Trieschmann, Hoyt & Sommer
Government Regulation of Risk Management and Insurance
Chapter 24
©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 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 McCarranFerguson 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 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
11
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
12
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
13
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
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 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
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-ofprocess 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
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
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