the possibility of contingencies, albeit not the one the

insurer preferred—regard any such costs as costs of capital and relegate State Farm Lloyds to

recovering these costs through the underwriting-profit provision of the rate. As previously indicated,

there was ample evidence to support the Commissioner’s rejection of State Farm Lloyds’s proposed

evidence will support a method of calculating [a rate component] that is an amalgam of methods
proposed by different witnesses”).
88
See City of El Paso v. Public Util. Comm’n, 883 S.W.2d 179, 185–86 (Tex. 1994) (where
evidence “ranged from expert testimony that no imprudence disallowance should be imposed, to
testimony that a 50% imprudence disallowance should be imposed, and finally to testimony that
there is no known theory to quantify the flaws in [the utility’s] decision making process,” and
“because of the admitted complexity in valuing decisional imprudence in this case,” holding that
“there is a reasonable basis for the Commission to, in its discretion, select an amount within the
range of figures provided by expert testimony of the parties”); Pioneer, 303 S.W.3d at 373–74
(where parties presented competing evidence as to whether utility’s capital structure for purposes
of ratemaking should be its actual 83/17% debt-to-equity ratio versus a hypothetical 60/40% ratio,
holding that Commission’s selection of a hypothetical 75/25 figure was supported by substantial
evidence, as “the evidence presented in favor of any against each endpoint was such as would allow
for a hypothetical capital structure to be selected between those endpoints”); cf. id. at 370 (also
acknowledging that, in a particular case, the evidence might conceivably permit only a binary choice
between two end points).

38
alternative. In this respect, State Farm Lloyds’s complaint about underwriting profit is merely a

corollary to its other arguments challenging the Commissioner’s refusal to include the surplus-note

and contingencies provisions in the rate.

State Farm Lloyds is correct, however, that no witness explicitly advocated taking

account of the surplus-note obligation and the possibility of contingency as additional elements of

risk to be factored into underwriting profit above the risk that would already be reflected in the 5%

underwriting profit State Farm Lloyds had advocated. But to the extent State Farm Lloyds is arguing

that the Commissioner should have refrained from making his upward adjustments to underwriting

profit after having rejected the two rate provisions, any error would only have been to the insurer’s

benefit.89 Regardless, the evidence reasonably supported the Commissioner’s decision to make an

upward adjustment to underwriting profit. A key underpinning of TDI and OPIC’s opposition to the

surplus-note provision (and, ultimately, of the Commissioner’s rationale in rejecting it) was that the

rate’s underwriting-profit provision already compensated State Farm Lloyds for its cost of capital.

This reasoning logically presumes a reasonably accurate calculation of State Farm Lloyds’s cost of

capital and underwriting profit. A key determinant of the cost of capital (and, in turn, underwriting

profit), everyone agrees, is the level of risk the insurer faces (i.e., the potential for future random

deviations between the estimated costs accounted for in the insurer’s rate and what its actual costs

turn out to be). Hence, if the Commissioner found the existence of additional risk that had not been

factored into the determination of underwriting profit and was material to it, it would follow that an

adjustment to that provision would be necessary to ensure that the insurer was reasonably

89
See Tex. Gov’t Code § 2001.174(2) (reversal required only “if substantial rights of the
appellant have been prejudiced”).

39
compensated for its cost of capital. The Commissioner found such an adjustment to be warranted

here, and this finding is reasonably supported by at least two evidentiary bases. First, and most

obviously, State Farm Lloyds itself had viewed the surplus-note obligation and contingencies issue

as justifying separate rate provisions and presumably would not have factored them into the

risk bearing on its underwriting-profit calculation. Second, the Commissioner heard evidence to the

effect that the 5% underwriting-profit figure advocated by State Farm Lloyds was to some extent a

standard or industry figure commonly used when fashioning property-insurance rates. This case was

different, the Commissioner reasoned, finding that “[t]he element of risk associated with repaying

a surplus note, plus interest, would not be present in a typical insurer, which has no surplus notes,

and would not be prominent in an aggregation of all insurers, as most insurers do not have surplus

notes.” State Farm Lloyds has not challenged that finding. In sum, while not advocated specifically

by any one witness, the Commissioner’s decision to consider the surplus-note obligation and

possibility of contingencies as indicia of additional risk and accordingly revisit underwriting profit

is nonetheless grounded in reasonable inferences from the evidence the parties did present.90

State Farm Lloyds further contends that the specific methodology through which the

Commissioner adjusted underwriting profit lacks support by substantial evidence. To the extent

State Farm Lloyds is urging that the Commissioner should have adjusted underwriting profit to some

amount higher than it did, we will proceed to address its contention.91 To determine the necessary

adjustments to underwriting profit, the Commissioner utilized the same basic formula that

90
See Pioneer, 303 S.W.3d at 367–70.
91
See Tex. Gov’t Code § 2001.174(2) (reversal required only “if substantial rights of the
appellant have been prejudiced”).

40
State Farm Lloyds had itself employed to calculate underwriting profit, a method that the evidence

further indicates is widely accepted among actuaries.92 Under this method, simply described,

State Farm Lloyds solved for the amount of underwriting profit the carrier would have to obtain to

yield, when combined with estimated investment income and other income, and after taxes, what

would be a reasonable average rate of return on a hypothetical risk-adjusted level of capital.93

According to State Farm Lloyds’s witnesses, the hypothetical level of capital—customarily

expressed in terms of a premium-to-surplus ratio, with a lower ratio signifying higher risk and vice

versa—represents a level at which the risk associated with the amount of capital allocated to each

exposure unit is of a targeted average intensity. In determining its underwriting profit, State Farm

Lloyds had chosen a hypothetical 1:1 premium-to-surplus ratio. With that input, State Farm Lloyds

had determined that 5% underwriting profit, when combined with its estimated investment and other

income, and after taxes, would yield an average rate of return on surplus of 12.4%, which it had

adjusted to an estimated return on equity calculated under GAAP of just under 10%. Although OPIC

advocated a lower underwriting profit of 2.5%, TDI staff ultimately concurred with State Farm

Lloyds that a 5% underwriting profit was appropriate and that the rate of return it had achieved

was reasonable.

The Commissioner found that “[i]t is reasonable to use SFL’s profit model in deriving

an underwriting profit provision for use in this case,” with “further consideration of the premium

to surplus ratio used in the profit model” in light of various risk factors he had identified. The

Commissioner then made the following specific findings:

92
See ASOP 30, at 7.
93
See id.

41
136. SFL’s theoretical [1:1] premium to surplus ratio was described by SFL as
being “minimally prudent” [for purposes of determining underwriting profit].

137. One SFL witness testified that analyses of premium to surplus ratios for
professional reinsurers and Bermuda property reinsurers, combined with “the
fact that SFL is not charging anything in the rate for catastrophe reinsurance”
could justify a premium to surplus ratio as low as 0.5 to 1.0. Elsewhere in his
testimony, the same witness acknowledges that SFL has made some provision
for catastrophe reinsurance, but that “since many exposures are not covered
by the catastrophic reinsurance coverage and since in Texas, many
catastrophes are too small to exceed the reinsurance deductible (or
‘attachment point’), the coverage is incomplete.”

138. Other evidence in the record demonstrates that SFL is making significant
provision for catastrophe reinsurance.

139. The fact that SFL is making significant provision for catastrophe reinsurance
greatly diminishes SFL’s assertion that a premium to surplus ratio as low as
0.5:1.0 could be justified; but the fact that some catastrophe exposure is not
fully covered by reinsurance offers some support for using a premium to
surplus ratio of modestly less than 1.0:1.0.

140. The justification for using a premium to surplus ratio of less than 1.0:1.0 is
strengthened significantly when other elements of risk are considered.

141. The fact that SFL is a single-state insurer deriving almost its entire premium
from a single line of insurance which includes catastrophe coverage in a
catastrophe-prone state was brought forth in the record as an indication of
risk.

142. As noted earlier . . . the existence of a surplus note, and the obligation to
repay such note by a date certain, along with related interest, is an element of
risk inherent in SFL’s writing of homeowners insurance in 2003.

143. The element of risk associated with repaying a surplus note, plus interest,
would not be present in a typical insurer, which has no surplus notes, and
would not be prominent in an aggregation of all insurers, as most insurers do
not have surplus notes.

144. SFL’s surplus note, and the obligation to repay it, along with related interest,
suggests that an otherwise reasonable premium to surplus ratio, or what might
be construed as a “minimally prudent” premium to surplus ratio, may not be
reasonable to determine an appropriate underwriting profit provision with
respect to SFL’s writing of homeowners insurance in 2003.

42
 145. SFL’s surplus note, and the obligation to repay it, along with related interest,
by December 31, 2016, suggests that the use of a lower premium to surplus
ratio to determine the underwriting profit provision may be, in consideration
of SFL’s writing of homeowner’s insurance in 2003, more reasonable than
the 1.0:1.0 ratio used in SFL’s analysis.

146. As noted earlier [in regard to the contingencies provision], the conclusion that
there may be a systematic variation between expected costs and actual costs
implies risk.

147. To the extent such risk is not contemplated in the 1.0:1.0 premium to surplus
ratio used in the SFL profit model, there is a basis for using a premium to
surplus ratio lower than 1.0:1.0.

With that prologue, the Commissioner found that:

148. . . . (1) SFL is a single-state writer, writing almost exclusively homeowners
insurance, which includes catastrophic coverage, in a catastrophe-prone state;
(2) SFL faces an element of risk associated with the obligation to repay the
$1.05 billion surplus note, along with related interest by a date certain; and
(3) there may be systemic variation between expected costs and actual costs
which has not been addressed in the ratemaking process. For these reasons,
it is reasonable to accord to SFL’s writing of homeowners insurance in 2003
[emphasis in the original] a greater measure of risk than is contemplated in
the 1.0:1.0 premium to surplus ratio contained in SFL’s profit model.

As for what that specific ratio should be, the Commissioner further found that a “reasonable

premium to surplus ratio for use in this proceeding would be somewhere below 1.0:1.0, but well

above 0.5:1.0.” This range of hypothetical premiums-to-surplus ratios, the Commissioner observed,

translated into “profit provisions . . . in the range of 7.0% to 10.0%.” The Commissioner then

selected 8.5% as “a reasonable profit . . . provision, including a provision for hurricane risk, for SFL

in conjunction with its writing of homeowners insurance in Texas in 2003.”

Although State Farm Lloyds is correct that no witness explicitly testified in support

of the upward adjustment to underwriting profit the Commissioner ultimately made, this was hardly

43
a case where the Commissioner “embarked on [his] own method that goes beyond anything in

the record.”94 To the contrary, the Commissioner utilized a formula that had been supplied by the

insurer’s own witnesses and adjusted but a single input—the appropriate hypothetical amount of

risk-adjusted capital, expressed as a premium-to-surplus ratio—which all agree is the means by

which risk is accounted for in that formula. While State Farm Lloyds had assumed a 1:1 premium-

to-surplus ratio, the Commissioner heard evidence that a ratio as low as 0.5:1 could be appropriate

depending on the extent to which the insurer was able to shift its risks of catastrophe losses through

reinsurance. The Commissioner chose a ratio (and a corresponding underwriting profit) in the

middle of this range, reasoning that while a 0.5:1 ratio was inappropriate in light of State Farm

Lloyds’s provision for catastrophe reinsurance, there remained risks of losses that had not been fully

addressed by that reinsurance, along with the additional risks presented by the surplus note and

possible contingency.95 While State Farm Lloyds would insist on greater exactitude in correlating

specific adjustments to the premium-to-surplus ratio to particular risk factors, we cannot conclude

that the Commissioner “selected a figure that is outside the range of the applicable evidence, or

that is otherwise unsupported by any evidence.”96 Accordingly, we overrule State Farm Lloyds’s

94
See Central Power & Light, 36 S.W.3d at 557–58.
95
See City of El Paso, 883 S.W.2d at 185–86.
96
Pioneer, 303 S.W.3d at 370; see also id. at 373 & n.1 (rejecting complaints that no
evidence established that a 75/25 capital structure “was more correct than a 77/23 structure, a 79/21
structure, or a 81/19 structure,” as “our inquiry is not whether the evidence establishes that the
capital structure selected was the best option available,” only whether there was a reasonable basis
for it, and in that regard “the record evidence may preponderate against the agency’s decision and
yet still . . . satisfy the substantial evidence standard) (emphasis in original).

44
challenge to the 8.5% underwriting profit the Commissioner awarded in the ordered rate for the

initial period.

Subsequent period

The foregoing holdings resolve each of State Farm Lloyds’s challenges to the

ordered rate for the initial period. We now turn to State Farm Lloyds’s arguments regarding the rate

the Commissioner determined for the “subsequent period” between September 1, 2004 and July 31,

2008, which are further components of its fifth point of error.

As a threshold matter, State Farm Lloyds questions (although does not extensively

brief or argue) whether the Commissioner had statutory authority to reduce its implemented rate

with respect to any period after August 31, 2004, the last day former art. 5.26–1 remained in effect.

While State Farm Lloyds is correct that the legality of its implemented rate, as applicable to periods

after August 31, 2004, is necessarily governed by statutes other than former art. 5.26-1, it overlooks

that each of the successor statutory regimes also empowered the Commissioner to order refunds

based on a final determination that State Farm Lloyds’s implemented rate had been excessive.

Under former art. 5.142, as previously noted, the Legislature provided for refunds with interest in

a manner identical to former art. 5.142 in the event the Commissioner’s rate determination

was upheld on appeal.97 Similarly, under the file-and-use regime, former art. 5.144 of the Insurance

97
See former art. 5.142, § 14. In fact, State Farm Lloyds acknowledged as much in State
Farm Lloyds III, observing that “[i]f [it] loses, and the Commissioner’s rate reduction order is
reinstated on appeal, then Articles 5.26–1 and 5.142 provide their own remedy for any overcharges
during that period . . . [it] will be required to refund the ‘overcharged premium’ to each policyholder,
plus interest, in accordance with the terms of those statutes.” 267 S.W.3d at 446.

45
Code (now codified as chapter 2254 of that Code)98 has authorized the Commissioner to order

refunds of any filed rate he determines to be excessive.99 State Farm Lloyds suggests that the

latter provision is inapplicable here because it contemplates a right to a rate hearing before the

State Office of Administrative Hearings, as opposed to the Commissioner alone,100 the procedure

followed here. This assertion is in the nature of an unpreserved complaint of procedural error

rather than a basis for holding former art. 5.144 inapplicable in the first instance. In short, the

Commissioner has had statutory authority to determine whether and the extent to which State Farm

Lloyds had charged its policyholders excessive rates, and to order refunds accordingly, not only

with respect to the initial period in which former art. 5.26–1 was in effect, but also in the

subsequent period that followed.

Assuming the Commissioner’s statutory authority to determine the appropriate rate

for the subsequent period, State Farm Lloyds’s core complaint is that the Commissioner, in setting

a rate that was flat or uniform throughout the entire subsequent period, failed to take account of

significant intervening increases in its costs of providing insurance. State Farm Lloyds points to

evidence that, beginning in 2006, its reinsurance costs had significantly increased as world

markets responded to Hurricanes Katrina and Rita in late 2005 and eight other hurricanes that had

hit Florida in 2004 and 2005. In fact, one of TDI’s experts, Dr. Mark Crawshaw, maintained during

the hearing that State Farm Lloyds’s initial rate had ceased to be excessive from July 2006 onward

98
See Act of June 2, 2003, 78th Leg., R.S., ch. 206, § 1.01, 2003 Tex. Gen. Laws 907,
912–13 (currently codified at Tex. Ins. Code §§ 2254.001–.004) (“former art. 5.144”).
99
See former art. 5.144(b).
100
See former art. 5.144(c).

46
and thereafter became inadequate. Based in part on these cost increases, State Farm Lloyds would

ultimately obtain Commissioner approval for the rate increase that took effect in mid-2008.

State Farm Lloyds attacks the ordered rate through two primary legal theories. First,

similar to its arguments regarding underwriting profit in the initial period, it asserts that the

Commissioner’s formulation of a flat rate for the entire subsequent period was founded on a

methodology that no witness had proposed and no evidence supported. Second, State Farm Lloyds

insists that the Commissioner acted arbitrarily and capriciously in imposing a flat rate that excluded

consideration of its significant cost increases during the subsequent term. Relatedly, it contrasts

the Commissioner’s failure or refusal to account for these cost increases with his reduction of

underwriting profit for the entire subsequent period—i.e., beginning September 2004—based on

surplus-loan repayments that did not occur until 2006.101 Such “arbitrary hindsight,” State Farm

Lloyds urges, represented a selective departure from the prospective ratemaking on which the

Commissioner had otherwise insisted, forcing it to absorb rate reductions based on actual post-2003

events while simultaneously depriving it of the benefit of actual post-2003 events that would have

increased its rates.

We are compelled to agree that the Commissioner’s reduction of underwriting profit

based on post-2003 events, in the context of imposing a single flat rate for the entire subsequent

period, was arbitrary and capricious. This becomes apparent when considering the methodology

the Commissioner used to set the rate. Having found that the evidence “suggests the level of

excessiveness in SFL’s rates declined over time,” the Commissioner considered two alternative

101
State Farm Lloyds also argues that the specific 0.5% downward adjustment the
Commissioner made was not supported by substantial evidence. We need not reach this contention.

47
methodologies for accounting for the changes that had been proposed by State Farm Lloyds’s

actuary, Rob Kelley. Both methodologies were prospective in nature, although their points of

reference differed. In the first, which the Commissioner would term the “Trend Projection

Method,” Kelley had utilized the data known and knowable as of September 2003 (i.e., the same

information from which the initial-period rate had been derived) and extended projections originally

used to develop certain cost components of the initial-period rate. Applying these projections to

State Farm Lloyds’s rate indication for the initial period, Kelley devised rates for each of

three successive annual periods beginning on September 1, 2004, 2005, and 2006, and a final period

between September 1, 2007, and the end of the subsequent period, July 31, 2008. In Kelley’s

second method, termed the “Augmented Data Method,” he determined these annual rates based on

data that would have been available at each interval.

The Commissioner found that the Trend Projection Method—the one relying

solely on September 2003 information—“is most suitable for determining a rate for SFL

for the subsequent period.” Taking the ordered rate for the initial period as his starting point, the

Commissioner, similar to Kelley, “trended” increases in State Farm Lloyds’s estimated earned

premiums and four cost components in the rate—(1) non-catastrophe loss and loss adjustment

expense (LAE); (2) hurricane catastrophe loss and LAE; (3) non-hurricane catastrophe loss

and LAE; and (4) fixed expenses—and made specific findings as to the annual percentage

increases that should be applied to each.102 However, rather than determining a rate for each of the

four annual segments within the subsequent period, as had Kelley, the Commissioner determined

102
The Commissioner found that both earned premiums and non-catastrophe loss and LAE
would increase by 1.3% each year, hurricane catastrophe loss by 1.8%, non-hurricane catastrophe
loss and LAE by 4.85%, and fixed expenses by 3%.

48
a single rate for the entire subsequent period by trending the aforementioned rate components up

to February 15, 2007.

The Commissioner offered two justifications for this departure from Kelley’s

approach. First, he explained that February 15, 2007, represented the “average date of loss” under

the State Farm Lloyds policies that would have been sold during the subsequent period, represented

by the midpoint between the first day such a policy could have been effective (September 1, 2004)

and the date the last policy could have expired (July 31, 2009).103 According to the Commissioner,

it was “common actuarial practice” to trend cost projections underlying a rate to the average date

of loss under the policy, and he pointed out all parties had accordingly trended their projections

underlying the initial period rate until September 1, 2004, the midpoint between the first day the

initial-period policies could have been effective and the last day they could have expired. On the

other hand, the Commissioner also acknowledged that “formulating a homeowner’s rate for such

a long duration,” as he was doing in the subsequent period, “is simply unheard of.”

The Commissioner’s second justification was that “there is no substantive

difference,” in terms of the amounts State Farm Lloyds would ultimately owe as refunds, between

his trending of the rate components for the entire subsequent period as a whole and Kelley’s

delineation of annual segments. “This is especially true,” the Commissioner added, in light

of evidence that State Farm Lloyds “has ‘extremely high’ renewal rates.” In essence, the

Commissioner reasoned that while the excessiveness of State Farm Lloyds’s initial rate would differ

at any given time within the subsequent period, the differences would average out at 3.4% over

103
I.e., one year after the last day in which State Farm Lloyds’s implemented rate had been
in effect, July 31, 2008.

49
the entire period, at least when viewed from the perspective of September 2003 looking forward.

While urging that no evidence supports the Commissioner’s departure from Kelley’s year-by-year

approach, State Farm Lloyds does not appear to dispute the Commissioner’s math.

In sum, the Commissioner set a flat rate for the entire subsequent period founded on

cost projections made from the perspective of September 2003, approximately a year before the

period to which the rate applied began. This model foreclosed consideration of actual cost increases

that might occur during the subsequent period. From that standpoint, State Farm Lloyds’s evidence

of significant increases in reinsurance costs beginning in 2006 would have had no bearing on the

appropriate rate for the subsequent period. For that matter, these subsequent developments would

have had no bearing upon rates determined in annual segments under Kelley’s original Trend

Projection Method, either, because that method likewise relied on September 2003 data.

But having deprived State Farm Lloyds of the benefit of any intervening

developments that could favorably impact its indicated rate, the Commissioner also forced it to

bear the unfavorable consequences to underwriting profit that he derived from the 2006 surplus-

note repayments. TDI and OPIC insist that both the Commissioner’s method in setting a single flat

rate for the entire subsequent period and his downward adjustment of underwriting profit

were supported by substantial evidence, and that it likewise supported the “amalgam” of rating

methodologies the Commissioner devised.104 Even if so, the Commissioner’s actions are

independently subject to reversal if arbitrary and capricious.105 An agency’s decision may be held

104
See Central Power & Light, 36 S.W.3d at 547.
105
See, e.g., State Farm Lloyds II, 260 S.W.3d at 245 (“Even if supported by substantial
evidence, however, an agency’s order may be arbitrary and capricious . . . .”).

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 arbitrary and capricious if, among other defects, “it is based on legally irrelevant factors or if legally

relevant factors were not considered or if the agency reached an unreasonable result.”106 In the

context of the single rate he established for the entire subsequent period, the Commissioner’s

reduction of underwriting profit was based on a factor that he had acknowledged to be legally

irrelevant and inappropriate—the use of 2006 and 2007 data to determine a rate that applied

prior to that time. In effect, the Commissioner engaged in prohibited retroactive ratemaking with

respect to those earlier periods. He also did so selectively and unreasonably, in essence cherry-

picking post-September 2003 data where it served to reduce State Farm Lloyds’s indicated rate

while excluding consideration of post-September 2003 data that could have increased it, with

no evident justification for the differential treatment. Even while recognizing the constitutional

leeway afforded to an agency’s choice of ratemaking methods, the Supreme Court has cautioned

nonetheless that a “decision to arbitrarily switch back and forth between methodologies in a way

which requires investors to bear the risk of bad investments at some times while denying them the

benefit of good investments at others would raise serious constitutional questions.”107

The Commissioner’s determination of the rate for the subsequent period was arbitrary

and capricious, and must be reversed.108 To that extent, we sustain State Farm Lloyds’s fifth point

of error.

106
Id. at 245 (citing City of El Paso, 883 S.W.2d at 184; Dunn v. Public Util. Comm’n,
246 S.W.3d 788, 791 (Tex. App.—Austin 2008, no pet.)).
107
Duquesne, 488 U.S. at 315.
108
See Tex. Gov’t Code § 2001.174(2)(f) (requiring reversal of agency “findings, inferences,
conclusions, or decisions” that are” “arbitrary or capricious”); Granek, 172 S.W.3d at 782 (reversing
agency decision that was arbitrary and capricious).

51
Interest

Having determined that State Farm Lloyds’s initial rate was excessive during both the

initial and subsequent periods, the Commissioner ordered refunds of the “overcharged premiums,”

plus interest, citing the refund provisions of both former art. 5.26–1 and chapter 2254 (the former

art. 5.144) without distinguishing between overcharges for the initial versus subsequent periods

or, with respect to the latter, those occurring while former art. 5.142 was in effect (i.e., before

December 1, 2004) as opposed to thereafter. The Commissioner similarly conflated the statutory

provisions in awarding interest on the refunds he held to be due, determining that interest on all

refunds should be awarded in accordance with former art. 5.26–1 for each year during both the initial

and subsequent periods, but only for the interest that accrued up to the date of his order. Interest

accruing from the date of the Commissioner’s order forward, he reasoned, would accrue under

chapter 2254, regardless of when the overcharge occurred. The statutory distinction is not merely

formal or technical. Under former art. 5.26–1, the Legislature had specified that “[t]he interest rate

is the prime rate plus one percent as published in the Wall Street Journal on the first day of each

calendar year that is not a Saturday, Sunday, or legal holiday.”109 An identical interest provision

appeared in former art. 5.142.110 In contrast, beginning in 2005, chapter 2254 (or its predecessor,

former art. 5.144) have specified that an “interest penalty” accrues on refund amounts at a rate that

109
Former art. 5.26–1, § 6.
110
Former art. 5.142, § 14.

52
is the lesser of 18 percent or the sum of six percent and the prime rate for the calendar year in which

the Commissioner’s order finding the rate excessive is issued.111

Apart from State Farm Lloyds’s complaints regarding the propriety of the refunds

themselves and the Commissioner’s underlying rate determinations, none of the parties have

challenged the Commissioner’s award of interest on all refunds at the rate of one percent over the

prime rate for each year at issue, consistent with the rate prescribed by former art. 5.26–1, up to

the date of his order (a/k/a “pre-order” interest). However, in its sixth issue, State Farm Lloyds urges

that the Commissioner reversibly erred in awarding post-order interest accruing on all refunds at the

higher rate specified in chapter 2254. In State Farm Lloyds’s view, interest on any refunds, both

before and after the date of the Commissioner’s order, is governed exclusively by former art. 5.26–1

regardless of when the overcharge occurred. With respect to the overcharges the Commissioner

found to have occurred during the initial period, we agree—as previously explained, former

art. 5.26–1, which continues in effect for these purposes, governs the validity of State Farm Lloyds’s

111
As originally enacted in S.B. 14, former art. 5.144 contained no requirement that interest
be awarded on refunds held to be due. See former art. 5.144. During the Legislature’s following
regular session, it twice amended former art. 5.144 to require interest on refunds at the rate described
above. See Act of May 29, 2005, 79th Leg., R.S., ch. 291, § 1, 2005 Tex. Gen. Laws 869; Act of
May 29, 2005, 79th Leg., R.S., ch. 899, § 16.01, 2005 Tex. Gen. Laws 3098, 3112. However, during
the same session, the Legislature recodified the underlying provisions of former art. 5.144—minus
the amendments adding the interest requirement—into chapter 2254 of the Insurance Code. See
Act of May 24, 2005, 79th Leg., R.S., ch. 727, § 2254.002, 2005 Tex. Gen. Laws 1752, 2145.
Although omitted from the recodification, the new interest requirement was nevertheless preserved
and effective by operation of law. See Tex. Gov’t Code § 311.031(c) (“The repeal of a statute by
a code does not affect an amendment, revision, or reenactment of the statute by the same legislature
that enacted the code. The amendment, revision, or reenactment is preserved and given effect as part
of the code provision that revised the statute so amended, revised, or reenacted.”). The Legislature
corrected the omission from the recodification during its next regular session with amendments
to section 2254.003 of the Insurance Code, see Act of May 23, 2007, 80th Leg., R.S., ch. 484, § 3,
sec. 2254.003, 2007 Tex. Gen. Laws 850, 851, and the provision has remained in substantially this
form through the present time, see Tex. Ins. Code § 2254.003.

53
implemented rate during the initial period, its policyholders’ right to refunds of “overcharged

premium,” and interest on those amounts. To this extent, we sustain State Farm Lloyds’s sixth issue.

As for interest on any refunds for overcharges during the subsequent period, our

definitive resolution of that issue must await the proceedings on remand to determine the appropriate

underlying rate or rates during that time and whether or for what times any refunds are owed. We

note, however, that we have held above that the Commissioner’s authority to order refunds during

the subsequent period is governed by former art. 5.142 with respect to any overcharges between

September 1, 2004 and November 30, 2004, and by former art. 5.144 and chapter 2254 for periods

thereafter. On the other hand, appellees have not preserved any complaint in this appeal regarding

the propriety of the Commissioner’s awarding of pre-order interest on all refunds held to be due in

accordance with former art. 5.26–1. We likewise observe that the Legislature did not authorize

interest awards under the former art. 5.144, at the higher prime-plus-six-percent rate or otherwise,

until 2005.112 On remand, if the Commissioner again finds that refunds are owing for the subsequent

period or a portion of it, the parties will have the opportunity to address whether or how these

observations bear upon the appropriate interest rate or rates.

Refunds

In its sole remaining point of error, its fourth, State Farm Lloyds argues that the

refunds with interest ordered by the Commissioner were confiscatory in light of their impact on the

insurer’s financial condition at the time of the order. Because we have reversed and remanded the

Commissioner’s determination of an appropriate rate for the subsequent period, any constitutional

112
See supra note 111.

54
challenge based on the financial impact of any refunds and interest ultimately awarded by the

Commissioner must await those further proceedings.

CONCLUSION

We affirm the portion of the district court’s judgment affirming the Commissioner’s

order determining a rate for the “initial period” and that State Farm Lloyds’s implemented rate

was excessive by 6.2% during that time frame. However, we reverse the portion of the judgment

affirming the Commissioner’s order setting a rate for the subsequent period and holding that

State Farm Lloyds’s implemented rate was 3.4% excessive then. We remand the question of the

appropriate rate and reductions for the “subsequent period,” as well as the ultimate determination

of refunds and interest awards, to the Commissioner for further proceedings consistent with this

opinion. We further hold that interest awarded on refunds for the initial period will be governed

exclusively by the rate specified in former art. 5.26–1, both before and after the date of the

Commissioner’s order.

__________________________________________
Bob Pemberton, Justice

Before Chief Justice Jones, Justices Pemberton and Henson;
Justice Henson not participating

Affirmed in part; Reversed and Remanded in part

Filed: November 26, 2014

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