Trieschmann Hoyt Sommer Government Regulation of Risk Management

Trieschmann, Hoyt & Sommer Government Regulation of Risk Management and Insurance Chapter 24 © 2005 Southwestern © 2005, Thomson/South-Western

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 2

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 3

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 4

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 5

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 6

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 7

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 8

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 9

The Mc. Carran-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 Mc. Carran. 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 10

The Mc. Carran-Ferguson Act • Except to the extent indicated by the provisions of the Mc. Carran-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 11

The Mc. Carran-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 12

The Mc. Carran-Ferguson Act • Following passage of the Mc. Carran-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 13

The Mc. Carran-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 14

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 15

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 16

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 17

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 18

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 1990 s 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 19

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 20

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 21

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 22

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 23

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 24

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 25

Table 24 -1: Guaranty Fund Net Assessments, 1993 -2002 26

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 27

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 28

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 29

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 30

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 31

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 32

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 33

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 34

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 35

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 36

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 37

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 38

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 39

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 40

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 41

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 42

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 43

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 44

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 45

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 selfinsure 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 46

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 47

Taxation of Insurance • Insurance companies are also subject to federal taxation – Stock property insurers pay taxes on underwriting and investment income at regular corporates – 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 corporates to investment income only 48

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 49

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 50

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 51

Future of Insurance Regulation • Another section of the GLB act involves the multistate 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 52