Trieschmann, Hoyt & Sommer

Government Regulation of Risk Management and Insurance

Chapter 24

©2005, Thomson/South-Western

22

Chapter Objectives

• Explain why insurance needs to be regulated • Identify what aspects of insurance are regulated• State the pros and cons of state versus federal

regulation • Indicate how regulation affects insurance rates • Indicate the direction in which insurance

regulation is headed

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Why Insurance is Regulated

• Certain characteristics of insurance set it apart from tangible goods industries and account for the special interest in government regulation – Insurance is a service that is paid for in advance

• But its benefits are reaped in the future • Often the beneficiary is entirely different from the insured and is not

present to protect his or her self-interest when the contract is made – Insurance is affected by a complex agreement that few lay people

understand • The insurer could achieve a great and unfair advantage if disposed to

do so – Insurance costs are unknown at the time the premium is

established • There exists a temptation for unregulated insurers to charge too little

or too much

• Insurance is also regulated to control violations of the public trust

44

Future Performance

• The management of other people’s money immediately becomes a candidate for regulation – Because of the temptations for the

unscrupulous to use these funds for their own ends

• Instead of for those to whom the funds belong

– Particularly when it has grown to be one of the largest industries in the nation

55

Complexity

• Even if the lay person understands the implications of every legal clause in a contract – The rights of that person are vitally affected by the operation of

certain legal principles and industry customs to which no reference exists in the written contract

• The legal battles that have been fought over the interpretation of the contractual wording of a policy – Offer testimony to the fact that misunderstandings arise over the

meaning of provisions even after the best legal minds have attempted to make the intent of the insurer clear

• An insurer would find no difficulty in framing a contract that looked appealing on the surface– But under which it would be possible for the insurer to avoid any

payment at all

66

Unknown Future Costs

• The price the insurer must charge for service must be set far in advance of the actual performance of the service

• The cost of the service depends on many unknown factors – Such as random fluctuations in loss frequency and unexpected

changes in the cost of repairing property • To increase business, an insurer may consciously

underestimate future costs in order to justify a lower premium and attract customers – This may ultimately lead to the bankruptcy of the insurer

• If the insurer refuses to accept business except at a very high premium – Those who pay may be overcharged and those who cannot pay

will go without a vital service

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Violations of Public Trust

• These include – Failure by the insured to live up to the contract provisions – Formulation of contracts that are misleading and seem to

offer benefits they do not cover – Refusal to pay legitimate claims – Improper investment of policyholders’ funds – False advertising

• Abuses in insurance have been such that major investigations of the insurance business have taken place – However, it should be emphasized that most insurers

operate their business in an ethical fashion

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The Legal Background of Regulation • Insurance has traditionally been regulated by the

states – Each state has an insurance department and an

insurance commissioner or superintendent

• Before 1850, insurance was operated as a private business – With no more regulation than any other business

sector

• As a result of the early abuses of insurance, the need for regulation became apparent

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The Legal Background of Regulation• In 1868 an important U.S. Supreme Court decision, Paul

v Virginia – Established the right of states to regulate insurance by holding

that insurance was not commerce • But was in the nature of a personal contract between two parties

• In 1871 an organization that was later named the National Association of Insurance Commissioners was formed – Through whose efforts a considerable measure of uniformity in

regulation has been achieved • The South-Eastern Underwriters Association case

overturned the Paul v. Virginia ruling – The court held that insurance was commerce and when

conducted across state lines it was interstate commerce • This made insurance subject to federal regulation

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The McCarran-Ferguson Act

• The complete abandonment of state regulation of insurance in favor of federal regulation is not desired by either the insurance industry or state insurance commissioners

• The National Association of Insurance Commissioners propose what later became known as the McCarran-Ferguson Act which made these declarations – It was the intent of Congress that state regulation of insurance should

continue • No state law relating to insurance should be affected by any federal law

unless such law is directed specifically at the business of insurance – The Sherman Act, the Clayton Act, the Robinson-Patman Act, and the

Federal Trade Commission Act would be fully applicable to insurance • But only “to the extent that the individual states do not regulate insurance”

– That part of the Sherman Act relating to boycotts, coercion, and intimidation would remain fully applicable to insurance

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The McCarran-Ferguson Act

• Except to the extent indicated by the provisions of the McCarran-Ferguson Act– The insurance business continues to be

regulated by the states

• The law does not exempt the insurance business from federal regulation and provides for limited applicability of certain federal laws to insurance

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The McCarran-Ferguson Act

• Federal regulation is carried out by many different agencies including – Federal Insurance Administration – Export-Import Bank of Washington, DC – Federal Trade Commission – Security and Exchange Commission – U.S. Department of Labor – Internal Revenue Service – Pension Benefits Guaranty Corporation

1313

The McCarran-Ferguson Act

• Following passage of the McCarran-Ferguson Act, the National Association of Insurance Commissioners formulated a model bill – Designed to accomplish at the state level what the

Sherman, Clayton, FTC, and Robinson-Patman Acts accomplished as applied to business generally

– Was adopted in whole or in part by most states – In general, the philosophy of the legislation is that

rate-making cooperation is neither required nor prohibited

• Except to the extent necessary to meet the general requirements that rates be adequate, not excessive, and nondiscriminatory

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The McCarran-Ferguson Act

• In summary– Both states and the federal government are

currently exercising regulatory control over the insurance industry

• States still have basic regulatory functions – While the federal government exercises regulation in

specified areas only

– The general trend seems to be for more federal control

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Federal Versus State Regulation

• The chief arguments for federal regulation are – State regulation is not uniform and is not likely to

become so – State regulation is relatively ineffective

• It is not suitable to regulate or control the activities of an insurer that is nationwide in its operation

– Federal regulation would be more effective and less costly for insurers than state regulation

• Ill-advised statutes have been enacted by various states

1616

Federal Versus State Regulation

• State insurance commissioners are opposed to federal regulation • The major arguments in favor of state regulation are

– State’s supervision and regulation of insurance is reasonably satisfactory • No overpowering reason exists why federal regulation should be necessary

– Most of the arguments of those who favor federal control rest on dubious claims of inefficiency and on unproved claims that federal control would be more efficient

– Although lack of uniformity is admitted, the really important needs for uniformity have been achieved

• Or are being achieved through the voluntary cooperation of state insurance commissioners

– State regulation is more flexible than federal regulation • State regulation can relate to local needs

– If federal regulation were imposed, the result might be two systems of regulation instead of one

• A very large number of insurance companies confine their operations entirely within the boundaries of a single state

– Presumably, the states would continue to regulate these activities as intrastate commerce

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Responsibilities of the Insurance Regulators • Can be classified into four primary

categories – Licensing and enforcement of minimum

standards of financial solvency – Regulation of rates and expenses – Agents’ activities – Control over contractual provisions in

insurance policies and their effects on the consumer

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Licensing and Financial Solvency

• The insurance commissioner enforces the state’s laws regarding the– Admission of an insured to do business – Formation of new insurers – Liquidation of insurers who become insolvent

• The commissioner must see that – Adequate reserves are maintained for each line

insurance written – The investments of the insurer are sound and within

the state requirements

1919

Minimum Capital

• Licenses are granted according to the type of insurance business to be conducted

• Different capital standards are applied to each type • Minimum standards are set forth in each state and they

vary considerably from state to state and by type of insurer

• In the 1990s additional capital requirements were added beyond the flat dollar minimums – Called risk-based capital requirements

• The minimum amount of capital an insurer must hold varies according to the insurer’s particular asset and liability portfolio

– Those with riskier assets and those who write riskier lines of insurance are required to hold more capital

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Minimum Capital

• Evidence shows that minimum legal capital requirements for some types of insurers have not always been set at adequate levels

• The turnover among insurers has been substantial – One reason for this is financial difficulty that

might have been avoided with greater financial resources

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Investments

• Insurers do not have complete freedom over how to invest policyholder funds

• Excessively risky investments may result in an insurer being unable to meet its obligations

• All states impose investment limitations on insurers – The idea behind these limitations is to require that

funds paid in as an advance payment of premiums be invested relatively conservatively

• The objective is to maintain safety and to give sufficient liquidity to enable insurers to pay all claims when due

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Liquidation

• The insurance commissioner is charged with the responsibility of liquidating an insolvent insurer

• An equitable treatment of policyholders and other creditors is essential

• Some types of insurers subject their policyholders to additional assessments in the event of financial inability to pay claims – The insurance commissioner must see that these

obligations are paid

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Security Deposits

• Most states require that each insurer make a deposit of securities with the insurance commissioner – To guarantee that policyholders will be paid

claims due them

• These laws have been unpopular because – The size of the deposit is generally too small

in proportion to the volume of business to be of any real protection to the insured

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Guaranty Funds

• All states have enacted some type of legislation covering the insolvency of insurance companies

• Much of this legislation is patterned after the modern bill proposed by NAIC in 1969– The purpose of the legislation is to

• Provide a mechanism for the payment of covered claims under certain insurance policies

• Avoid financial loss to claimants or policyholders because of the insolvency of an insurer

• Assist in the detection and prevention of insurer insolvencies • Provide an association to assess the cost of such protection

among insurers

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Guaranty Funds

• Have been established by all states • When insurers become insolvent these funds

pay the policyholder claims that the bankrupt insurers are unable to pay – The fund obtains the money needed through

assessments on the remaining insurers

• From their beginning in 1969 through 2000 – Assessments of over $7 billion have been made

against insurer members

• Table 24-1 lists guaranty fund net assessments during recent years

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Table 24-1: Guaranty Fund Net Assessments, 1993-2002

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Regulation of Rates and Expenses

• The state insurance department is responsible for regulating the rates and expenses of insurance companies

• If inadequate rates are charged– Insolvency becomes a threat

• If excessive or discriminatory rates are allowed – The insurance department must handle public

complaints

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Property-Liability Rates

• In all states, rates must meet three basic requirements – The rate shall be reasonable – The rate shall be adequate to cover expected losses and

expenses – The rate shall not be unfairly discriminatory among different

insured groups • The typical rating law permits insurers to form rating

bureaus – And to pool statistical information with these bureaus

• In about 30 states, prior approval laws dictate that a rate must be filed with the insurance commissioner before it can be used – The commissioner must give permission to use the rate or not

• The remaining states have open competition laws – Rating bureaus can publish advisory rates only

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Prior Approval Versus Open Competition Laws • One advantage of open competition laws is their relative

flexibility – Especially in regard to eliminating the delays in getting approval

for rating changes that exist under prior approval laws • Open competition laws also help increase the availability

of insurance – Under prior approval laws, if a rate is turned down, the insurer

may refuse to issue any coverage • Prior approval laws are also said to discourage

innovation • Prior approval laws subject the insurance commissioner

to political pressures to refuse to approve rate increases – Even though the increases may be justified – Rates are subject to negotiation between the commissioner and

the insurers, and are not determined scientifically

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State-Mandated Rates

• A few states have passed laws setting rates for given lines of insurance – Or requiring insurers to reduce automobile insurance rates

• Political factors usually have a large role in setting rates in these states – Frequently, private insurers withdraw from states with

undue restrictions • Another example of state-mandated rates is unisex

rating – Several states require insurers to pool loss experience for

males and females and quote a single rate • The effect of these laws has to been to increase the rates women

pay for some lines of insurance and reduce the rates women pay for other lines

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Life Insurance Rates

• Are essentially unregulated by states – Except indirectly through regulation of expenses and reserves

• Are affected by reserve and mortality assumptions – Life insurance reserves represent an insurer’s obligation to the

policyholder for the savings element in the life insurance policy – In calculating the reserve, an insurer assumes that it will earn

some interest rate and will experience a certain mortality rate • The higher the interest assumption and the lower the mortality rate

assumption, the lower the reserve and the associated premium rate will be

• States generally regulate the maximum interest assumption and the minimal mortality table

– In order to be assured that the life insurer will not charge so little that it cannot meet its obligations to the policyholder

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Life Insurance Rates

• It is assumed that competition among insurers will operate to keep life insurance rates from becoming excessive

• However, wide variations exist in life insurance premiums among insurers in the open market

• An active movement exists to require life insurers to disclose more information about costs to the policyholder – So that a more intelligent buying decision can be made – It can be presumed that as additional cost information is made

available • Open competition will become more efficient and will result in less

variation in premiums

• The internet may also contribute to reduced variation in premiums – A number of websites make it easy to compare prices of life

insurance across a large number of insurers

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Agents’ Activities

• The agent has been a dominant figure in the insurance industry almost from the beginning

• For most consumers the agent is the only contact with the insurer

• It is vital that the agent be well trained and posses a requisite degree of business responsibility

• Most states require any insurance representative to be licensed – And to pass an examination covering insurance and

the details of the state’s insurance law

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Agents’ Activities

• Part of the reason for the failure of insurers to insist on higher standards is due to the fact that agents generally are paid on a commission basis – The insurer assumes that because nothing is

paid out unless the agent produces business • The easiest way to obtain more businesses to hire

more agents • In such an atmosphere, the insurer is not likely to

insist that its agents be exceptionally well trained

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Agents’ Activities

• Most state laws prohibit such practices as – Twisting

• Occurs when an agent persuades an insured to drop an existing insurance policy by misrepresenting the facts for the purpose of obtaining an insured’s new business

– Rebating • Occurs when an agent agrees to return part of the

commission to an insured as an inducement to secure business

– Misrepresentation • An example would be making misleading statements about

the cost of life insurance

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Agents’ Activities

• In recent years, the insurance industry has expanded its offerings to include various types of equity products – Such as variable life insurance and mutual funds

• Variable annuities are subject to federal as well as state regulations

• An insurance sales agent of equity products must pass an examination covering the securities market and variable annuities before selling equity products

– In addition, the agent must satisfy any state licensing and education requirements

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Regulation of Contract Provisions

• New policy forms must be approved in most states before they’re offered to the public

• The purposes of such laws is to – Ensure that the rates being used meet state requirements as to

adequacy, nonexcessiveness, and fairness – Protect the public against deceptive, misleading, or unfair provisions – Approve the language in policies that is intended to make them

more readable and understandable by the consuming public • A recent trend has been the deregulation of commercial

lines contracts and rates – The idea is that while individuals may need protection from certain

unscrupulous insurers• Large businesses have the knowledge and resources to be able to take

care of themselves – State regulators can then focus their efforts on personal lines, where

consumer protection is likely to be more valuable

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Service-of-Process Statutes

• When a legal action is brought against an insurer, it is necessary to deliver a court summons to the insurer’s representative – The state insurance commissioner is generally the individual

who is authorized to receive such a summons• Formally, a problem arose as to how best to serve an

insurer that did not operate within a given state • Through the NAIC most states have now passed

statutes known as the unauthorized insurer’s service-of-process acts – It is no longer necessary for an insured to resort to distant courts

to bring suit on contracts written by unauthorized insurers – It is only necessary to serve summons on the insurance

commissioner or on someone representing the out-of-state insurer

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Retaliatory Laws

• Most states have laws requiring that, if an insured chartered in one state is subjected to some burden – That one state will automatically impose a like burden

on all insurers of the second state that are operating in the first state

• About ¾ of all states have such retaliatory laws • The effect is to discourage each state from

passing any unusual taxes on foreign insurers operating within its borders – For fear that the same burden will immediately apply

to its own insurers operating in other states

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Anticancellation Laws

• Laws restricting the rights of the insurers of automobiles to cancel policies without good reason

• In general, only private passenger autos are subject to the restrictions

• Insurers are also required to give ample advance notice of intent not to renew when the policy is approaching its expiration date

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Anticancellation Laws

• Most of the laws state that unless an insurer cancels a newly issued policy within 60 days after its effective date – It may cancel after that only for certain specified

reasons including • Nonpayment of premiums • Insurance obtained through fraudulent misrepresentation • Violation by the insured of any term or condition of the policy • Suspension of the driver’s operator’s license• Existence of heart attacks or epilepsy of the insured• Existence of an accident or conviction record • Habitual use of alcoholic beverages or narcotics to excess

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Anticancellation Laws

• The effect of anticancellation laws is further diluted by the use of six-month auto policies that must be renewed every six months – This gives the insurer the option not to renew

every six months • Because a nonrenewal is not a cancellation

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Reciprocal Laws

• Provide that if one state does something for another – That state shall do the same thing for the first

• For example, it is common for state financial responsibility laws to provide that – If under the laws of another state an insured

motorist would be disqualified from driving • The motorist shall also be prohibited from driving in

the first state

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Anticoercion Laws

• Aimed against the former practice of some lending agencies to require the placing of insurance with the agency as a condition of granting a loan

• Thus, the purchaser of a house might be prevented from placing property insurance with a personally-chosen insurer – The borrower had to pay premiums that were not

necessarily the lowest obtainable – These practices were held to be in restraint of trade

and illegal under one or more federal antimonopoly laws

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Tort Reform

• Because of rising liability awards in the nation’s courts public pressure for reform of tort liability rules has existed for years

• Many states have enacted new laws affecting the liability of the manufacturer for defective products

• Among laws passed by many states to reform the tort system are those that– Abolished joint and several liability – Modified the collateral source rule – Changed the state-of-the-art defense – Limited punitive damages

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Tort Reform

• The purpose of this type of legislation is to reduce the frequency and cost of court awards under liability insurance policies – And to make insurance more readily available and affordable

• The Product Liability Risk Retention Act of 1981 permits the formation of private insurance corporations to self-insure commercial liability risks – Two types of companies were authorized under this legislation

• Risk retention groups – Enabled a group of buyers to join together and form their own

insurance company to insure their own liability risks

• Risk purchasing groups – Enabled a group of buyers to join together and purchase liability

insurance on a group basis from commercial insurers

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Taxation of Insurance

• Insurance companies represent a relatively substantial source of revenue to states – In 2002 insurance premium taxes amounted to $11.1

billion

• In each state, these revenues are raised mainly from a tax on gross premiums

• Many states also have special taxes or assessments in connection with different lines of insurance, such as workers’ compensation

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Taxation of Insurance

• Insurance companies are also subject to federal taxation – Stock property insurers pay taxes on underwriting

and investment income at regular corporate rates – Mutual property insurers are exempt from taxation

if they have a net income of less than $75,000 • For larger mutuals, the tax is the larger of 1% of gross

income – Or the tax that would be collected by applying regular

corporate rates to investment income only

4949

Taxation of Insurance

• Life insurers are subject to federal income taxation under the Deficit Reduction Act of 1984 – Taxable income is defined as gross income

less special deductions – Regular corporate income tax rates apply to

the balance

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Future of Insurance Regulation

• In 1995 the U.S. Supreme Court ruled that annuities were not a form of insurance – The restrictions on banks selling insurance did not apply to

the sale of annuities – This has allowed banks to greatly expand their annuity

business

• In 1999 the Gramm-Leach-Bliley (GLB) Act was passed – Repeals the Glass-Steagall Act which was passed during

the Great Depression to create a firewall between banks, investment companies, and insurers

• Today these firewalls are no longer effective – Multinational firms operate all over the world, and U.S. domicile firms

must have the freedom to work in such markets

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Future of Insurance Regulation

• Under GLB, firms may be in all three businesses at the same time – Insurers can own and operate banks and vice

versa – During the next several years, more mergers

will likely occur between insurers, banks, and investment brokers

• An increase in the concentration of economic power will occur

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Future of Insurance Regulation

• Another section of the GLB act involves the multi-state licensing of insurance agents – Presently an agent must have a separate license for each

state – Over time the provisions in the GLB act will likely lead to a

national licensing procedure

• Other provisions affect the relationship of state versus federal regulation of insurance companies– The exclusive domain of state regulation will be diminished – Federal regulation will have more influence

• Because of the Treasury Department and the Federal Reserve’s need to supervise banks and investment companies