Chapter 8 Government Regulation of Insurance

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 Market Conduct Regulation

Reasons for Insurance Regulation Transparency Master 1.2 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.

Historical Development of Insurance Regulation (Continued) 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

Historical Development of Insurance Regulation (Continued) 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

Historical Development of Insurance Regulation (Continued) The Dodd-Frank Wall Street Reform and Consumer Act (2010) was enacted to address abuses in the financial services industry. It has numerous provisions designed to: Reform the financial services industry Deal with destabilizing practices of commercial banks, investment firms, mortgage companies and credit-rating agencies Provide protection for consumers The Act also created the Financial Stability Oversight Council (FSOC)

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

What Areas Are Regulated? (Continued) 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

What Areas Are Regulated? (Continued) 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

What Areas Are Regulated? (Continued) 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

What Areas Are Regulated? (Continued) 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

What Areas Are Regulated? (Continued) 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

What Areas Are Regulated? (Continued) 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

What Areas Are Regulated? (Continued) 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

What Areas Are Regulated? (Continued) 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

What Areas Are Regulated? (Continued) 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

State versus Federal Regulation (Continued) 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

State versus Federal Regulation (Continued) 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)

Modernizing Insurance Regulation (Continued) The Financial Stability Oversight Council (FSOC) has the authority to treat systemic risk and to classify nonbank financial companies, which include insurance companies, as systemically important financial institutions (SIFIs) A financial company that is classified as a SIFI receives tougher oversight and is regulated by the Federal Reserve

Modernizing Insurance Regulation (Continued) The Federal Insurance Office (FIO) 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.

Modernizing Insurance Regulation (Continued) The Dodd-Frank Act required the FIO to study and report on the regulation of insurance. The report (2013) recommends a hybrid model of insurance regulation, with many areas for state-level reform. The FIO also recommends direct federal involvement in several areas, including: Supervision and standards for mortgage insurers Collateral requirements for reinsurers

Modernizing Insurance Regulation (Continued) 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 Mismanagement and fraud Bad investments Problems with affiliates Overstatement of assets Catastrophe losses Failure of reinsurers to pay claims

Insolvency of Insurers (Continued) The Solvency Modernization Initiative (SMI) is an ongoing program that began in 2008. Provides for a critical self-examination of insurance solvency regulations in the US Includes a review of international development Key parts of SMI include: Capital requirements Risk management Corporate governance Group supervision Reinsurance Statutory accounting and financial reporting

Insolvency of Insurers (Continued) The principal methods of ensuring solvency are: Minimum capital and surplus requirements Risk-based capital standards Reserve requirements Restrictions on investements Review of annual financial statements Field examinations Early warning system (IRIS ratios) FAST system analysis

Market Conduct Regulation Market conduct refers to the marketing practices of insurers and agents that involve interaction with insureds, claimants, or consumers. Practices include: Sales of insurance policies Advertising of insurance products Underwriting and rating Collection of premiums Policy renewals, termination, and changes Claims settlement

Market Conduct Regulation (Continued) Regulators are concerned that certain industry practices may have an adverse effect on policyholders, beneficiaries, claimants and insurance consumers Concerns include: Sale of unsuitable insurance products Misrepresentation of coverage Excessive sales pressure Rates that are excessive or unfairly discriminatory Denial of legitimate claims Improper termination of policies

Market Conduct Regulation (Continued) The FIO report makes several recommendations regarding market conduct, including: Every state should participate in the Interstate Insurance Product Regulation Commission (IIPRC) to improve the approval of products Each state should adopt the Suitability in Annuities Transactions Model Regulation drafted by the NAIC States should identify regulatory practices that best promote competitive markets for personal lines insurance consumers

Insight 8.1: Credit-based Insurance The credit based insurance score is derived from an applicant’s credit history and is combined with other underwriting factors Proponents of credit-based insurance argue: There is a high correlation between an applicant’s credit record and future claims experience Insurance scores permit insurers to accept more high-risk consumers for whom otherwise an appropriate premium could not be determined Most consumers have good credit scores and benefit from credit scoring

Insight 8.1: Credit-based Insurance (Continued) 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