Chapter 8 Government Regulation of Insurance. Copyright ©2014 Pearson Education, Inc. All rights...

Chapter 8

Government Regulation of

Insurance

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-2

Agenda

• Reasons for Insurance Regulation• Historical Development of Insurance

Regulation• Methods for Regulating Insurers• What Areas are Regulated?• State versus Federal Regulation• Modernizing Insurance Regulation• Insolvency of Insurers• Credit-Based Insurance Scores


Reasons for Insurance Regulation

• Maintain insurer solvency

• Compensate for inadequate consumer knowledge

• Ensure reasonable rates

• Make insurance available


Historical Development of Insurance Regulation

• Insurers were initially subject to few regulatory controls.

• State legislatures first granted charters to new insurers; insurance commissions were first created in 1851.

• In Paul v. Virginia (1868), the Supreme Court ruled that insurance was not interstate commerce, and that the states rather than the federal government had the right to regulate the insurance industry.



• In U.S. v. South-Eastern Underwriters Association (1944) the Court ruled that insurance was interstate commerce when conducted across state lines and was subject to federal antitrust laws

• The McCarran-Ferguson Act (1945) states that continued regulation and taxation of the insurance industry by the states are in the public interest – Federal antitrust laws apply to insurance only to

the extent that the insurance industry is not regulated by state law



• The Financial Modernization Act (1999) changed federal law that earlier prevented banks, insurers, and investment firms from competing outside their core area– State insurance departments regulate insurers– State and federal bank agencies regulate banks– The Securities and Exchange Commission (SEC)

regulates the sale of securities– The Federal Reserve has umbrella authority over

bank affiliates that engage in underwriting insurance


Methods for Regulating Insurers

• The three principal methods used to regulate insurers are:– Legislation, through both state and federal laws– Court decisions, e.g., interpreting policy

provisions– State insurance departments


What Areas Are Regulated?

• All states have requirements for the formation and licensing of insurers– Licensing includes minimum capital and surplus

requirements– A domestic insurer is domiciled in the state– A foreign insurer is an out-of-state insurer that is

chartered by another state, but licensed to operate in the state

– An alien insurer is an insurer that is chartered by a foreign country, but is licensed to operate in the state



• Insurers are subject to financial regulations designed to maintain solvency– Assets must be sufficient to offset liabilities– Admitted assets are assets that an insurer can

show on its statutory balance sheet in determining its financial condition

– States have regulations that address the calculation of reserves

– An insurer’s surplus position is carefully monitored by state regulators



• Life and health insurers must meet certain risk-based capital (RBC) standards– Insurers must hold a certain amount of capital,

depending on the riskiness of their investments and insurance operations

– An insurer’s RBC depends on asset risk, underwriting risk, interest rate risk, and business risk

– A comparison of the company’s total adjusted capital to the amount of required risk-based capital determines whether company or regulatory action is required



• The purpose of investment regulations is to prevent insurers from making unsound investments that could threaten the company’s solvency and harm the policyowners– Laws generally place a limit on the proportion of

assets in a specific asset category, such as real estate

• Many states limit the amount of surplus a participating life insurer can accumulate, rather than pay as dividends



• Each insurer must file an annual report with the state insurance department in the states where it does business

• The state insurance department assumes control of insurance companies that they determine to be financially impaired– All states have guaranty funds, guaranty laws and

guaranty associations that pay the claims of policyowners of insolvent insurers

– The assessment method is the major method used to raise the necessary funds to pay unpaid claims



• Rate regulation takes a variety of forms across states– Forms of rate regulation for property and casualty

insurance include:

– Many states exempt insurers from filing rates for large commercial accounts

– Life insurance rates are not directly regulated by the states

• Prior approval law • Flex-rating law

• Modified prior approval law • State-made rates

• File-and-use law • No filing required

• Use-and-file law



• State insurance commissioners have the authority to approve or disapprove new policy forms before the contracts are sold to the public– Insurance contracts are technical and complex– Purpose is to protect the public from misleading,

deceptive, and unfair provisions



• Sales practices are regulated by the laws concerning the licensing of agents and brokers– All states require agents and brokers to be

licensed– All states require agents to obtain continuing

education to upgrade their knowledge and skills



• Insurance laws prohibit a variety of unfair trade practices, such as misrepresentation, twisting, and rebating– Twisting is the inducement of a policyowner to

drop an existing policy and replace it with a new one that provides little or no economic benefit to the client

– Rebating is the practice of giving an individual a premium reduction or some other financial advantage not stated in the policy as an inducement to purchase the policy



• State insurance departments typically have a complaint division for handling consumer complaints– Most complaints involve claims

• Information is provided to consumers on insurance department websites and in brochures

• Insurers pay numerous local, state, and federal taxes


State versus Federal Regulation

• Proponents for federal regulation argue that federal regulation:– would provide uniformity in state regulations– is more effective in negotiations of international

insurance agreements– is more effective in the identification and

treatment of systemic risk– would enable insurers to become more efficient



• Advantages of state regulation include:– Quicker response to local insurance problems– Federal regulation could lead to a dual system of

regulation and increase costs– Poor quality of federal regulation, e.g., in the

banking industry– Reasonable uniformity of laws can be achieved

by the model laws of the NAIC– Greater opportunity for innovation– Unknown consequences of federal regulation



• Shortcomings of state regulation include:– Inadequate protection of consumers– Improvements needed in handling complaints– Inadequate market conduct examinations– Insurance availability


Current Problems and Issues in Insurance Regulation

• Should the McCarran-Ferguson Act be repealed?

• Critics of state regulation argue:– The insurance industry no longer needs broad

antitrust exemption– Federal regulation is needed because of the

defects in state regulation.

• Counterarguments include:– The insurance industry is already competitive.– Small insurers may be harmed.– Insurers may be prevented from developing

common coverage forms


Modernizing Insurance Regulation

• Critics believe the current regulatory system is broken, and lax regulatory oversight at both the state and federal levels contributed to the financial meltdown

• The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) contained numerous provision to reform the financial services industry– Created the Financial Stability Oversight Council

(FSOC) to identify and treat systemic risk– Created the Federal Insurance Office (FIO)



• The Federal Insurance Office has the authority to:– Monitor all aspects of the insurance industry– Identify gaps in insurance regulation and identify

issues that contribute to systemic risk– Assist the FSOC in identifying insurers that could

create systemic risk– Represent the federal government in

international discussions of insurance regulation– Negotiate international agreements with foreign

countries that pertain to insurance regulation.



• Another approach to insurance regulation is an optional federal charter– Proposals would allow insurers to choose either a

federal or state charter.– Proponents argue that national insurers are at a

competitive disadvantage under the present system.

– Opponents suggest this creates a dual system of insurance regulation which will increase the cost of insurance regulation


Insolvency of Insurers

• Insolvency of insurers continues to be an important regulatory concern

• Reasons for insolvencies include:– Inadequate rates– Inadequate reserves for claims– Rapid growth and inadequate surplus– Problems with affiliates– Overstatement of assets– Alleged fraud– Failure of reinsurers to pay claims– Mismanagement– Catastrophic losses


Insolvency of Insurers

• The principal methods of ensuring insolvency are:– Financial requirements, such as minimum capital

and surplus requirements– Risk-based capital standards – Review of annual financial statements– Field examinations– Early warning system (IRIS ratios)– FAST system analysis


Credit-based Insurance

• The majority of insurers use the applicant’s credit record for purposes of underwriting and rating in auto and homeowners insurance.

• Proponents of credit-based insurance argue:– There is a high correlation between an

applicant’s credit record and future claims experience

– Most consumers have good credit scores and benefit from credit scoring


Credit-based Insurance

• Critics of credit-based insurance argue:– The use of credit data in underwriting or rating

discriminates against minorities and other groups– Credit-based insurance scores may penalize

consumers unfairly during business recessions

• Most states have enacted legislation that regulates the use of credit-based insurance scores

Chapter 8 Government Regulation of Insurance. Copyright ©2014 Pearson Education, Inc. All rights...

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