CHAPTER OBJECTIVES

When you have finished this chapter, you should be able to

• Identify and explain the reasons why insurance is subject to regulation
• Identify the major areas of insurer operations that are regulated
• Trace the history of insurance regulation and identify the landmark cases and laws that led to the current regulatory environment
• Identify the major aspects of insurance company operations that are subject to regulation
• Identify and explain the statutory requirements that exist with respect to insurance rates
• Describe the different approaches the states have taken toward the regulation of insurance rates
• Identify the arguments favoring state or federal regulation of insurance

THE WHY OF GOVERNMENT REGULATION OF INSURANCE

Before turning to the manner in which the insurance industry is regulated, it is appropriate that we examine the rationale for that regulation. Many of the original reasons for the regulation of the insurance industry are being challenged, and new regulatory goals are being proposed. In analyzing the issues discussed in this chapter, it will be helpful if the reader is familiar with the general theory of regulation that serves as the foundation for the theory of insurance regulation.

The Why of Regulation Generally

Important differences of opinion exist among economists on the subject of government regulation, and much of the controversy concerning insurance regulation stems from these differences. Although there is much agreement in principle on the need for some form of government control of business, there is serious disagreement on the form that this control should take.

Some economists believe in the concept of an efficient market and maintain that competition will generally produce the greatest benefits to society. These economists agree that some form of government control is necessary, yet they would like the principal role of government to be maintaining competition. Other economists distrust the market or, at least, have less confidence in its operation. They believe the lesson of history is that regulation is often needed to prevent abuse of consumers and should be imposed wherever there is a likelihood of market failure.

Approaches to Government Control of Business

Broadly speaking, government control of business takes one of two forms, paralleling the two economic philosophies noted: antitrust and regulation. Antitrust concentrates on maintaining competition, and regulation involves the application of specific performance standards to the firms in an industry. The principal thrust of antitrust is to curtail monopoly power. It focuses on preventing collusion, opposing mergers that lead to excessive concentration, and abating market power. The theory of antitrust is that if the government prevents monopoly and unfair competition, competition will result in the public welfare.

Regulation represents a more direct involvement of government in the affairs of business. It usually consists of two types of actions by government: restricting entry into the market (usually because competition is thought to be infeasible) and controlling prices so the firms in an industry do not obtain excessive profits. In a sense, regulation replaces competition in industries that are natural monopolies or are considered to have special importance in size or influence.

Economic Theories of Regulation Having noted the attitudes of economists toward government control and the different forms that control may take, we will examine three theories of regulation that will help us interpret the current issues concerning insurance regulation. One theory provides an economic rationale for what regulation is intended to do; the other two theories attempt to explain why regulation does not always work as it is intended and why regulation sometimes fails to deal with the economic problems it is meant to solve.

The Market Failure Theory of Regulation The predominant theory of regulation is the market failure theory, which is based on the view that the purpose of regulation is to correct market failures.¹ A market failure occurs when the free market produces too much or too little of a product or a service at a price that is too high or too low. The classic example of a market failure occurs in the case of a monopoly with the incentive and the ability to produce too little and charge too much for a product. Another market failure is an unstable competitive process that leads to destructive competition. A third example is a lack of safety or security for consumers in financial markets or industries of a fiduciary nature. The role of regulation under the market failure theory is to restrict the actions of firms in an industry, forcing them to behave in a way that will produce results as near as possible to those that would occur in a competitive market.

Although the market failure theory provides an explanation of how regulation should work, casual observation shows that it does not always function the way the theory suggests. Regulatory systems are complicated, cumbersome, and costly, and there is a serious question whether they achieve their intended purpose. Indeed, they sometimes produce objectionable results. Although proponents of regulation argue that the defects of regulation are due to legal and procedural problems that can be corrected by reform of the regulatory system, another view is that the market failure theory does not explain the way regulation works in the real world. This second view abandons the notion that correcting market failures is a serious goal of regulatory agencies and suggests that regulators operate under a different set of incentives. Two views on the motivation of regulators have emerged: the capture theory of regulation and the public choice theory.²

The Capture Theory of Regulation According to the capture theory of regulation, regulators often become “captured” by the industry they are responsible for regulating. They lose focus and become more concerned about the success of the regulated industry than about consumers. Proponents of this theory observe that regulators often come from the industry they regulate. In those cases in which the regulators do not come from the regulated industry, they are likely to accept a job with a regulated firm at the end of the regulatory appointment. The result, according to critics, is that regulatory agencies are characterized by revolving doors, in which regulators come from and return to the industry. This may cause them to view problems in the same way as the firms they regulate, a problem known as “intellectual capture.” More generally, critics argue, these regulators place the interest of the industry they are supposed to regulate above the interest of consumers.

The recent global financial crisis has increased attention on the problem of regulatory capture, particularly in federal banking regulation. Although the capture theory of regulation has found many adherents, it does not seem to adequately explain regulation in the insurance field in the United States. If the theory prevailed, one would expect far different results in insurance regulation from those that exist.

The insurance industry, like most regulated industries, is not controlled by a regulatory agency alone. It is also regulated by the legislatures and by the courts. The capture theory of regulation does not explain how the industry succeeds in capturing the legislatures and the courts.

The Public Choice Theory of Regulation The public choice theory of regulation, like the capture theory, attempts to explain why regulation sometimes produces results other than those suggested by the market failure theory. The public choice theory views regulation as a part of a political-economic system that serves to reallocate wealth among competing groups based on preferences expressed in a political-economic marketplace. Its basis is that every regulation reallocates resources and in the process makes some individuals or groups richer and others poorer. Regulators perform the same functions as legislators in imposing taxes on some groups (the regulatory taxpayers) and dispensing benefits to others (the regulatory recipients). Any proposed regulation will attract the attention of payers and beneficiaries, who will express their opposition or support through political and economic channels. The major goal of regulation is to transfer resources to groups that generate the most support for the program in a way that minimizes opposition to the regulatory tax.

The most important implication of the public choice theory is the conclusion that regulation will tend to favor (subsidize) relatively small and well-organized groups that have a high per capita stake in the regulation at the expense of large, poorly organized groups with a lower per capita stake. Members of groups with a stake in proposed regulation must organize themselves to support or oppose the regulation. If the regulation involves a large tax or a large subsidy, there will be a strong incentive for the group to organize and oppose or support the regulation. When the tax or subsidy is small, the incentive is less. At the same time, the larger the group, the greater the cost of organizing and, therefore, the less likely is the group to be effectively organized.³

Importance of the Three Theories The market failure theory and the public choice theory of regulation are important in understanding the regulation of insurance. Although the market failure theory remains the standard against which regulatory programs should be measured, the public choice theory helps to explain why regulation in some areas departs from this standard.

Rationale for Regulation of the Insurance Industry

As noted, regulation is adopted as an alternative to antitrust in those instances in which competition is considered infeasible or in the case of industries that, because of monopolistic tendencies, must be subject to control. Natural monopolies, for example, are licensed and their pricing decisions controlled to protect the consumer from exploitation. Cartelized industries are regulated for the same reasons. Here regulation is required because of a lack of competition; it seeks to generate results similar to those that would exist in a competitive industry. In insurance, the problem of monopoly is not significant, but there are still reasons for government restraint.

The rationale for regulation of insurance differs from monopolized or cartelized industries because the potential market failures also differ. The first of the potential market failures in insurance stems from the fiduciary nature of insurer operations; the second arises from the uncertainties inherent in the insurance pricing process.

Vested-in-the-Public-Interest Rationale The first rationale for the regulation of insurance is that it is an industry vested in the public interest. The courts have long held that insurance, like banking, is pervasive in its influence, and that failures in this field can affect persons other than those directly involved in the transaction.⁴ Individuals purchase insurance to protect against financial loss at a later time, and it is important to the public welfare that the insurer promising to indemnify insureds for future losses fulfills its promises.

Classical economists held that competition serves the consumer by forcing inefficient firms out of the market. Contrary to this classical model, which held that the failure of some firms from time to time was a wholesome phenomenon, the public interest was not served by the failure of insurers because of the resulting losses to policyholders and claimants. The vested-in-the-public-interest rationale for regulation of the insurance industry holds that the insurance industry, like any other business holding vast sums of money in trust for the public, should be subject to government regulation because of its fiduciary nature.

Besides the solvency issue, there are other public interest reasons that legislators have felt require regulation of the industry. The complex nature of insurance contracts makes them difficult for a consumer to understand. Regulation is, therefore, deemed necessary to ensure that the contracts offered by insurance companies are fair and that they are fairly priced.

Although the public interest rationale has a relationship to the area of pricing and competition, its implications are much broader. It implies a need for regulation of insurance in many areas, of which pricing is only one. The fiduciary nature of insurer operations and the extensive influence of insurance on members of society require regulation of entry into the market (i.e., the licensing of companies), the investment practices of insurers, and similar areas related to insurer solvency. In addition, the complexity of the insurance product requires regulatory scrutiny of contracts and the licensing of practitioners to ensure their competence. Therefore, because insurance is vested in the public interest, the industry would require regulation even if it were not for the second rationale for regulation discussed next.

Destructive-Competition Rationale The second rationale for the regulation of insurance, currently being challenged by some parties, is that competition in some fields of insurance, if left unregulated, would become excessive. Although regulation in other industries aims at enforcing competition and preventing artificially high prices, insurance regulation was initially designed in the opposite direction: preventing excessive competition. It has long been argued that, in the absence of regulation, the natural tendency in the insurance industry would be toward the keenest sort of cut-throat competition. The assumption that the natural tendency in insurance pricing is toward destructive competition rests on two premises:

1. The cost of production is unknown until the contract of insurance has run its full term.
2. Classes of desirable and undesirable insures exist. The danger is that in attempting to compete, insurance companies might assume their insureds are from the more desirable class and make unwarranted assumptions about their future costs.

As we will see later, there is considerable disagreement about these premises, and many experts question the validity of the argument. Nevertheless, those who argue that insurance regulation must be aimed at preventing too much competition maintain that the basic danger in the insurance industry is the possibility that, in vying for business, companies may underestimate future losses and as a result fail.

Goals of Insurance Regulation

Originally, the goals of insurance regulation were understood and generally agreed on by all concerned. The function of insurance regulation was to promote the welfare of the public by ensuring fair contracts at fair prices from financially strong companies. The market failures that insurance regulation was intended to correct were insolvencies (no matter what their source) and unfair treatment of insureds by insurers. In short, the dual goals of regulation were solvency and equity.⁵

Although the original goals dominate the regulatory philosophy, new and emerging goals focus on the availability and affordability of insurance. Public dissatisfaction with the increasing cost of insurance, the inability of some consumers to obtain insurance at a price they are willing and able to pay, and a growing philosophy of entitlement have created pressure from some quarters for regulatory programs designed to guarantee the availability of insurance to all who desire it at affordable rates. Increasingly, those who cannot obtain insurance at a price they feel they can afford are demanding a subsidy from the rest of society. The traditional approach to this subsidy has been a residual risk pool, such as the Automobile Insurance Plans, the Fair Access to Insurance Requirements (FAIR) plans, and the medical malpractice insurance pools. Here, insurers are compelled to write coverages at rates below those required to cover losses and expenses. The losses sustained are passed on to other insureds as higher premiums. More recently, the availability/affordability demands have focused on a new issue: the manner in which insurance rates should be determined and the extent to which the insureds' costs should reflect the hazards they bring to the pool of insured persons.⁶

A Brief History of Insurance Regulation

The earliest forms of insurance regulation were related to the premium taxes imposed by the states on out-of-state insurers and grew out of the registration and reporting requirements imposed for the purpose of determining insurers' tax liabilities. Although statutes dealing with insurance had been enacted by the states as early as the beginning of the nineteenth century, the history of modern insurance regulation begins shortly before the Civil War, when several states established bodies to supervise insurance operations within their borders. The New Hampshire Board of Insurance Commissioners, established in 1851, was the first of these bodies. Massachusetts followed shortly thereafter,⁷ and New York instituted its board in 1859. The panic of 1857, which had been precipitated by the failure of a New York branch of the Ohio Life Insurance and Trust Company of Cincinnati, was probably the leading factor in the creation of the New York Commission as well as those of other states that followed.

Paul v. Virginia The case of Paul v. Virginia focused on the preeminence of the right of the states or federal government to regulate insurance. The U.S. Constitution gives the federal government the right to regulate interstate commerce, and the issue in Paul v. Virginia was whether insurance is interstate commerce. Samuel Paul was a native of Virginia who represented New York insurance companies in his home state. Paul challenged the right of the state to regulate insurance by selling policies without obtaining a state license. The state denied Paul a license because his insurer would not comply with the demand of the state of Virginia for a security deposit. Likewise, a license for the insurer was denied on the same grounds. When Paul continued to sell insurance without a license, he was arrested and fined $50. The case was carried to the U.S. Supreme Court, where it was finally decided in 1869. In rendering its decision, the Supreme Court ruled that insurance was not interstate commerce:

The decision of the U.S. Supreme Court that insurance was not interstate commerce and was not subject to regulation by the federal government stood for 75 years.

Regulation from 1869 to 1944 During the years following the Paul v. Virginia decision, the insurance industry was regulated by the individual states. This was a period of rapid development and expansion for the entire economy, and the insurance industry was no exception. The quality of regulation varied from state to state, and it was inevitable that abuses would creep into the operation of the insurance business.

In the period after the Civil War, many life insurance companies were operated in a precarious manner. Unsound business practices were common, and advertising claims were inflated. During the Depression era of the 1870s, many of these poorly managed firms failed. In addition, many innovations were developed in the field of life insurance, some of which were detrimental to the insurance-buying public. One such innovation was the tontine policy, a life insurance contract with a higher than necessary premium that provided for the payment of dividends at some future time. Dividends on these policies were paid at the end of the tontine period (which was usually 10, 15, or 20 years). The dividends were paid only to those policyholders who survived to the end of the period, at the expense of those who had died or permitted their policies to lapse.

The Armstrong Committee Investigation Shortly after the turn of the century, big business was being condemned and investigated, and the rapid growth of the life insurance industry, including the previously mentioned abuses, attracted attention. In 1905, the New York State legislature appointed a committee to investigate the abuses in the life insurance industry. The committee was named after its chairman, Senator William W. Armstrong. The Armstrong Investigation turned out to be a sober, responsible examination of the life insurance industry. Many abuses were identified, and although the investigation caused a temporary loss of confidence among the insurance-buying public, legislation was enacted in New York following the investigation correcting these abuses, a result that proved to be a benefit to the public and the life insurance industry.

The Merritt Committee Investigation In 1910, a second committee was appointed in New York, this time to investigate the property insurance industry. Edwin A. Merritt, Jr., was chairman of this committee, which became known as the Merritt Committee. The principal concern of the Merritt Committee was with the methods used by property insurers in making rates.

As we saw in Chapter 3, the accuracy of an insurer's predictions increases with the number of exposures on which the predictions are based. This principle led insurers to the practice of cooperative ratemaking, in which the experience of many insurers is pooled to increase the accuracy of insurers' predictions. The organizations that collect loss data and perform the actuarial calculations required to generate rates were called rating bureaus. From 1885 to 1910, over half the states passed laws prohibiting cooperative ratemaking and outlawing rating bureaus. These anticompact laws, as they were called, prohibited insurance companies from joining together to make rates, a practice that the companies argued was necessary to achieve the accuracy inherent in the operation of the law of large numbers. Following the San Francisco fire of 1906, many fire insurance companies went bankrupt, in part because they had charged inadequate rates. Fire insurance rates then increased throughout the country in what appeared to be a concerted action. After an extensive study, the Merritt Committee made its recommendations, which became the basis for New York legislation. The committee opposed the anticompact laws and urged that rating bureaus be recognized and, further, that a company be permitted to belong to a rating bureau, or to file its rates independently if it chose.

The Armstrong Committee and the Merritt Committee investigations were significant events in the development of the industry. Although they were state inquiries, the fact that many states patterned their laws after those of New York (plus the impact of the Appleton rule discussed in Chapter 5) made their effect pervasive.

South-Eastern Underwriters Association Case After a period of 75 years, the authority of the federal government to regulate insurance was again tested. In 1942, the U.S. attorney general filed a brief under the Sherman Act against the South-Eastern Underwriters Association (SEUA), a cooperative rating bureau, alleging the bureau constituted a combination in restraint of trade. In its decision of the SEUA case in 1944, the U.S. Supreme Court reversed its decision of Paul v. Virginia, stating that insurance is interstate commerce and as such is subject to regulation by the federal government.⁹ This decision stands today.

Public Law 15 While the SEUA case was being decided and appealed, the insurance industry viewed with considerable alarm the prospect that the court might overturn Paul v. Virginia. This would have especially affected the property and casualty field, where concerted ratemaking through bureaus was the rule rather than the exception. Since pooling loss information to generate standard industry rates constituted a form of price fixing that would be illegal per se under the Sherman Act, the industry moved to obtain an exemption from the Sherman Act and other federal antitrust laws.

The insurance industry arranged to have bills introduced into Congress that would have exempted it from the federal antitrust laws, but these bills were defeated. Finally, a law was drafted by the National Association of Insurance Commissioners that could be passed. This was Public Law 15, or the McCarran-Ferguson Act, which became law on March 9, 1945.

In the McCarran-Ferguson Act, Congress reaffirmed the right of the federal government to regulate insurance but agreed that it would not exercise this right as long as the industry was adequately regulated by the states. The law declared a two-year moratorium on the regulation of insurance by the federal government, stating that the federal government would not regulate the industry until January 1, 1948, when the federal antitrust laws would be “applicable to the business of insurance to the extent that such business is not regulated by the states.” In effect, the law explicitly granted to the states the power to regulate the insurance business, a power that the U.S. Supreme Court in the SEUA case had concluded was vested in Congress under the Commerce Clause of the Constitution. The exemption from federal law was incomplete however. The act provided that the Sherman Act would continue to apply to boycott, coercion, or intimidation.

REGULATION TODAY

Following enactment of Public Law 15, the states attempted to put their houses in order, passing rating laws, defining fair trade practices, and extending licensing and solvency requirements.

The Current Regulatory Structure

Insurance is presently regulated by the states through the three basic branches of our state governments: legislative, judicial, and executive.

Regulation by the Legislative Branch Each state enacts laws that govern the conduct of the insurance industry within its boundaries. These laws spell out the requirements that must be met by persons wishing to organize an insurance company in the state. As noted in the previous chapter, a company domiciled within the state (i.e., which has its home office in the state) is called a domestic insurer. The laws also specify certain requirements that a company domiciled in another state (called a foreign insurer) must meet to obtain a license to do business in the state.¹⁰ In addition, the insurance code sets forth the standards of solvency that are to be enforced and provides for the regulation of rates and investments. It also regulates the licensing of agents.

Regulation by the Judicial Branch The judicial branch exercises control over the insurance industry through the courts by rendering decisions on the meaning of policy terms and ruling on the constitutionality of the state insurance laws and the actions of those administering the law.

Regulation by the Executive Branch: The Commissioner of Insurance The central figure in the regulation of the insurance industry in each state is the commissioner of insurance.¹¹ In most states, this official is appointed by the governor of the state and is charged with the administration of the insurance laws and the general supervision of the business. Although a part of the executive branch of the state government, the commissioner frequently makes rulings that have the binding force of law and exercises judicial power in interpreting and enforcing the insurance code.

National Association of Insurance Commissioners

The National Association of Insurance Commissioners (NAIC) has been an active force in the regulation of insurance since it was founded in 1871. Although it has no legal power over insurance regulation, it is an important influence. Through it, the nation's 56 insurance commissioners exchange information and ideas and coordinate regulatory activities.¹² Based on the information exchanged at its four annual meetings, the NAIC makes recommendations for legislation and policy. The individual commissioners are free to accept or reject these recommendations, but in the past most commissioners have seen fit to accept the recommendations appropriate for their particular states.

AREAS REGULATED

It is common to distinguish between two broad, but interrelated, areas of insurance regulation: solvency regulation and market regulation.

Solvency Regulation

Clearly, a primary focus of insurance regulation is on insurer solvency. Indeed, it has been argued this should be the primary function of regulation. Regulatory interest in insurer solvency is concerned with the early detection of potential insolvencies and the prevention of consumer suffering when insolvencies occur.

The U.S. insurance solvency system is constantly changing to respond to new issues. In June 2008, the NAIC announced it was undertaking a critical self-examination of U.S. insurance solvency regulation in response to international developments. This effort, known as the Solvency Modernization Initiative (or SMI), is focused on five specific areas: group supervision, regulatory capital requirements, statutory accounting and financial reporting, reinsurance, and enterprise risk management and corporate governance. The major areas of financial regulation are discussed below.

Licensing of Companies In effect, when a company is licensed, the commissioner certifies the company with regard to its financial stability and soundness of methods of operation. Before licensing a firm to conduct business in the state, the commissioner must be satisfied that the company to be licensed meets the financial requirements specified in the insurance code of the state. To qualify for a license, the insurance company making the application must have a certain amount of capital or surplus. The exact amount of capital and surplus required varies from state to state, being relatively small in some states and substantial in others. The amount of capital or surplus required also depends on the type of business the firm will conduct and whether the company is a stock or mutual carrier. These capital and surplus requirements usually apply to individuals who wish to form an insurer in the state and to foreign companies that request a license to do business in the state.

Besides enforcing the capital and surplus requirement, the commissioner reviews the personal characteristics of the organizers, promoters, and incorporators of the company to determine their competence and experience. The commissioner may deny the application for a license if the company's founders seem unworthy of public trust.

Reporting and Financial Analysis It has long been recognized that the key to protecting policyholders from insurer insolvencies lies in detecting potential failures before they occur. Insurance regulators rely on analysis of various insurer reports and financial examinations to detect potentially troubled companies.

Insurers are subject to significant regulatory reporting requirements. State insurance codes require every licensed insurer to submit annual and quarterly reports to the commissioner of insurance. These reports include information on the assets and liabilities of the company, its investments, its income, loss payments, expenses, and any other information required by the commissioner. Actuaries must sign opinions attesting to the adequacy of reserves. Insurers must calculate and report their risk-based capital (RBC) requirements annually. All this information, along with other publicly available information about the company, is analyzed by state insurance departments on an ongoing basis.

The NAIC serves an important role in the financial analysis process. It maintains a database of financial information filed by insurers and automated tools to assist with financial analysis. In 1974, the NAIC adopted the Insurance Regulatory Information System (IRIS) to assist regulators in identifying potentially troubled insurers. Under IRIS, an insurer's performance on a series of financial tests is examined. Deviations from expected norms are taken as an indication that closer scrutiny of the insurer is needed. In the early 1990s, IRIS was expanded and enhanced to create the Financial Analysis Solvency Tracking (FAST). Under FAST, a score is assigned to each company, based on its performance on a series of ratios and other financial indicators. The specific financial tests used and the company scores are kept confidential by the NAIC. Today, FAST is widely used by state regulators when prioritizing companies for further review. In addition to the many tools made available to the states, the NAIC has created the Financial Analysis Division (FAD) to monitor the financial performance of “nationally significant companies.” This division reports potential problems to the Financial Analysis Working Group (FAWG) of the NAIC, which coordinates with the commissioners in the company's state of domicile to resolve concerns. The FAWG serves as a mechanism for peer review and encourages domestic states to take timely regulatory action.

Examination of Companies In addition to examining the annual report, supplemental filings by insurance companies, and other available information, insurance departments conduct periodic on-site examinations of each company conducting business in the state. The insurance commissioner may examine or inquire into the affairs of any company transacting business in the state at any time, but the insurance code normally requires examining domestic companies at least once every five years. During the detailed and often extended procedure, the examiners scrutinize every aspect of the firm's operation. Targeted exams may be done more frequently and focus on a particular area of concern. In the mid-2000s, the NAIC developed a new risk-focused examination system, which increased regulatory focus on a firm's risk management processes. It was implemented in all states by 2009.

To eliminate duplication of effort, it has become the practice for each state insurance department to examine only those companies that are domiciled in the state. The state calling the exam invites participation from the other zones in which the company does business. (The NAIC is divided into four zones.) Other states in which the insurer does business typically accept the examination results, eliminating the need for separate exams of foreign insurers.

Group Supervision The NAIC Model Holding Company Act has long applied to the regulation of an insurer within a group of companies. The intent of the model law and its related regulation is to protect the insurers from risks that might arise from other areas of the group. This is done by “ring-fencing”, or protecting, the insurer and regulating transactions between the insurer and the rest of the group. For example, the commissioner must approve dividends paid from an insurer to a parent company if they are in excess of certain limits, and intragroup transactions must be conducted on an arms length basis and be reported to the commissioner. Certain transactions require prior regulatory approval.

Lessons learned in the recent global financial crisis have caused U.S. regulators to strengthen their system of group supervision. Specifically, in 2008, the holding company of American International Group (AIG), a large international group with significant insurance operations, was threatened with a rating downgrade because of losses from an unregulated operation known as the Financial Products Division (or AIG-FP). Although the AIG holding company was regulated by the U.S. Office of Thrift Supervision (OTS), a federal banking regulator, the credit default swaps sold by AIG were unregulated.¹³ While the insurance regulators had been focused on the risks in the insurance companies, they were unaware of the increasing risks in AIG-FP. Unfortunately, a downgrade in the holding company had implications for the life insurance companies.¹⁴ Insurance regulators concluded that, while it remained important to ring-fence the insurer from risks outside the insurance company, they also needed to have a better understanding of those risks.

In December 2010, the NAIC adopted revisions to the Model Holding Company Act and Regulation. These revisions strengthened the ability of insurance regulators to gather information and examine the noninsurance operations of the group, authorized regulators to participate in supervisory colleges (where multiple regulators of a group coordinate their activities) and provided funding, and required insurers to file a new Enterprise Risk Filing (Form F) that provides information on risks that might impact the insurance entity.

Risk-Based Capital Risk-based capital (RBC) requirements are another tool used to detect companies that are potentially troubled. With RBC requirements, the amount of capital required for an insurer will vary, based on the specific risks facing the insurer, including risks associated with under-writing, the insurer's investment portfolio, and other risks not reflected by these factors. RBC standards enable regulators to more easily identify an insurer whose capital is inadequate to support the risks it has assumed.

In the 1990s, the NAIC developed RBC standards for life insurers (1992), property and liability insurers (1993), and health insurers (1997), and these models have been adopted widely across the country. RBC standards do not replace statutory capital and surplus requirements. Rather, the purpose of the RBC standards is to alert regulators to the need for closer scrutiny of insurers based on an analysis of the insurer's capital and surplus relative to the specific risks in its portfolio.

The RBC models require comparison between the insurer's total adjusted capital and the amount of capital required under risk-based capital. For a property and liability insurer, RBC requirements recognize asset risk, underwriting risk, and off–balance sheet risks. The capital and surplus of a life insurer must protect and absorb four risks: (1) risk of loss due to defaults in assets and variations in the market value of common stock; (2) risk of claims, expenses, and catastrophes; (3) risk of loss due to changes in interest rates; and (4) risks not otherwise reflected.

A deficiency in RBC is indicated by the ratio of the company's actual capital and surplus and the required risk-based capital. Depending on the magnitude of the deficiency, the RBC regulations will require specific action, ranging from corrective action by the insurer under a plan approved by the commissioner, to seizure of the company by the state insurance department.

The NAIC's SMI is reviewing the current RBC formulae and will likely make changes. The specific charges for asset risk are being reviewed, and the NAIC is considering adding a catastrophe risk charge for catastrophes such as hurricanes and earthquakes.

Enterprise Risk Management The NAIC's SMI is increasing regulatory focus on enterprise risk management and corporate governance. As already indicated, the NAIC's enhanced risk-focused examination system increases focus on insurer risk management. In addition, the NAIC is implementing a new Own Risk and Solvency Assessent (ORSA) requirement, in which insurers must undertake their own assessment of their risk management systems and current and future solvency positions. The ORSA requirement is anticipated to become effective in 2015.¹⁵

Regulation of Reserves Because insurers operate on the unusual plan of collecting for a product to be delivered at some time in the future, insurance laws require specific recognition of the insurer's fiduciary obligations. Life insurers are required to maintain policy reserves on outstanding policies and to reflect these reserves as liabilities in their financial statements.¹⁶ In the property and liability field, insurers are permitted to include premiums as income only as the premiums become earned (i.e., only as the time for which protection is provided passes). In addition, the insurer is required to establish a deferred income account as a liability, called the unearned premium reserve, whose primary purpose is to place a claim against assets that will presumably be required to pay losses occurring in the future. In addition to the unearned premium reserve, property and liability insurers are required to maintain loss reserves. These include a reserve for losses reported but not yet paid and a reserve for losses that have occurred but have not yet been reported to the insurer because of a lag in claim reporting. The insurance code of most states specifies the manner in which the reserves must be computed.

The critical importance of the reserves in the financial stability and solvency of an insurer is apparent when we recognize that the reserves are true liabilities. They are an actuarial measurement of the company's liabilities to its policyholders and claimants that must be offset by assets. If the reserves are understated, the net worth of the company is overstated.

Investments To the extent that an insurer's promises depend on the value of its investments, those investments must be sound. For this reason, the insurance code of each state spells out the particular investments permitted to each type of insurance company in the state. The investments permitted are usually U.S. government obligations; state, municipal, and territorial bonds; Canadian bonds, mortgage loans, certain high-grade corporate bonds; and, subject to limitations, preferred and common stocks. In general, property and liability insurers are granted greater latitude in their investments than life insurers are. Life insurers are generally allowed to invest only a small percentage of their assets in common stocks. Consequently, common stocks account for less than 5 percent of the general account invested assets of life insurance companies while over 15 percent of the assets of property and liability companies are in common stocks. Insurers must file their investments with the NAIC's Securities Valuation Office (SVO), which rates the credit quality of securities and establishes rules for valuing them.

Reinsurance Reinsurance which is discussed further in Chapter 8, is essentially insurance purchase by insurance companies. For example, Acme Insurance may purchase insurance from a reinsurer to protect against catastrophic losses from a hurricane. The U.S. system of reinsurance regulation recognizes two types of reinsurers: admitted reinsurers, who have obtained a license in the state in which they are doing business, and nonadmitted or unlicensed reinsurers. Until recently, when an insurer purchased reinsurance from a nonadmitted reinsurer, it was not permitted to take credit on its financial statements unless the nonadmitted reinsurer posted collateral to back its obligations. Many non-U.S. reinsurers operate as nonadmitted reinsurers in the United States, and they objected strongly to what they viewed as discriminatory treatment.

As part of its SMI, the NAIC adopted revisions to its Credit for Reinsurance Model Act and Regulation. These changes allow for a reduction in collateral requirements if the reinsurer is supervised by an approved jurisdiction. The amount of the reduction depends on the financial strength of the reinsurer. By mid-2013, 13 states representing approximately 50 percent of direct written premiums had adopted the model.¹⁷

Dealing with Insolvencies The main goal of insurance regulation is to avoid policyholder losses when an insurer becomes insolvent. If examination or analysis suggests the company is operating in a hazardous manner, the regulator will intervene to correct the problem. Often, this intervention is confidential and the public is not aware of the action being taken.

In more severe cases, where the insurer is insolvent or financial impaired, the commissioner of the state in which the insurer is domiciled will petition the court to be appointed receiver and assume responsibility for the affairs of the company. As receiver, the commissioner will often attempt to rehabilitate the company. The commissioner may direct that substantial portions of the firm's business be reinsured with other companies. Sometimes the shaky firm may be merged with a stronger insurer.

When these efforts fail or when the company's position is too hazardous to attempt rehabilitation, the commissioner will petition the court for permission to liquidate the company. In a liquidation, the receiver/liquidator will gather or “marshall” the assets, distribute them to the firm creditors as required by law, and dissolve the insurer. State receivership laws specify the priority of the distributions to creditors, and the obligations to policyholders are second in priority, just behind the expenses of the liquidation. This high priority means policyholders get paid before other creditors, increasing the likelihood they will receive the amounts owed to them.¹⁸

State Insolvency Funds If the assets in a liquidation are inadequate to fully compensate policyholders, state insolvency guarantee funds will typically cover part of the losses. Guarantee funds designed to compensate members of the public who suffer loss because of failure of property and liability insurers or life and health insurers exist in all states. Generally, each claim covered by the guarantee fund is subject to a deductible (e.g., $100), and there is a cap on the amount that will be paid, requiring the policyholders and claimants to bear a part of the loss themselves.

Most of the property and liability insolvency guarantee funds date from the early 1970s, when they were established to forestall the formation of a federal agency that had been proposed to perform the same function.¹⁹ Most operate on a postinsolvency basis, in which insurers operating in the state are assessed their proportionate share of losses after an insolvency occurs. The New York plan for property and liability insurers is based on a preinsolvency assessment. In some states, the assessments are allowed as tax offsets, permitting solvent insurers that have paid assessments to recoup these losses by reducing their premium taxes.

NAIC State Accreditation Program In 1990, the NAIC created its Financial Regulation Standards Accreditation Program, which is designed to assist state legislatures and insurance departments in developing an effective system of solvency regulation. The program provides for NAIC certification of states that meet the requirements of the accreditation program. The measures that must be adopted by a state to be accredited by the NAIC include a number of model laws and rules affecting regulation of insurance holding companies, managing general agents, reinsurance intermediaries, credit for reinsurance, examination processes, and liquidation proceedings. By 2013, insurance departments in all states and the District of Columbia were accredited by the NAIC. In addition to the original certification, states must submit to an annual evaluation process and undergo recertification review every five years.

The Dodd-Frank Act The global financial crisis and widespread government support for financial entities has led to heightened attention on the problem of systemic risk and too big to fail (TBTF). With the exception of AIG and a couple of European insurers affiliated with European banks, insurers largely survived the financial crisis intact.²⁰ Most of the attention on systemic risk and TBTF was focused on the large global banks, and traditional insurance activities were generally not considered to be a source of systemic risk. Nonetheless, given that the majority of AIG's operations were related to insurance, policymakers recognized the potential for systemic risk from insurance groups.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) created the most significant change to U.S. financial regulation since the Gramm-Leach-Bliley Act (GLBA). DFA created a new federal Financial Stability Oversight Council (FSOC), comprised primarily of federal regulators.²¹ The FSOC is charged with identifying bank and non-bank systemically important financial institutions (SIFIs), which will be subject to higher capital standards and heightened supervision by the Federal Reserve. The long-term implications of designating a subgroup of insurers as being systemically important are unclear. Some experts worry that designated firms could have a competitive advantage if consumers and other market participants believe the federal government will bail out the firms when they have financial difficulty. Others believe the designated firms will be at a disadvantage if they are more strictly regulated than other firms in the market. To a large extent, the implications will depend on how strictly the firms are regulated. The regulatory system for nonbank SIFIs had not yet been finalized in July 2013.²²

In addition to creating the possibility that some insurance groups might be designated for federal regulation, the Dodd-Frank Act contained some specific elements aimed at the insurance sector. The Dodd-Frank Act created a new Federal Insurance Office (FIO), within Treasury to monitor the insurance sector and coordinate Federal efforts and develop Federal policy on “prudential aspects of international insurance matters.” The FIO also assists the Treasury Secretary in negotiating international agreements related to insurance (along with the U.S. Trade Representative), and can preempt a state regulation in very narrow areas (i.e. where the regulation is inconsistent with an international agreement and treats a non-U.S. insurer less favorably than a U.S. insurer). The Act specifically states the FIO is not a regulator. Because insurance regulation remains state-based, and the FIO has no authority to establish regulatory standards in the states, it is expected that the FIO and U.S. insurance regulators will work closely together on international insurance regulatory matters. The DFA also contained provisions intended to make the regulation of surplus line and reinsurance more efficient by preempting multistate regulation.

Market Regulation

A second major focus of insurance regulation is the fair treatment of policyholders. An insurer might be financially sound and yet indulge in practices that are detrimental to the public, such as unfairly discriminating against an insured or engaging in sharp claim practices. The commissioner attempts to control such activities. Market regulation encompasses such areas as advertising and other marketing issues, claims payment, underwriting, content of insurance policies, and rates charged.

Unfair Practices All states have Unfair Trade Practices Acts prohibiting an insurer from using unfair methods of competition or other unfair or deceptive acts or practices. States have also adopted laws governing claims settlement and prohibiting unfair claims settlement practices.

Unfair Trade Practices Acts prohibit unfair discrimination in underwriting, misrepresentation and false advertising, and rebating and twisting. Rebating consists of directly or indirectly giving or offering to give any portion of the premium or any other consideration to an insurance buyer as an inducement to the purchase of insurance. An example of unlawful rebating would be an offer by an insurance agents to give a part of their commission to a prospective insured.²³

Twisting is the practice of inducing a policyholder to lapse or cancel a policy of one insurer to replace it with the policy of another insurer in a way that would prejudice the interest of the policyholder. Obviously, there is no crime in a complete comparison without misrepresentation agents may make between a policy sold by their companies and one sold by another company. It has been estimated that 30 to 40 percent of life insurance sales are replacements. This is unfortunate because, in a surprising number of cases, replacement of a contract does not benefit the policyholder.²⁴

Policy Forms Because the insurance product is a contract, by its very nature, it is technical. In most cases, customers are asked to purchase a product in which they become a party to a contract they have not read nor would understand if they read it. Because insurance contracts are complicated, they are subject to regulatory standards and must contain certain required provisions. In most cases, they must be approved by the regulatory authorities to ensure that the insurance-buying public will not be mistreated as a result of unfair provisions.

In addition, the solvency of the insurers must be protected against unreasonable commitments they might make under stress of competition. In some states, new policy forms and endorsements need only be filed with the commissioner's office before they are used; if the commissioner does not approve of the form, it is then withdrawn. In most states, however, the law requires the approval of a form before it is adopted.

Competence of Agents Because of the technical complications in the insurance product, it is particularly important that those selling insurance understand the contracts they propose to sell. All states require a license from applicants to demonstrate by examination that they understand the contracts they propose to offer to the public and the laws under which they will operate. Also, the agents must be respected and responsible residents of their individual communities.

Consumer Complaints and Assistance All state insurance departments offer assistance to consumers in resolving disputes with insurers and insurance agents. During 2005, the states processed approximately 475,000 complaints and answered more than 3 million consumer inquiries. In addition, most states have consumer information programs that provide educational brochures and other useful information. The NAIC maintains a Consumer Information Source (CIS) website that allows consumers to obtain information about insurers, including claims history, basic financial information, and states in which the company is licensed.

Privacy and the Gramm-Leach-Bliley Act In 1999, Congress enacted the Financial Services Modernization Act, widely known as the Gramm-Leach-Bliley Act (GLBA), after its principal sponsors. The primary purpose of the GLBA was to relax the barriers between insurance, securities, and banking that had existed since the Great Depression. In the insurance area, the GLBA permitted affiliations between banks and insurers and expanded the ability of national banks to sell insurance. It also defined the regulatory structure for these activities.

Although privacy was not the main focus of the GLBA, the law contains important new privacy protections. During the debate over the GLBA, many became concerned with the increasing ability of financial institutions to collect personal information about consumers and share it with others. Advancements in information systems and technology have increased the amount of information collected, and firms increasingly use this information to target their marketing. As more information is collected and it becomes easier to share with others, societal concerns about privacy have increased.

The consumer privacy protections in the GLBA set some basic standards that all financial institutions, including insurance companies and agents, must meet. In general, the law requires insurers to notify consumers about their privacy policies and to give them the opportunity to prohibit the sharing of their protected financial information with nonaffiliated third parties. Information sharing between affiliated companies is not restricted. State insurance regulators are charged with enforcing the privacy provisions of GLBA as they apply to the insurance industry.

In response to GLBA, the NAIC adopted the Privacy of Consumer Financial and Health Information Model Regulation in September 2000. Recognizing the significance of health information in the insurance industry, the NAIC model regulates the privacy of financial information and health information. Most states have adopted the NAIC model or amended their existing privacy laws to be consistent with the model.

The U.S. Department of Health and Human Services (HHS) finalized regulations in April 2001 intended to protect the privacy of health records. These rules govern health plans (including health insurers and HMOs), health care clearinghouses, and health care providers. Covered entities must disclose their privacy policies, allow patients to have access to their medical records, and obtain consumer consent before releasing information to others.

Regulation of Rates

The original rationale for regulation of insurance rates was that such regulation was needed to achieve the dual goals of regulation: solvency and equity. Because the rates charged play an important role in achieving these goals, many believed the rates must be subject to government control. All states (except Illinois, which does not currently have a rating law) provide for the regulation of insurance rates, requiring that the rates must be adequate, not excessive, and not unfairly discriminatory.

Adequacy is the primary requirement. The rates, with interest income from investments, must be sufficient to pay all losses as they occur and all expenses connected with the production and servicing of the business.

In addition to being adequate, the insurance rates must not be excessive. Insurance has become regarded as a product that is essential to the well-being of society's members, and insurers may not take advantage of this need to realize unreasonable returns. Finally, insurance rates must not discriminate unfairly. The emphasis in this requirement is on unfairly since insurance rates requires some degree of discrimination. By not being unfairly discriminatory, we mean the insurance company may not charge a significantly different rate for two clients with approximately the same degree of risk. Any variation in rates charged must have an actuarial basis.

All states have legislation requiring that rates must be reasonable, adequate, and not unfairly discriminatory, yet the manner in which these requirements are enforced varies with different lines of insurance and from state to state.

Regulation of Life Insurance Rates Apart from making certain the companies do not engage in price discrimination, most states do not exercise any form of direct control over the level of life insurance rates.²⁵ However, life insurance rates are regulated indirectly. Regulation of dividends and mutual insurers' accumulation of surplus represents an indirect control on maximum rates. In addition, legal limits on the expense portion of the premium help control the cost of life insurance in those states that impose such limits.²⁶ Finally, state laws prescribe the mortality tables and interest assumptions that must be used in computing policy reserves, which means that the adequacy of life insurance rates is indirectly regulated. If the insurer's rate structure is too low, premium income will be insufficient to generate the assets required to meet the required reserves. Although these indirect forms of rate regulation do exist, they represent an extremely limited form of control. Most expenses are not controlled, and there are no limits set on profits other than those imposed on mutual insurers in accumulating surplus. The chief justification for the absence of stricter regulation of life insurance rates has been the proposition that competition is an effective regulator and can be depended on to keep life insurance rates from being excessive. Informed authorities question this assumption, arguing that the pricing complexities in life insurance make determination of the true cost of the insurance beyond the ability of even the sophisticated buyer.²⁷ This is because the combination of savings and protection in the life insurance policy tends to obscure the cost of the protection and the return on savings.

Recognizing consumers have difficulty understanding the cost of life insurance, many states now insist that an insurer provide prospective buyers with cost disclosure information. In 1976, the NAIC adopted and proposed to the states the Model Life Insurance Solicitation Regulation, which was subsequently adopted by many states. This regulation requires insurers to make cost comparison information available to prospective buyers. The required information includes standardized cost indexes and dividend information. The model regulation was revised in 1983, after critics, including the Federal Trade Commission (FTC), argued that it provided inadequate disclosure. Although the 1983 model regulation is an improvement over the original version, it too has been criticized as inadequate disclosure.

Regulation of Property and Liability Rates There is considerable diversity in the approaches taken by states to regulate property and casualty rates. In some cases, states exercise direct control over rates, requiring specific approval of rates before they can be used. In other cases, states follow the life insurance pattern, and exercise only indirect forms of regulation. Although there are other systems, the major approaches to rate regulation fall into four categories: prior approval, file and use, informational filing, and no filing.²⁸ The latter three are known collectively as competitive rating or open rating systems.²⁹ In addition, we will briefly note a hybrid system known as “flex-rating.”³⁰

The Prior Approval System Following the enactment of the McCarran-Ferguson Act, most states adopted the prior approval approach to rate regulation, patterned after the All Industry Model Rating Law, developed by the NAIC in 1946. Under this system, the insurance company must obtain approval of its intended rates from the commissioner before they may be used, and the commissioner retains the right to disapprove the rates after they become effective. Insurers file statistical data in the form of trended loss experience and projected expenses with requests for approval of rates. An insurer may accumulate and file its own loss data, or it may authorize an advisory organization (i.e., rating bureau) to file industry-wide trended loss data on its behalf. In either case, the insurer must complete the filing data using its own projected expenses. If the commissioner is satisfied that the statistical data support the proposed rate, it is approved. In most states, the law includes a deemer provision, which grants that if the rates have not been disapproved within a specified period of time (ranging from 15 to 60 days), they are deemed to have been approved.

The prior approval system has been the subject of considerable criticism. Insurers complain the system tends to make the commissioner the justifier of rates to the public, so the level of rates is often determined by political rather than actuarial considerations. Public pressure for containment of insurance prices may act to deny insurers needed rate increases. In some states, requests for rate increases are frequently denied or compromised, and sometimes they are delayed for unconscionable periods. The resulting rigidity of rates at inadequate levels produces the traditional market response to an inadequate price level: a reduction in supply. Ironically, while insurers complain that the prior approval system results in inadequate rates, other critics argue that its effect is quite the opposite. A 1977 study by the U.S. Department of Justice, for example, concluded that the prior approval system is an unnecessary limitation on competition by insurers and has discouraged rate reductions.³¹

No Filing Although prior approval remains a common approach to the regulation of property and liability rates, there is currently a trend toward eliminating prior approval requirements and adopting a competitive rating approach to rate regulation. One option is the no-file law, also referred to as open competition. Under a no-file system, rates are not required to be filed with or approved by the state insurance department. However, the company must maintain records of experience and other information used in developing the rates and make these available to the commissioner on request.

The no-file approach follows the pattern of a California law, which existed from 1947 until it was repealed by Proposition 103 in 1987.³² The California law made it clear that competition, not government authority, is the preferred governor of rates and that barring the existence of an anticompetitive situation or practice, the commissioner was not to regulate rates as such. In effect, the position of property and liability insurers under such a law is much the same as that of life insurers, which, as we have noted, are subject only to indirect control of their rates.

During the late 1960s and 1970s, a short-lived movement advocated replacing prior approval laws with open competition laws. No-file or open competition laws were passed in Florida, Georgia, Idaho, Illinois, Missouri, and Montana. The trend stalled in 1976 amid furor by consumer groups over the escalation in insurance costs. It was an accident of history that the no-file approach was gathering momentum when severe underwriting losses in 1974 and 1975 prompted insurers to increase their rate levels. Consumerists associated the increases with the absence of regulation and insisted that states control the level of rates.³³

File-and-Use Laws A third system of rate regulation, file-and-use laws, represents something of a compromise between the prior approval system and the no-file system. Under the file-and-use approach, the insurer must file proposed rate changes but may use the new rates after a short waiting period.³⁴ However, the rates may subsequently be disapproved by the commissioner. The chief advantage of the file-and-use system is that no delay occurs between the time a rate adjustment is needed and the time it becomes effective.³⁵

Informational Filing The fourth system, informational filing, is considered by many authorities to be almost identical in effect with the open competition approach. Rates may be used without regulatory approval, but they are filed with the regulator for information purposes.³⁶

Flex-Rating The newest approach to rate regulation, known as flex-rating, combines elements of the prior approval system and the open competition system. Under the flex-rating system, a range is established for insurance rates. Insurers are permitted to change their rates up and down within the established range in response to market conditions and without prior approval. Increases above or decreases below the established range (e.g., 10 percent) require prior approval.

Diversity as a Reflection of State Preference Although it may be surprising that the states have taken such diverse approaches to the regulation of property and liability insurance rates, the truth is that there is still considerable disagreement about the proper role of regulation with respect to rates. Originally, prior approval laws were enacted to prevent insurers from engaging in cut-throat competition, which regulators viewed as the major threat. More recently, many prior approval laws have been administered under a different philosophy: The purpose of the regulation is to keep rates from becoming excessive. As a result, insurers have come to favor the no-file, informational filing, or file-and-use approaches to regulation.

Numerous arguments have been advanced in favor of free competition in property and liability insurance. It is argued, for example, that government attempts to regulate prices result in restrictions in the market. When price ceilings are imposed by regulators, insurers tend to compete in attracting only the better classes of insureds, leaving the less desirable ones without coverage. In addition, it has been argued that greater pricing freedom for insurers makes premium rates more responsive to changing conditions. Experience seems to indicate that the prior approval system exacerbates the underwriting cycle. Under the prior approval system, an insurer that discovers it is losing money faces a delay in adjusting its rates, whereas adjustments can be made immediately under the other systems. In prior approval states, the changes tend to come less often but turn out larger.³⁷ This results in a more dramatic underwriting cycle. Finally, more competition, it is argued, will give insurers greater incentive to operate efficiently to cut costs and permit rate reductions.³⁸

Risk-Retention Groups

As we noted briefly in Chapter 4, the Risk Retention Act of 1986 authorized groups with common exposures to band together and form risk-retention groups or purchasing groups. The major effect of the law was to carve out a federal exemption from state regulation for both risk-retention groups and purchasing groups. Risk-retention groups and purchasing groups are subject to regulation by the state in which they are formed but are generally exempt from regulation by other states. Initially, the organizers of a risk-retention group submit a business plan or feasibility study to the insurance department of the chartering state and are regulated by that state. The group must submit copies of the plan or study to the insurance departments of all other states in which it will be doing business, but it need not be licensed to operate in other states. The group must file with the insurance commissioner in each state in which it does business a copy of the annual financial statement it files with the chartering state. In addition, risk-retention groups are subject to the unfair claim settlement practice laws, residual market mechanisms (i.e., assigned-risk pools), and registration with the state insurance commissioners of those states. Risk-retention groups are prohibited from joining the state insolvency guaranty fund. In the event of insolvency of a risk-retention group, there is no source of recovery other than the assets of the members. Policy forms of purchasing groups are regulated by only one state.

STATE VERSUS FEDERAL REGULATION

The prospect of federal regulation of the insurance industry has loomed since the South-Eastern Underwriters Association (SEUA) case in 1944. Although the McCarran-Ferguson Act (Public Law 15) left regulation in the hands of the states, it did so with the implicit condition that the federal government would not regulate insurance as long as the states did a good job.

Pressure for Repeal of the McCarran-Ferguson Act

Bills to repeal or otherwise modify the McCarran-Ferguson Act have been introduced in nearly every session of Congress since 1977. During the 1980s and early 1990s, the focus of most bills was on the insurance industry's federal antitrust exemption. Some bills would have made the insurance industry subject to federal antitrust laws without exception. Others would have granted a partial exemption from the antitrust laws, allowing insurers to engage in limited cooperation in ratemaking, primarily through exchange of loss data and in joint preparation and filing of policy forms. The insurance industry opposed both approaches but generally found the partial exemption version less objectionable.³⁹

More recent attempts to modify the McCarran-Ferguson Act have gone to the heart of the system of state regulation. The GLBA, enacted in 1999, expanded the ability of national banks to engage in the insurance business. Since then, many large banks have taken an active interest in the system of insurance regulation. Given that national banks are regulated by the Office of the Comptroller of the Currency (OCC), it is not surprising they would prefer a federal system of insurance regulation. Similarly, large insurers (particularly life insurers) became more vocal in their criticism of state regulation. Both groups argued that it is inefficient and unnecessarily costly to comply with individual state laws, and they sought a federal regulatory system to achieve national uniformity.

The 2008-2009 financial crisis caused many insurers to reassess their support of federal regulation. In the aftermath of widespread banking failures and federal bank bailouts, the Congress and federal banking regulators tended to support much stricter regulation. Insurance industry support for federal regulation began to diminish. Whether this reflects a fundamental shift or merely a strategic decision to wait until the environment in Washington is more favorable is unclear.

Arguments Favoring Federal Regulation

Those who advocate repeal of the McCarran-Ferguson Act may be divided into three broad groups, fundamentally different in their philosophies but unanimous in their agreement that the law should be repealed.

The first group consists of those who argue that the states have done an inadequate job of regulating the industry. Although these critics admit that some states have done a good job in regulating insurance, they point out that the quality of regulation nationwide has varied markedly. The result in some cases has been the failure of companies and public suffering. These advocates of federal regulation argue that the lack of consistency among the states has caused inconvenience, duplication of effort, and waste. There are 50 different insurance codes, each of which imposes restrictions and limitations on insurers. An insurance company seeking a rate adjustment or a change in policy form must obtain approval from each of the jurisdictions. A single federal system of regulation, it is argued, would provide uniformity and better quality regulation. This group also questions the ability of the states to influence policy development in Washington and internationally, when these venues are assuming increasing importance for insurance regulation and the industry. In essence, it is argued that since insurance is interstate commerce, there should be one body to provide for uniform nationwide regulation.

The second group advocating repeal of the McCarran-Ferguson Act sees it as a way to eliminate state rate regulation. These proponents, primarily large property casualty insurers, believe the spread of open competition laws has been too slow and that a repeal of the McCarran-Ferguson Act, coupled with preemption of state rate regulation, would enable companies to respond more quickly to changing market conditions and compete more effectively.

Finally, some proponents view the industry's limited antitrust protection under the McCarran-Ferguson Act as unnecessary or inherently anti-competitive. The most recent example of this perspective is provided in the April 2007 report of the Antitrust Modernization Commission (AMC).⁴⁰ Although the AMC did not explicitly call for repeal of the McCarran-Ferguson Act, it did argue that statutory immunities should be granted rarely. Pointing to the McCarran-Ferguson Act specifically, it rejected the typical arguments in favor of the limited antitrust exemption.⁴¹

Interestingly, those who have suggested a change from state regulation to a federal system often see this shift in different terms. Some favor the change because they feel that state regulation has been ineffective. These advocates of federal regulation expect more regulation under a federal system. Other advocates of change favor the shift because of a philosophical predisposition in favor of antitrust. Still others are concerned about consumer issues relating to availability and affordability and see a shift to a federal system of regulation as a solution to these contradictory goals. Finally, some people within the insurance industry view the prospect of the repeal of the McCarran-Ferguson Act as an escape from the burdensome requirements of state regulation.

Arguments Favoring State Regulation

The opponents of federal regulation argue that the individual states have the experience and expertise necessary to meet and solve the critical issues and that state regulatory authorities, being more familiar with location conditions and problems, are more responsive to local needs. They point to the assistance regulators give local consumers, and they argue that a federal system of regulation would of necessity be superimposed on the state system.

Perhaps the most impressive argument against federal regulation is the same as the one generally raised in favor of federal regulation: that a federal system would substitute a uniform system for the existing diversity under the states. Although the differences in approach to regulation taken by the states are often condemned as a defect of state regulation, uniformity is a neutral term, implying neither goodness nor badness. Given the performance of some regulatory agencies, at the state and federal levels, the uniformity that it is claimed would exist under a federal system might be viewed as a defect rather than a benefit. State regulation provides the ability and freedom to innovate, experiment, and emulate. If a mistake is made in state regulation, it is limited to one jurisdiction and does not become national in scope. Federal regulation, with its uniformity, would eliminate the localized expressions of preference regarding the manner in which the industry should be regulated. To argue there is something fundamentally wrong with differences in regulation among the various states is to quarrel with the entire concept of federalism and the legitimacy of individual states to have independent powers and responsibilities.

Consequences of the Repeal of the McCarran-Ferguson Act

The effect of the repeal of the McCarran-Ferguson Act (Public Law 15) would depend on the nature of the regulatory system that would evolve following such a repeal. Although it is impossible to determine precisely what that system might be, we can identify some possibilities.

Continuation of State Regulation Repeal of Public Law 15 would superimpose the federal system of regulation on a continuing state system. The leading proposals for repeal of the McCarran-Ferguson Act would grant insurers the option of state or federal charters, and state-chartered companies would require retention of the state system of regulation.⁴² Even without alternative chartering, many insurers would not be subject to federal control because they operate on an intrastate basis and are not engaged in interstate commerce. In addition, the states would undoubtedly continue to license and regulate at least some agents and would probably require reports from federally regulated insurers for premium tax purposes. Industry proponents of federal regulation favor a system that preempts all or most state regulation of federally chartered insurers. Skeptics argue that a dual system of regulation is more likely to emerge, with states continuing to enforce some aspects of market regulation.

Possible Varieties of Federal Control Despite the considerable rhetoric on the subject, there is no way to predict the form that federal control would take. Yet most arguments for or against federal regulation have been based on some presumed system. Although the competitive markets approach suggested by those who favor preempting state rate regulation is one possible model, there are other systems of federal regulation as well. Federal regulatory agencies have used the prior approval approach in regulating the prices of natural gas, banks and other financial institutions, and the airline and trucking industries, and this approach could be used under a federal system of insurance regulation. Despite the trend toward deregulation in other areas, there is a serious question whether Congress would permit insurers the freedom in pricing contemplated by a pure antitrust approach. It is becoming increasingly evident that consumers want some regulation of insurance rates. Although the original purpose of rate regulation was to prevent destructive competition, most consumers perceive its purpose to be that of controlling increases in rates. The public choice theory of regulation suggests that this attitude will play an important role in determining the system of insurance regulation under either a state or federal system.

Repeal of the McCarran-Ferguson Act as a States-Rights Issue

Because the McCarran-Ferguson Act grants the industry an exemption from the federal antitrust laws, some advocates of repeal characterize their position as procompetition and the position of those who oppose repeal as opposing competition. In fact, repeal of the McCarran-Ferguson Act is consistent with either a free-market or a market-intervention approach.

There are two issues related to the regulation of insurance. The first involves the question of whether an antitrust approach or regulation should be used with respect to insurer pricing, whether we should depend on market forces to control prices or resort to market intervention through regulation. This is not really the question in the debate over the repeal of the McCarran-Ferguson Act. The debate is over where the decision of market intervention or nonintervention should be made. Repeal of the McCarran-Ferguson Act is fundamentally a states rights issue. The McCarran-Ferguson Act does not exempt the industry from antitrust regulation but only from federal antitrust laws. It was enabling legislation that allows the states to regulate as they choose. The states are free to choose between an antitrust, free-market approach or rigid regulation. As we have seen, the states have taken different approaches.

The NAIC's Efforts to Modernize State Insurance Regulation

Recognizing the increasingly global nature of the industry, the competition insurers face from other sectors of the financial services industry, and the increasing complaints from the insurance industry about the state-based system, the NAIC and the states have made several efforts to streamline system. In its 2000 “Statement of Intent on the Future of State Insurance Regulation,” the NAIC committed to reforms in the areas of producer licensing, company licensing, rate and form regulation, market conduct, and solvency oversight. In general, the Statement of Intent initiatives seek more uniformity among the states and greater coordination in regulatory oversight to reduce the duplication of dealing with multiple states. One result of the Statement of Intent was the creation of an interstate compact to enable the multistate approval of life insurance, annuities, disability income, and long–term care insurance.⁴³ In December 2002, the NAIC adopted the model Interstate Insurance Product Regulation Compact, designed to create a single point of filing for these products, subject to one set of national standards. The legislation creates a Compact Commission composed of a representative of each member state, and the commission is charged with developing product standards and reviewing products.⁴⁴ Approval of a product by the commission is effectively the same as approval by the state. This essentially creates a single set of national standards that apply to member states and a streamlined review process.

Over the past decade, the NAIC has significantly increased its presence in Washington and internationally. The NAIC was a founding member of the International Association of Insurance Supervisors (IAIS) in 1994 and managed its operations for a number of years. As international developments increase in importance, the NAIC has devoted more resources to influencing their outcomes.

Although the NAIC has made some progress with its efforts, critics argue that the progress is not enough, meaning there are still too many differences among the states and that the large states have often chosen not to participate in the reforms. Whether the NAIC's efforts are enough to maintain the primacy of state insurance regulation remains to be seen.

State versus Federal Regulation and Public Choice

The public choice theory of regulation suggests that the eventual decision with respect to state versus federal regulation will be determined by the intensity of efforts of payers and beneficiaries. Unfortunately, the issues in this controversy are not clearly understood by many of the debaters, and there is some uncertainty regarding who will be payers and who will be beneficiaries.

We have noted that the principal supporters of federal regulation include some members of Congress, banks, and most large insurers. The supporters of state regulation include the National Association of Insurance Commissioners, most insurance agents and their associations, and a large number of insurance companies. In measuring the attitudes of insurance company managers, it should be remembered that most insurers are small regional organizations; it is logical that they would favor continuation of state regulation. Although it is an oversimplification to assume that the larger national companies all favor federal regulation and the smaller companies oppose it, a large insurer coping with 50 different insurance departments would be understandably more inclined to favor federal regulation than would the smaller, regional company.

In the last analysis, the attitudes of the insurance industry itself should not be a major factor. The issue of state versus federal regulation should not be determined on the basis of the preferences of those who are being regulated. Nor should the decision be based on the preferences of state regulators or those who would run the federal system of regulation. Rather, it should be decided on the basis of the costs and benefits to the consumer under either system.

The controversy between the proponents of state regulation and those who advocate federal control will continue. The eventual result may be a dual system of regulation, but even if this takes place, the debate regarding the superiority of one system over the other will continue.

GLOBAL INFLUENCES ON INSURANCE REGULATION

With the globalization of the insurance industry and increased cross-border activity, cooperation has increased among the world's insurance regulators (known as supervisors in many countries). The International Association of Insurance Supervisors (IAIS) was established in 1994 and represents insurance regulators from about 180 jurisdictions. The IAIS develops global insurance principles, standards, and guidance papers, and it provides training and support on issues related to insurance supervision. The IAIS has developed a set of 26 core principles for insurance supervision, essentially laying out the critical elements of an effective regulatory system.

IAIS standards have an important influence in the structure of insurance regulation in the United States. The International Monetary Fund (IMF) periodically assesses country compliance with the core principles under the Financial Stability Assessment Program (FSAP), and U.S. insurance regulators are reluctant to be found out of compliance. Thus, U.S. insurance regulators, through the NAIC, actively participate in the development of IAIS standards to ensure they are appropriate for the U.S. market. The Federal Insurance Offie is also a member of the IAIS as a representative of the federal government.

In 2013, the IAIS was working on two significant projects that were likely to affect the U.S. market. The first is the development of a Common Framework for the Supervision of Internationally Active Insurance Groups, or ComFrame. This was an effort to further refine the core principles and standards to promote international cooperation in supervising a group. According to the IAIS, a specific framework is needed “to assist supervisors in collectively addressing group-wide activities and risks, identifying and avoiding regulatory gaps, and coordinating supervisory activities under the aegis of a group-wide supervisor.” One area of disagreement in the development of ComFrame is the role of uniform global requirements for capital and accounting and how to accommodate different local market and requirements. Over time, the outcome of this debate will have significant implications for the competitive balance between internationally active firms and those not active internationally.

Second, the IAIS was working with the Financial Stability Board (FSB) to identify global systemically important insurers (G-SIIs) and to define the policy measures, such as higher capital requirements and more intensive supervision, that should be imposed on them. It was generally agreed that traditional insurance activities do not pose systemic risk, so the IAIS work was primarily focused on identifying nontraditional activities that should be penalized.

International developments with respect to accounting are also influencing regulatory developments. Recognizing the increasingly global nature of financial markets, many corporations, investors, and policy makers have urged more consistency in global accounting standards. In 2001, the International Accounting Standards Board (IASB) was created, and its International Financial Reporting Standards (IFRS) have been adopted widely around the world. In the European Union (EU), all publicly traded companies are now required to report under IFRS.

Unfortunately, the IASB has been unable to come to agreement on a rule for accounting for insurance contracts. Thus, even where IFRS is used, there is no common standard to insurance policy liabilities, and it is unclear when one will occur. Insurance regulators are following the work of the IASB closely since it will affect regulatory reporting requirements around the world. Although it is possible to maintain separate regulatory and public reporting requirements, as currently exists in the United States with statutory insurance reporting, insurance companies and regulators have expressed the desire to reduce reporting burdens on global companies by minimizing the variation.

Finally, developments in the European Union were creating challenges for transatlantic insurance groups. Beginning in the early 2000s, the EU began to develop Solvency II, a major revision to its system of solvency regulation and supervision for insurers, most of which dated from the 1970s. Solvency II is aimed at creating a consistent set of requirements across the EU, allowing for free movement of insurance business across the EU market. Because of certain “extraterritorial” elements, the design of Solvency II also creates implications for insurance groups that have business both in and outside of Europe, whatever their home country. This includes European groups doing business in the U.S., as well as U.S. groups doing business in Europe. These consequences can be mitigated, however, if the other jurisdiction is deemed to have a system of regulation and supervision that is “equivalent” to Solvency II. As of mid-2013, Solvency II had not yet been finalized, and the timing of its implementation was unclear.

IMPORTANT CONCEPTS TO REMEMBER

antitrust

regulation

market failure theory

capture theory

public choice theory

vested-in-the-public-interest theory

Paul v. Virginia

Armstrong Committee Investigation

Merritt Committee Investigation

SEUA case

domestic insurer

foreign insurer

alien insurer

Public Law 15

McCarran-Ferguson Act

National Association of Insurance Commissioners

accreditation program

zone examination

insolvency guarantee funds

group supervision

Financial Analysis Solvency Tracking

risk-based capital

Dodd-Frank Act

reverse competition

legal requirements of insurance rates

prior approval law

file-and-use law

use-and-file law

competitive rating law

no-file approach

rebating

twisting

involuntary markets

social pricing

gender-neutral rating

redlining

availability

affordability

cross-subsidies

QUESTIONS FOR REVIEW

1. Explain why the field of insurance has been regarded as a type of business that requires government regulation.

2. Precisely what is meant by the statement that insurance is an industry that is vested in the public interest.

3. Identify the landmark decisions and statutes that led to the present status of insurance with respect to the federal antitrust laws.

4. Briefly outline the provisions of Public Law 15.

5. Describe the four principal approaches to rate regulation in the property and liability field.

6. List and briefly explain the statutory requirements with respect to insurance rates.

7. Distinguish among a domestic company, a foreign company, and an alien company.

8. Describe the operation of the state insolvency funds. To what types of insurers do they apply?

9. Briefly describe the arguments for and against federal regulation of insurance.

10. What arguments would probably be advanced by those opposing a change from a prior approval rating law to an open competition law? What arguments would be advanced by those who favored the change?

QUESTIONS FOR DISCUSSION

1. In most states, the office of commissioner of insurance is an appointive office. Do you feel that it would be better if it were elective? Why or why not?

2. Why is it necessary for insurance agents and brokers in many states to pass qualification examinations? Do you feel that these examinations in your state are too hard or too easy?

3. It is generally agreed that unrestricted price competition among insurers could be detrimental to the public, yet some people argue that antirebating laws represent an unnecessary restriction on price competition among insurance agents and that such laws should be repealed. What is your opinion?

4. “Competition can be depended on to keep rates from being excessive, and good management will keep them from being inadequate; regulation of rates is an infringement on the right of management to make business decisions.” Do you agree or disagree with this statement? Why?

5. What, in your opinion, are the major factors that should be considered in evaluating state regulation of insurance as opposed to federal regulation? What advantages do you see in each system?

SUGGESTIONS FOR ADDITIONAL READING

Belth, Joseph M. Life Insurance: A Consumer's Handbook, 2nd ed. Bloomington: Indiana University Press, 1985.

———. “Price Competition in Life Insurance.” Journal of Risk and Insurance, vol. 33, no. 3 (Sept. 1966).

———. The Retail Price Structure in American Life Insurance. Bloomington: Bureau of Business Research, Graduate School of Business, Indiana University, 1966.

Cooper, Robert W. “Banking Regulation and Proposed Reforms: Implications for Insurance Regulatory Reform that includes an Optional Federal Charter,” Journal of Insurance Regulation, 2010.

Cummins, J. David, editor. Deregulating Property-Liability Insurance: Restoring Competition and Increasing Market Efficiency. Washington, D.C.: AEI-Brookings Joint Center for Regulatory Studies, 2002.

Cummins, J. David and Mary Weiss “Systemic Risk and Regulation of the Insurance Industry,” Networks Financial Institute Policy Brief, March 2013. Available at http://indstate.edu/business/nfi/leadership/briefs/2013-PB-02^.Cummins-Weiss.pdf.

Goodwin, David. “The Case for Abolishing Anti-Rebate Laws.” CPCU Journal, vol. 43, no. 4 (Dec. 1990).

Grace, Martin F. and Robert W. Klein, editors. The Future of Insurance Regulation in the United States. Brookings Institution Press, 2009. Available at http://muse.jhu.edu/books/9780815703860.

Hanson, John S., Robert Dineen, and Michael B. Johnson. Monitoring Competition: A Means of Regulating the Property and Liability Insurance Business. Milwaukee: National Association of Insurance Commissioners, 1974.

International Association of Insurance Supervisors. Insurance and Financial Stability. November 2011.

Harrington, Scott E. The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation. National Association of Mutual Insurance Companies, 2009.

Kimball, S. L. Insurance and Public Policy,. Madison: University of Wisconsin Press, 1960.

Klein, Robert W. Insurance Regulation and the Challenge of Solvency II: Modernizing the System of U.S. Solvency Regulation. National Association of Mutual Insurance Companies, 2012.

Manders, John M. “Proposed Congressional Amendments to the McCarran-Ferguson Act: Their Impact on State Regulation.” Journal of Insurance Regulation, vol. 9, no. 1 (Sept. 1990).

Manders, John M., Therese M. Vaughan, and Robert H. Myers, Jr. “Insurance Regulation in the Public Interest: Where Do We Go From Here?” Journal of Insurance Regulation, vol. 12, 1994.

Patterson, Edwin W. The Insurance Commissioner in the United States: A Study in Administrative Law and Practice. Cambridge, Mass.: Harvard University Press, 1927.

Peltzman, Sam. “Toward a More General Theory of Regulation.” Journal of Law and Economics, vol. 19 (Aug. 1976).

Phillips, C. F. The Economics of Regulation. Homewood, Ill.: Richard D. Irwin, 1969.

State of New York. Report of the Joint Committee of the Senate and Assembly of the State of New York, Appointed to Investigate Corrupt Practices in Connection with Legislation, and the Affairs of Insurance Companies, Other Than Those Doing Life Insurance Business. Assembly Document No. 30, 1911, p. 76.

Stigler, George. “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science, vol. 2, no. 1 (Spring 1971).

U.S. Department of Justice. A Report of the Task Force on Antitrust Immunities: The Pricing and Marketing of Insurance. Washington, D.C.: U.S. Government Printing Office, 1977.

Vaughan, Emmett J. “Economic Implications of the Repeal of the McCarran-Ferguson Act.” State Solutions for State Problems. Tallahassee, Fla.: The Last Manifesto, 1980.

———. “The Case for Retaining Anti-Rebate Laws.” CPCU Journal, vol. 43, no. 4 (Dec. 1990).

Vaughan, Therese M. “The Financial Crisis and Lessons for (and from) U.S. Insurance Regulation.” Journal of Insurance Regulation, vol. 28, no. 1 (Fall/Winter 2009) Available at http://www.naic.org/documents/cipr^.jir^.vaughan.pdf.

Vaughan, Terri M. “Financial Stability and Insurance Supervision: The Future of Prudential Supervision,” The Geneva Papers on Risk and Insurance—Issues and Practice, vol. 29, no. 2, 2004.

Wallison, Peter J., editor. Optional Federal Chartering and Regulation of Insurance Companies. Washington, D.C.: AEI Press, 2000.

WEB SITES TO EXPLORE

The Geneva Association	www.genevaassociation.com
Insurance Information Institute	www.iii.org
Insurance Services Office, Inc.	www.iso.com
International Association of Insurance Supervisors	www.iaisweb.org
Journal of Insurance Regulation	www.naic.org/store-jir.htm
National Association of Insurance Commissioners	www.naic.org
National Conference of Insurance Guaranty Funds	www.ncigf.org
National Council on Compensation Insurance	www.ncci.com
National Organization of Life and Health Guaranty Associations	www.nohlga.com
National Underwriter Company	www.nationalunderwriter.com

¹For a more complete discussion of the market failure view of regulation see C. F. Phillips, The Economics of Regulation (Homewood, Ill.: Richard D. Irwin, 1969). This draws heavily on the early work of A. C. Pigou, The Economics of Welfare, 4th ed. (London: Macmillan, 1932).

²The evolution of the capture theory and the public choice theory of regulation is revealed in George Stigler, “The Theory of Economic Regulation,” Bell Journal of Economics and Management Science, vol. 2, no. 1 (Spring 1971), and Sam Peltzman, “Toward a More General Theory of Regulation,” Journal of Law and Economics, vol. 19 (August 1976).

³Kenneth J. Meier offers another view: that regulatory policies result from the interaction of four political institutions within an environment that influences their abilities to use their political resources effectively. The four players in the political process are regulators, consumers, the industry, and political elites (legislators, governors, federal officials, et al.). The major influence on the effectiveness of these parties in the politics of regulation is the nature of the regulatory issue. Meier suggests that regulatory issues can be characterized according to their salience and complexity. A salient issue is one in which large numbers of people feel that the issue affects them and that the political system is the way to address the issue. A complex issue is one in which specialized knowledge is required to understand the policy question. When an issue is salient, consumers and political elites are more likely to become involved. When an issue is complex, it is costly for them to be involved, and regulators and the industry have a relative advantage. See Kenneth J. Meier, “The Politics of Insurance Regulation,” Journal of Risk and Insurance, vol. 58, no. 4 (December 1991).

⁴The U.S. Supreme Court ruled that insurance is a business “affected with the public interest” in 1914. See German Alliance Insurance Company v. Lewis, 233 U.S. 380 (1914).

⁵These goals were articulated by Professor Spencer L. Kimball, who referred to them as the principles of solidity and aequum et bonum. See Spencer L. Kimball, Essays in Insurance Regulation (Ann Arbor, Mich.: Spencer Kimball, 1966), pp. 3–10.

⁶The availability/affordability debate is discussed in the chapter appendix.

⁷One member of the Massachusetts board was Elizur Wright, who is often called the father of insurance regulation. Wright was an abolitionist who turned his energies toward the elimination of unsavory practices in the insurance industry. He was an ardent proponent of federal regulation of insurance and viewed the state insurance department as a step toward a national insurance bureau.

⁸Paul v. Virginia, 231 U.S. 495 (1869).

⁹United States v. South-Eastern Underwriters Association, 322 U.S. 533 (1944).

¹⁰A company domiciled in a foreign country is called an alien insurer.

¹¹Although the title commissioner of insurance is the most common, in some states, the chief insurance regulator is referred to as the director of insurance or the superintendent of insurance.

¹²The 56 members of the NAIC include the 50 states plus the District of Columbia, American Samoa, Guam, Puerto Rico, the U.S. Virgin Islands, and the Northern Mariana Islands.

¹³As was mentioned in Chapter 2, in September 2008, AIG was bailed out by the U.S. Federal Reserve (Fed) and by the U.S. Treasury. AIG-FP had sold protection against credit risk to a number of large U.S. and European banks under an instrument known as credit default swaps (CDSs). The Commodities Futures Modernization Act, a federal law, prohibited the regulation of credit default swaps. Although CDSs bear some similarity to insurance, there is no requirement that there be an insurable interest, and they can be used for purely speculative purposes. When housing prices began to fall, AIG's losses on these instruments accumulated. AIG's contracts with the counterparty banks required AIG to post collateral that depended on its financial strength rating. When AIG was faced with a reduction in its AAA rating, it was required to increase the amount of collateral it provided. The U.S. government stepped in to assist AIG so it could pay off the U.S. and European banks.

¹⁴The life insurance companies had a securities lending operation, in which securities were lent to other institutions (primarily banks) on a short-term basis in return for fees. Collateral requirements for that operation also increased with a downgrade of the holding company.

¹⁵The ORSA requirement will apply to U.S. insurers that write more than $500 million of annual direct written and assumed premium and/or insurance groups that collectively write more than $1 billion of premium.

¹⁶The major liabilities of insurance companies are debts to policyholders; they are called reserves in the U.S. In many countries, they are called technical provisions. In insurance accounting and insurance terminology generally, the term reserve is almost synonymous with liability.

¹⁷The states that had adopted the model were California, Connecticut, Delaware, Florida, Georgia, Iowa, Indiana, Louisiana, Maryland, New Jersey, New York, Pennsylvania, and Virginia.

¹⁸In December 2005, the NAIC adopted the Insurance Receivership Model Act (IRMA) to govern the receivership and liquidation process. IRMA was controversial, however, and by 2013, only one state (TX) had substantially adopted it. In 2013, the NAIC was reviewing IRMA to identify elements that states should be encouraged to adopt.

¹⁹The earliest of the funds was established in New York (1947), New Jersey (1952), and Maryland (1965). However, these early funds did not pay claims on all lines of property and liability insurance, they did not provide for the return of premiums that policyholders had paid to the insolvent insurer. These laws were revised in the 1970–1971 period when the rest of the plans were established.

²⁰ING Group, the largest financial services group in the Netherlands, was often cited as a bancassurance success story. In 2009, however, ING's banking operations suffered severe losses. As a condition for receiving support from the Dutch government, ING was forced to divest of its insurance operations. Fortis is another European bancassurance firm that suffered losses in its banking operations and was broken up as a result of the financial crisis.

In the U.S., three insurance companies (AIG, Hartford Financial Services, and Lincoln National) received financial support from the U.S. Treasury Capital Purchase Program (CPP), out of a total of 707 financial institutions receiving support. Treasury took the position that only federally regulated institutions were eligible for the program, so Hartford and Lincoln purchased thrifts to become subject to oversight by the Office of Thrift Supervision.

²¹The FSOC is chaired by the U.S. Treasury Secretary and has 15 members, 10 of which are voting members. Most voting members represent federal banking or securities regulatory agencies. One of the voting members is required to be an independent member with insurance expertise, appointed by the President and confirmed by the Senate for a six-year term. The nonvoting members serve in an advisory capacity and include a state insurance regulator and the director of the Federal Insurance Office.

²²In June 2013, the FSOC designated two insurance groups as nonbank SIFIs: AIG and (in a divided vote) Prudential Financial. Other institutions were still under consideration. As this was written, Prudential was appealing the designation.

²³Although antirebate laws have been accepted without much question for about 70 years, they are being challenged as anticompetitive in effect. Critics of the antirebate laws believe they represent anticompetitive laws, designed to prevent price competition among insurance agents. In fact, the original purpose of the laws was to complement the unfair discrimination provisions in the state rating laws. Legislators believed it makes little sense to forbid insurers to charge different rates to persons with the same risk, and then permit the companies' agents to adjust the price at the point of sale. The original antirebate provisions of the New York Code—Sections 89 and 90—were titled Discrimination Prohibited and Discrimination Against Colored People. The first antirebate law was designed to protect blacks, “colored people” in the vernacular of the day, from discriminatory pricing. Nevertheless, we will undoubtedly see more challenges to the antirebate laws.

²⁴In response to concerns about improper replacements of life insurance and annuity policies, the NAIC adopted a model Life Insurance and Annuities Replacement Regulation in 2000. The model requires insurers to establish systems to review the appropriateness of replacements by its agents. It requires agents to gather information from the insured on existing policies. If the insured has other insurance, the agent must provide the applicant with a “Notice Regarding Replacement” that encourages the applicant to analyze existing benefits and proposed benefits and to consult with the agent who sold the existing insurance.

²⁵Credit life insurance rates represent a special exception. In most states, the sale of credit life insurance is subject to special regulation, resulting from past abuses in the field characterized by a phenomenon called reverse competition. Credit life insurance is sold through lenders to a captive market. Reverse competition tends to increase rates and keep them high because of the insurance companies' practice of bidding for the lenders' business through the payment of excessive commissions whose cost is passed on to the consumer. Most states regulate rates for credit life, credit accident and health, and credit unemployment insurance under the terms of the NAIC Consumer Credit Insurance Model Act, originally adopted in 1958, but since amended a number of times.

²⁶New York, for example, limits the amount of commission payable to a soliciting agent in the first year of an ordinary life policy to 55 percent of the premium. Different limitations apply to other types of policies. Companies not licensed to sell in New York sometimes pay commissions as high as 125 percent of the first-year premium.

²⁷A study by Professor Joseph M. Belth has shown that wide differences exist in the cost of identical products in the life insurance field and that the consumer is not generally aware of the price he or she pays when buying life insurance. See Joseph M. Belth, The Retail Price Structure in American Life Insurance (Bloomington: Bureau of Business Research, Graduate School of Business, Indiana University, 1966).

²⁸In addition to these four basic systems and their many variations, there have been two other systems, state-made rates and mandatory bureau rates. State-made automobile rates have been used in Massachusetts. Mandatory bureau rates are used in North Carolina for fire and automobile insurance.

²⁹The term competitive rating, which has been used widely to identify the laws that do not require prior approval, has proven to be an unfortunate choice, for it has been interpreted by some to imply an absence of competition in states using the prior approval system. Because prior approval rate regulation is often used in other industries as an alternative to competition, some observers assume this is also the case with insurance. The industry is highly price competitive in those states with competitive rating laws and in the prior approval states as well.

³⁰It is difficult to classify states with respect to their system of rate regulation because many states follow more than one system. A given state may use the prior approval system for some lines and a form of competitive rating for others.

³¹U.S. Department of Justice, A Report of the Task Group on Antitrust Immunities: The Pricing and Marketing of Insurance (January 1977), passim.

³²Proposition 103 repealed California's 40-year-old open competition law and replaced it with a prior approval system. Proposition 103 is discussed in the chapter appendix.

³³States using the no-file system for some lines in 2006 included Illinois, Nevada, and Wyoming. In addition, a number of states use a no-file approach for contracts written to cover large commercial insureds (e.g., Arkansas, Georgia, Indiana, Maine, Missouri, Nebraska, Pennsylvania, Rhode Island, and Virginia).

³⁴After a one-year experiment with file-and-use in 1977, Massachusetts returned to state-made rates for automobile insurance in 1978. In July 2007, the Massachusetts Insurance Commissioner ruled that the state would return to a file-and-use system, effective April 1, 2008.

³⁵The file-and-use system encompasses a wide range of rate regulatory systems, some of which are similar to the prior approval system, with others that operate like the open competition system. For example, some states impose a waiting period before the rates may be used and operate in much the same way as a prior approval law with a deemer period. In other states, rates may be used immediately on filing but may subsequently be disapproved.

³⁶Use and file is another approach, closely related to informational filing. Under use and file, rates may be used without regulatory approval, but an informational filing must be made within a specified period of time (e.g., 15 days) after the insurer begins using the rates. Generally, the commissioner retains the right to request supporting information when there is reason to believe the filing might violate statute, and the right to disapprove the rates prospectively based on review of the additional information.

³⁷A 1977 U.S. Department of Justice study suggested that insurers make smaller, but more frequent, rate changes in open competition states. U.S. Department of Justice, The Pricing and Marketing of Insurance (Washington, D.C.: U.S. Government Printing Office, 1977). Numerous other studies support the conclusion that the underwriting cycles are worsened under prior approval laws.

³⁸Since the expansion of competitive rating systems during the early 1970s, a number of researchers have studied market performance under prior approval and open competition systems in an attempt to draw conclusions about the differences between the two rating systems. Harrington provides a detailed analysis of the many studies prior to 1984. After considering the results, he concludes, “A considerable amount of the evidence suggests that average loss ratios and prices did not differ between CR [competitive rating] and NCR [noncompetitive rating] states during the overall time period analyzed.” See Scott Harrington, “The Impact of Rate Regulation on Prices and Underwriting Results in the Property-Liability Insurance Industry: A Survey,” Journal of Risk and Insurance 51 (December 1984), pp. 577–623.

³⁹A 1977 U.S. Department of Justice study argued that regulation of rates is unnecessary and the repeal of the McCarran-Ferguson Act is desirable because it would subject insurers to the Sherman Act and other federal antitrust statutes. During the early 1990s, the House Judiciary Committee held a series of hearings on the McCarran-Ferguson Act, culminating in a report that recommended modifying the industry's antitrust exemption. However, the three main legislators pushing for amending the McCarran-Ferguson Act left office following the 1994 elections, either because they did not run for reelection or ran but lost. In 2006, congressional activity picked up again, with the Senate Judiciary Committee holding hearings on the McCarran-Ferguson Act in June 2006 and March 2007. Senators Leahy, Specter, Lott, Reid, and Landrieu introduced S 618, the Insurance Industry Competition Act of 2007, which would repeal the limited antitrust exemption of the McCarran-Ferguson Act.

⁴⁰The Antitrust Modernization Commission (AMC) was authorized by federal statute in 2002. It had 12 members: 4 appointed by the House, 4 by the Senate, and 4 by the president. The AMC was charged with doing a comprehensive review of U.S. antitrust law to determine what changes were needed. Most of the AMC's work addressed issues other than insurance, but it did have one hearing on the McCarran-Ferguson Act in the fall of 2006.

⁴¹If the McCarran-Ferguson Act was repealed, “Insurance companies would bear no greater risk than companies in other industries engaged in data sharing and other collaborative under-takings. To the extent that insurance companies engage in anti-competitive collusion, however, then they appropriately would be subject to antitrust liability.” Antitrust Modernization Commission Report and Recommendations, April 2007, p. 351.

⁴²The optional federal charter option has received significant attention in recent years. In 2001, several proposals for a system of federal chartering were developed by segments of the insurance industry. The American Bankers Insurance Association (which represents banks entering the insurance industry), the American Council of Life Insurers (ACLI), and the American Insurance Association developed legislation to create a dual system of regulation, with federally chartered insurance companies under federal supervision. In 2005, the Optional Federal Charter Coalition, representing 135 insurance companies, agencies, banks, and trade associations, was created to promote the creation of an optional federal charter. Legislation was introduced in the U.S. House and in the Senate in 2006 and in 2007. Activity has been limited since the 2008-2009 financial crisis.

⁴³An interstate compact is a structure to facilitate collective action by states. It is effectively a treaty between/among states.

⁴⁴A state joins the compact by enacting the model legislation. By June 2013, the model had been adopted by 42 states and Puerto Rico. Compacting states as of June 2013 were Alabama, Alaska, Arkansas, Colorado, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Maryland, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, North Carolina, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Utah, Vermont, Virginia, Washington, West Virginia, Wisconsin, and Wyoming.

⁴⁵In 2003, for example, drivers under age 21 constituted about 6.3 percent of all drivers but were involved in 17.6 percent of all police-reported accidents and in 13.8 percent of all fatal accidents. Drivers under age 25 represented 13.2 percent of all drivers but were involved in 24.5 percent of all fatal accidents. National Highway Traffic Safety Administration (NHTSA).

⁴⁶Louisiana and Florida commissioners banned the use of sex and marital status in automobile insurance rates in 1979, but both were overturned by the courts. Regulatory orders in Wyoming (1978) and New Jersey (1981) to discontinue the use of sex and marital status were challenged successfully by the insurance industry. Other states in which unisex automobile rating has been proposed include South Carolina (1979), Minnesota (1984), and New Mexico (1985).

⁴⁷In 1989, the Montana legislature voted to repeal the unisex law, but the repeal was vetoed by the governor, and the legislature failed to override the veto.

⁴⁸In March 2007, the Florida Insurance Department issued a report that concluded the industry's use of occupation and education for underwriting and rating auto insurance policies unintentionally harms minorities and low-income individuals. The commissioner indicated he would seek legislation to ban their use. In 2003, the Florida legislature restricted the use of credit scoring for similar reasons. For a further discussion of the use of credit scores in insurance underwriting, see Chapter 7.

⁴⁹The term redlining originated in the underwriting departments of insurers and has a historical basis in the “red lines” that were drawn on maps maintained by property insurance underwriting departments of insurers. In an effort to avoid unacceptable concentrations of risk, property insurers maintained maps (published by Sanborne and therefore referred to as Sanborne maps) on which underwriting personnel indicated the location of each building insured by the company. When the number of insured buildings in a particular area had reached a saturation point at which additional exposures might create a catastrophe exposure, the insurer declined to accept applicants from the area. In some cases, a red line was drawn around the area to alert underwriting personnel to the concentration of risks.

⁵⁰Proposition 103 applies to all lines of insurance except life insurance, title insurance, certain types of marine insurance, disability insurance, workers compensation insurance, mortgage insurance, and insurance transacted by county mutual fire insurers.

⁵¹CalFarm Insurance v. Deukmejian, 43 Cal. 3d 805 (258 Cal. Rptr. 161) (1989).

⁵²In October 1990, the Ninth Circuit U.S. Court of Appeals declared unconstitutional a 15 percent automobile insurance rate rollback that was scheduled to take effect in Nevada on October 1. The court ruled unanimously that the Nevada rollback statute violated insurance companies' constitutional guarantee to earn a “fair and reasonable return on their investment.”

⁵³Proposition 103 passed narrowly, with 4,853,298 (51.2 percent) of the electorate voting in favor of the law, and 4,630,689 (48.8 percent) voting against, a margin of 222,609. Interestingly, the margin in Los Angeles County was 641,710. Excluding Los Angeles County, the proposition was defeated statewide by 419,101 votes.