trieschmann, hoyt & sommer government regulation of risk management and insurance chapter 24...
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Trieschmann, Hoyt & Sommer
Government Regulation of Risk Management and Insurance
Chapter 24
©2005, Thomson/South-Western
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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
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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
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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
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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
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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
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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
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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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4545
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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4747
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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4848
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
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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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5050
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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5151
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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5252
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