Chapter 27 Government Regulation of Private Insurers in the United States

Transcription

1 Chapter 27 Government Regulation of Private Insurers in the United States Overview You ve probably heard of The Food and Drug Administration (FDA), The Security and Exchange Commission (SEC), and the Environmental Protection Agency (EPA). Federal boards, agencies, and departments are charged with regulating various aspects of commerce in the United States. Which federal regulatory body is charged with regulation of the insurance industry? The answer is... NONE! For a number of reasons, states are the primary regulators of insurance, and federal regulation applies only to the extent that state regulation does not apply. In this chapter we examine why insurance is regulated, the history of insurance regulation, the methods of regulating insurers, the areas that are regulated, the objectives of insurance regulation, and some current issues in the regulation of insurance. Learning Objectives After studying this chapter, you should be able to: Explain the major reasons why insurers are regulated. Identify key legal cases and legislative acts that have had an important impact on insurance regulation. Identify the major areas that are regulated. Explain the objectives of rate regulation and the different types of rating laws. Explain the major arguments for and against state regulation of insurance. Define the following: Admitted assets Alien insurer Assessment method Credit-based insurance score Domestic insurer File-and-use law Financial Modernization Act of 1999 Flex-rating law Foreign insurer Guaranty funds McCarran-Ferguson Act Modified prior-approval law National Association of Insurance Commissioners (NAIC) No filing Paul v. Virginia Policyowners surplus Prior-approval law Rebating Reserves Retaliatory tax laws Risk-based capital (RBC) South-Eastern Underwriters Association (SEUA) Systematic risk Twisting Use-and-file law

2 556 Rejda Principles of Risk Management and Insurance, Eleventh Edition Outline I. Reasons for Insurance Regulation A. Maintain Insurer Solvency B. Compensate for Inadequate Consumer Knowledge C. Ensure Reasonable Rates D. Make Insurance Available II. Historical Development of Insurance Regulation A. Early Regulatory Efforts B. Paul v. Virginia C. South-Eastern Underwriters Association Case D. McCarran-Ferguson Act E. Financial Modernization Act of 1999 III. Methods of Regulating Insurers A. Legislation B. Courts C. State Insurance Departments IV. What Areas Are Regulated? A. Formation and Licensing of Insurers B. Solvency Regulation C. Rate Regulation D. Policy Forms E. Sales Practices and Consumer Protection F. Taxation of Insurers V. State Versus Federal Regulation A. Advantages of Federal Regulation B. Advantages of State Regulation C. Shortcomings of State Regulation D. Repeal of the McCarran-Ferguson Act VI. Current Problems and Issues in Insurance Regulation A. Crisis in Insurance Regulation B. Modernizing Insurance Regulation C. Insolvency of Insurers D. Credit-Based Insurance Score

3 Chapter 27 Government Regulation of Private Insurers in the United States 557 Short Answer Questions 1. Why is regulation of the insurance industry necessary? 2. What are the three principal methods of regulating insurers? 3. What areas are regulated by insurance regulators? 4. What is meant by the terms: admitted assets, reserves, and policyowners surplus?

4 558 Rejda Principles of Risk Management and Insurance, Eleventh Edition 5. How do risk-based capital requirements help to reduce the risk of insurance company insolvencies? 6. What are the various types of rating laws that are used by the states? 7. How are consumers protected through the regulation of insurer sales practices?

5 Chapter 27 Government Regulation of Private Insurers in the United States What are the advantages of state regulation of insurance? 9. What are the arguments in support of federal regulation of insurance? 10. Critics argue that the current system of insurance regulation suffers from many deficiencies and must be modernized. Proposals to modernize insurance regulation are moving in two directions. Discuss these two regulatory reform ideas.

6 560 Rejda Principles of Risk Management and Insurance, Eleventh Edition 11. Why did American International Group (AIG) experience financial problems in 2008, and what was the justification for the federal government s intervention to prevent AIG s insolvency? 12. What are the arguments for and against the use of credit-based insurance scores in insurance underwriting? Multiple Choice Questions Circle the letter that corresponds to the BEST answer. 1. In a certain state, all insurance rates must be approved by the state insurance department before the rates can be used. This type of rating law is called: (a) file-and-use (b) no-filing required (c) flex-rating (d) prior-approval 2. Which statement is true with regard to insurance regulation? I. The federal government plays no role in regulating insurance. II. Insurance is regulated primarily by the states. (a) I only (b) II only (c) both I and II (d) neither I nor II

7 Chapter 27 Government Regulation of Private Insurers in the United States Regulators are concerned with a number of financial characteristics of insurers. One measure is the difference between an insurer s assets and its liabilities. This measure is known as an insurer s: (a) policyowners surplus (b) reserves (c) risk-based capital (d) admitted assets 4. Assume that the premium tax rate is 2.5 percent in Florida and 3 percent in Georgia. If insurers domiciled in Florida are required to pay a 3 percent tax on premiums written in Georgia, Florida requires insurers domiciled in Georgia to pay a 3 percent premium tax on business written in Florida even though the premium tax rate in Florida is 2.5 percent. This scenario illustrates a(n): (a) retaliatory tax law (b) prior-approval law (c) insurance guaranty fund (d) open-competition law 5. The amount of new business an insurer can write is limited by the insurer s: (a) nonadmitted assets (b) policyowners surplus (c) common stock investments (d) premium tax rate 6. Insurance companies are regulated: I. To ensure reasonable rates. II. To make insurance available. (a) I only (b) II only (c) both I and II (d) neither I nor II 7. Insurance companies are subject to many laws and regulations. The principal areas regulated include all the following EXCEPT: (a) sales practices and consumer protection (b) rate regulation (c) the number of policies sold (d) formation and licensing of insurers 8. Cathy is a life insurance agent. She was trying to sell a policy to Frank. In an effort to close the deal, Cathy offered to give Frank a share of her commission if he purchased the policy. This practice, which is illegal in almost all states, is called: (a) rebating (b) collateral estoppel (c) twisting (d) churning

8 562 Rejda Principles of Risk Management and Insurance, Eleventh Edition 9. All of the following are advantages of state regulation of insurance EXCEPT: (a) greater opportunity for innovation (b) uniformity of laws (c) greater responsiveness to local needs (d) decentralization of political power 10. Mutual of Omaha, domiciled in Nebraska, and has been admitted to write coverage in Tennessee. In Tennessee, Mutual of Omaha is considered a(n): (a) domestic insurer (b) foreign insurer (c) captive insurer (d) alien insurer 11. The landmark court decision that established the right of states to regulate insurance was: (a) the South-Eastern Underwriters Association Case (b) the McCarran-Ferguson Act (c) Metropolitan Life Insurance Company v. The Commissioner (d) Paul v. Virginia 12. The Financial Modernization Act of 1999 (Gramm-Leach-Bliley): (a) made it clear that states were to be the primary regulators of insurance (b) deregulated commercial insurance lines (c) removed barriers separating financial services fields (d) repealed the McCarran-Ferguson Act and shifted insurance regulation to the federal government True/False Circle the T if the statement is true, the F if the statement is false. Explain to yourself why a statement is false. T F 1. Insurance is regulated primarily at the state level. T F 2. The primary purpose of the premium tax is to raise revenues for the state, not to provide funds for insurance regulation. T F 3. If the National Association of Insurance Commissioners (NAIC) drafts a model law, all states must adopt the law. T F 4. Insurance guaranty funds provide for the payment of unpaid claims of insolvent insurers. T F 5. If a state is using a file-and-use rating law, state regulatory officials must approve the rates before an insurer can use them. T F 6. Just as auto makers often offer rebates to car purchasers, rebating in insurance is a widespread sales practice in all states. T F 7. Federal regulation of insurance would provide greater uniformity of laws from state to state. T F 8. Life insurance rates are not directly regulated by the states.

9 Chapter 27 Government Regulation of Private Insurers in the United States 563 T F 9. The decision in the South-Eastern Underwriters Association Case affirmed the right of states to regulate insurance. T T T F 10. While insurers are exempt from income taxes, they are required to pay a tax on premiums written that averages about 10 percent. F 11. Some automobile and homeowners insurers are using an applicant s credit record for the purposes of underwriting and rating. F 12. Requiring insurers to satisfy risk-based capital requirement helps to reduce the risk of insurer insolvencies. Case Applications Case 1 Tom is a life insurance agent with E-Z Pay Life Insurance Company. He met with Jenny who purchased a life insurance policy from another company six years earlier. Tom compared the competitor s policy with a comparable E-Z Pay Life policy. The E-Z Pay policy requires a significantly lower premium and offers a higher rate of return. Tom was honest and forthright about the policy comparison. Jenny surrendered her old policy and purchased a new policy through Tom. Has Tom done anything wrong? Explain your answer. Case 2 Although domiciled in South Carolina, Palmetto Casualty Company is licensed to sell insurance in twelve states. In eight states, prior-approval of rates is required. Two states use a file-and-use rating law, one state has adopted a flex-rating law, and in the remaining state no filing is required. Explain what is required of Palmetto Casualty Company under each of these rating laws.

10 564 Rejda Principles of Risk Management and Insurance, Eleventh Edition Solutions to Chapter 27 Short Answer Questions 1. Regulation of the insurance industry is necessary to maintain insurer solvency, to protect consumers who have inadequate knowledge of insurers and insurer practices, to ensure reasonable rates, and to make insurance available. 2. Insurers are primarily regulated through legislation, court decisions, and through state insurance departments. 3. The principal areas regulated include: formation and licensing of insurers, solvency regulation, rate regulation, policy forms, and sales practices and consumer protection. 4. Admitted assets are those assets that state law allows an insurer to list on its statutory balance sheet in determining the insurer s financial condition. Reserves are liabilities that reflect obligations that the insurer must satisfy in the future, such as payments for future losses. Policyowners surplus is the difference between an insurer s assets and its liabilities. 5. Risk-based capital requirements mean that insurers must have a certain amount of capital depending on the riskiness of their investments and insurance operations. The risk-based capital standards give regulators an early warning with respect to insurer financial problems. The standards also discourage insurers from investing too heavily in risky investments. 6. The various types of rating laws include: prior-approval laws, modified prior approval laws, file-anduse laws, use-and-file laws, flex-rating laws, state-made rates, and no filing required. 7. Consumers are protected in a number of ways. In order to represent an insurer or the insured, agents and brokers must be licensed by the state. Licensing usually requires that the agent or broker pass a written examination. To assure agents and brokers remain current in their field, states have enacted continuing education requirements. In addition, states have promulgated laws to protect consumers against twisting, rebating, and other unfair trade practices. Policy forms used by insurers must be readable. State insurance departments have a complaint division, and some states provide a variety of publications and brochures for consumers. 8. The major advantages of state regulation include: greater responsiveness to local needs, uniformity of laws promoted by the National Association of Insurance Commissioners (NAIC), greater opportunity for innovation, unknown consequences of federal regulation, and decentralization of political power. 9. Proponents of federal regulation of insurance assert that federal regulation will lead to uniformity of insurance laws, greater efficiency, and more competent regulators. 10. Under the first reform idea, a dual system of regulation would be used. Insurers would be allowed to choose to be regulated by the states or by a federal agency. The federal option would eliminate the need to comply with 51 sets of different laws. The second proposal would modernize regulation at the state level. The states would work with the NAIC to develop uniform state standards.

11 Chapter 27 Government Regulation of Private Insurers in the United States A division of AIG sold a derivative called credit default swaps. Credit default swaps guaranteed the performance of mortgage related securities. As many of the mortgages were issued to sub-prime, high-risk borrowers, default rates increased. AIG was required to pay billions of dollars on the securities they guaranteed, and to post additional collateral. AIG was close to declaring bankruptcy when the federal government stepped-in and loaned AIG billions of dollars, taking an equity stake in the company. The federal government justified the AIG bailout because if AIG failed, there would have been serious worldwide economic repercussions, exacerbating the global recession. 12. Proponents of using credit scores argue that there s a high correlation between credit history and future claims experience, use of insurance scores benefits consumers, and that most consumers have good credit scores and benefit from credit scoring. Critics argue that use of credit scoring discriminates against minorities and other groups, credit reports often are incorrect and contain errors, and credit scoring may penalize consumers during recessions. Multiple Choice Questions 1. (d) The rating law described is a prior-approval law. Under prior-approval, state regulators must approve the rates before they can be used. 2. (b) While insurers are primarily regulated at the state level, federal law applies to the extent that state law does not apply. 3. (a) The difference between an insurer s assets and liabilities is known as the policyowners surplus. 4. (a) A retaliatory tax law is illustrated in this scenario. Florida is retaliating against Georgia s treatment of Florida insurers doing business in Georgia by charging the higher tax rate. 5. (b) The amount of new business an insurer can write is limited by the amount of policyowners surplus. A conservative rule of thumb specifies that a property and liability insurer can safely write $2 in new net premiums for each $1 of policyowners surplus. 6. (c) Insurance companies are regulated to make insurance available, to make sure insurance is affordable, and for a number of other reasons. 7. (c) The number of policies sold is not regulated. State regulators will, however, consider the ability of the insurer to discharge any liabilities that may arise from the policies sold. 8. (a) Cathy is offering a rebate as a financial inducement to purchase the coverage. Rebating is an illegal sales practice in almost every state. 9. (b) State regulation of insurance does not promote uniformity of laws. Indeed, what may be legal in one state may be illegal in a neighboring state. 10. (b) Mutual of Omaha would be considered a foreign insurer in Tennessee. A foreign insurer is an insurer domiciled in another state that has been licensed to do business in your state. 11. (d) The landmark decision establishing the right of states to regulate insurance was Paul v. Virginia. 12. (c) The Financial Modernization Act of 1999 repealed rules that prevented banks, insurers, and investment firms from making full entry into each other s markets.

12 566 Rejda Principles of Risk Management and Insurance, Eleventh Edition True/False 1. T 2. T 3. F The NAIC can only recommend adoption of a model law. Although the NAIC has no legal authority to force states to adopt their recommendations, many model laws drafted by the NAIC have been adopted by states or adopted in a modified form. 4. T 5. F Under a file-and-use rating law, insurers are required only to file their rates with state regulators. Once filed, the rates can be used immediately; however, insurance regulators may later not approve the rates. 6. F Rebating in insurance is an illegal sales practice in almost all states. 7. T 8. T 9. F The decision in the South-Eastern Underwriters Association Case said that insurance was interstate commerce when conducted across state lines, therefore was subject to federal anti-trust laws. 10. F Insurers are not exempt from state and federal income taxes. In addition, insurers are taxed on the premiums they write. The premium tax rate is usually between 2 and 3 percent. 11. T 12. T Case Applications Case 1 Tom has done nothing wrong. If he had used incomplete or inaccurate information when comparing the policies, he would have been guilty of an illegal sales practice known as twisting. Based on the description provided, the replacement of Jenny s old policy with an E-Z Pay Life policy appears to be justified. Case 2 In the eight states that have prior-approval laws, the rates must be filed with state regulators and approved before the rates can be used. Under a file-and-use law, Palmetto is required to file rates with the state insurance department, however the rates can be used immediately. The regulators have the right to disapprove the rates later. No filing is the most liberal form of rating law. Under no filing, insurers are not required to file their rates with state regulators. Under this type of rating law, it is assumed that market forces will determine the appropriate price and availability of insurance coverage. Finally, under flexrating, prior approval is only required if the rate increase or decrease exceeds a specific, predetermined, range.