CHAPTER OBJECTIVES

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

• Outline the most likely changes in the future environment of insurance
• Identify the continuing problems of the insurance industry and the possible solutions to those problems
• Describe important trends affecting insurance globally and how those might affect the U.S. industry
• Discuss career opportunities in insurance and the necessary training to prepare for those opportunities

Since the end of World War II, the insurance industry has experienced remarkable growth. Along with this growth has come dramatic change. The multiple-line transition, the introduction of package policies, the variable annuity and variable life insurance, universal life, changes in the regulatory framework, adoption of automobile no-fault laws, continued expansion of the Social Security system, the involvement of government as a provider of private insurance, health insurance reform, and new mechanisms for transferring risk are all a part of the changing environment in which insurance operates. This final chapter examines the implications of future economic and social changes for the insurance industry. Just as the industry has had to adjust in the past to developments in its environment, future changes undoubtedly will be demanded.

Projecting past trends to predict a future environment is always subject to error, for things may not continue to happen in the future as they have in the past. Still, we can gain some insight into the probable future of the insurance industry by extrapolating some developments of the current environment in which the industry operates.

HEALTH AND RETIREMENT SECURITY

The growth of the private insurance sector is influenced by the extent to which the government acts as a source of financial security for its citizens. With the aging of the baby boom population, decreases in fertility, and continued growth in costs for medical care, these government programs will face considerable pressure in future years. At the same time, the federal government has created new programs aimed at other societal problems, most recently federal health insurance reform to address the increasing number of individuals without health insurance.

The Social Security System

The problems affecting the Social Security system were discussed in Chapter 11. As noted in that discussion, the system faces long-range financial problems, and these problems are likely to come to a head in the next 10 years. The growing imbalance between workers and beneficiaries, and the automatic increases in benefits, have put the system on a collision course with insolvency. Several solutions (such as reducing benefits, increasing taxes, and increasing the retirement age) have been suggested in the past. In 2001, the President's Commission to Strengthen Social Security recommended partial privatization, including the creation of personal retirement accounts, a controversial recommendation. Unfortunately, Congress has seemed unwilling to make the tough decisions that are required to address the program's financial difficulties.

By 2013, a number of reform proposals had been circulated, with very different approaches recommended. One set of reforms would tweak the current system, attempting to solve the fiscal problem by increasing taxes and reducing benefits. Many of these proposals embraced indexing benefits by the Chained-CPI, as discussed in Chapter 11. Other proposed changes included increasing the normal retirement age from 67 to 70, changing the benefit formulas to more strongly favor lower income individuals, and introducing means testing, which would lower the benefits of high-income individuals. Most of these proposals would grandfather those nearing retirement age (typically defined as anyone age 55 or older), protecting them from a reduction in benefits. Another common element is to improve the ratio of taxpayers to beneficiaries by requiring newly hired employees of state and local government to be covered. (Immigration reform would also add new workers to the system.)

In December 2010, the National Commission on Fiscal Responsibility and Reform (NCFRR), chaired by former Senator Alan Simpson (R-WY) and former White House Chief of Staff (under President Clinton) Erskine Bowles, released a set of recommendations to improve Social Security's fiscal condition. The recommendations included changing the benefit formula to make it significantly more progressive, creating a new minimum benefit for individual with 25 years of employment (equal to 125 percent of the federal poverty level), and using the Chained-CPI to calculate cost-of-living increases. Normal and early retirement ages would be indexed for improvements in life expectancy, newly hired state and local workers would be added after 2020, and the cap on taxable wages would increase.

Another set of reform proposals would dramatically change the nature of the Social Security program. In 2011, the Heritage Foundation proposed transitioning Social Security to a program that provides a flat benefit of $1200 per month (in 2010 dollars), indexed in the future by the growth in wages. The benefit would be means tested, and benefits would be reduced for individuals with non-Social Security incomes over $55,000 and eliminated for those with incomes above $110,000. The proposal uses the Chained-CPI to adjust benefits for inflation, increases the normal and early retirement ages (and indexes them to changes into life expectancy), and introduces private accounts in which 6 percent of each worker's income is placed. Enrollment would automatic, but individuals would have the ability to opt out.

A variety of plans have been suggested, and it is beyond the scope of this text to discuss all. The breadth of recommendations, however, suggests we have not yet reached a consensus on how to solve Social Security's problems. In April 2013, Simpson and Bowles called for the creation of a new bipartisan commission to recommend a full Social Security reform package. As Armageddon for OASDI nears, congressional attention will necessarily become more focused. It is unclear, however, how the program will ultimately change.

Medicare

The Medicare system faces problems similar to those of the OASDI program, but its difficulties will come sooner and are more severe. Both programs face the demographic problem of growing numbers of beneficiaries and fewer workers per beneficiary. Medicare's problems are exacerbated by the fact that health care costs are increasing faster than wages. The Medicare system will reach a crisis stage when costs exhaust the Hospital Insurance (HI) Trust Fund, projected to occur in 2026.¹ Medicare Part B (Supplementary Medical Insurance) and Part D (Prescription Drug Coverage) are funded by a combination of premiums and federal government subsidies. Costs for those programs will also rise in the future, with increasing premiums and federal outlays.

Numerous changes to the system have been legis-lated over the years in attempts to control costs and save the system. Medicare's Medical Savings Accounts (MSAs) and Medicare Advantage plans were created, reflecting the introduction of consumer-directed health care and managed care into the Medicare program. The 2010 Patient Protection and Affordable Care Act (ACA) has introduced additional features designed to control costs. As described in Chapter 22, a new Independent Payment Advisory Board (IPAB) was created, a 15-member group that must make recommendations on how to reduce the per capita rate of growth in Medicare spending if spending exceeds a target growth rate. The IPAB's recommendations must be implemented unless the Congress overrides its recommendations. The IPAB's powers are limited, and it has no authority to change the tax rate or benefits, or Medicare. It can, however, reduce provider compensation, a source of considerable angst to providers.

The IPAB's cost reduction activities are triggered when the Medicare Chief Actuary makes a determination that projected costs over a five-year period (prior two years, current year, and next two years) exceed the target. Medical cost increases fell following the enactment of the ACA. The reasons have been much debated—and it is unclear how long the trend will continue—but the impact on Medicare has been positive. In April 2013, the Chief Actuary determined Medicare costs were below the target for the 2011 to 2015 period, thus eliminating the need for IPAB recommendations. It is unclear when costs will rise to the level necessary to trigger the IPAB, but there is little doubt that they will.

Two other ACA provisions change the way in which providers are reimbursed in an attempt to control costs and improve quality. The ACA allows providers to organize into Accountable Care Organizations (ACOs) that are responsible for coordinating the care received by an individual and are compensated, in part, on the basis of quality metrics. This is known as the Shared Savings Program. CMS has also been testing alternative payment programs with a group of ACOs known as Pioneer ACOs. In other cost control efforts, hospitals with excessive unnecessary readmissions will have their payments reduced, as will hospitals whose patients acquire new conditions (such as an infection) while in the hospital.

It is too early to tell how well these arrangements will control costs. In July 2013, CMS announced results for the first year of the Pioneer ACO program, reporting that 12 of 32 Pioneer ACOs produced savings for Medicare, while all performed well on a set of 15 quality measures. Many health care experts are optimistic about the future of ACOs, and many providers are reorganizing to deliver care through an ACO.

Few people believe the changes enacted in the ACA will solve Medicare's fundamental problems however. In the opinion of most experts, the various reforms will only defer the time at which the imbalance between income from taxpayers and outgo to beneficiaries occurs. Many experts believe that at least part of the solution will involve “means testing,” with higher-income individuals paying higher costs. As with OASDI, Congress has done little to address the long-term financial imbalance, which remains a problem in search of a solution.

Health Insurance

Although health insurance is a private form of insurance, we have witnessed a shift in national attitudes toward the risks associated with medical expenses. Our current philosophy is that the risk of health care costs is a fundamental risk and that a national policy is needed to define the ways in which this risk will be addressed. The ACA reflects that view and establishes a national policy for comprehensive health insurance coverage. In Chapter 21, we identified the problems facing the nation with respect to health care and the increasing cost of health care. These problems are among the most troublesome facing the insurance industry and society today. For the insurance industry, the influence of runaway health care costs is pervasive. In addition to the obvious impact on health insurance, the costs of hospital and physicians' services are a significant factor in the price of automobile insurance, general liability insurance, and workers compensation insurance. The cost trends in Medicare and Medicaid have challenged federal and state budgets. For society, public concern is driven by the lack of adequate health care for some segments of the population and the ever-increasing cost of health care.

The ACA promises to fundamentally change the structure of health insurance in the U.S., with universal coverage, guaranteed issue, and rating restrictions. The vision reflected in the ACA is for universal health insurance coverage (with subsidies as necessary for low income individuals), health insurance exchanges to promote greater competition and consumer choice, and the spreading of health care costs across the population without regard to health status. In mid-2013, efforts to implement the ACA were intensive, with the October roll-out of the exchanges only months away.

ACA implementation is a massive undertaking for the federal government, state governments, and insurers. As discussed in Chapter 21, a number of states have chosen to establish their own exchanges, while others have defaulted to the federal exchange. In either case, the work required to have a functioning exchange is significant. In June 2013, the GAO reported the federal exchange faced challenges in being ready for implementation in October.²

In Chapter 21, we discussed the structure the ACA, with an individual mandate, large employer mandate, and subsidies for small businesses. Employers with more than 50 employees are required to pay a penalty for each employee who works more than 30 hours. These features of the law become effective in January 2014. According to numerous press reports in mid-2013, some employers were altering their business practices to reduce employee hours below 30 hours a week and thus avoid having to pay the penalty—arguably an unintended consequence of the law. Employers were also complaining about what they viewed as onerous federal requirements to report health plan enrollment information. In July, the administration announced it would delay enforcement of the employer mandate until 2015 and would revisit the reporting requirements.

A key principle embodied in the ACA is that all Americans should have health insurance, and medical costs should be spread widely across the population. Health policy experts argued that prohibiting insurers from underwriting for health status would force them to focus more on managing health care delivery and less on trying to avoid individuals with health conditions. Students of insurance, however, understand that efforts to spread costs across a population must take adverse selection into consideration. If healthy individuals opt not to purchase insurance because the cost of subsidizing the sick is too high, insurance premiums will increase. ACA critics have argued the penalties imposed for not having insurance are inadequate to promote universal coverage, and the young and healthy are likely to elect not to purchase coverage. Others counter that subsidies are available to help low income individuals buy insurance, and many young adults would qualify. The catastrophic plan available to young adults would provide a low-cost option for them, but it would also mean a lower contribution to the expenses of the older and the sick.

In mid-2013, it was too early to assess the impact of the ACA. Companies had only begun to file their policy forms and rates with their regulators, and the exchanges had not become operational. Some concerns were being raised however. In some states, insurance premiums for young adults were predicted to more than double. There was increased interest by some small employers in self-funding, and some insurers were reducing the minimum group size for stop-loss reinsurance to make it easier for small employers to self-fund.

Another concern related to the ability of individual consumers to navigate what was supposed to be a new, simple marketplace—the exchange. The ACA and CMS created a variety of new categories of individuals to facilitate enrollment, provide outreach and education to raise awareness, and refer consumers to other assistance programs when necessary. These include navigators, non-navigator assistance personnel (also known as in-person assistant personnel), and certified application counselors. Insurance agents and brokers can also provide assistance. Navigators are funded through state and federal grant programs. One area of debate in 2013 was whether navigators should be licensed and subject to continuing education laws, as are insurance agents and brokers. Those supporting state licensure requirements pointed to the similar roles played by insurance agents and navigators.

As the date for implementing the exchanges neared, even the law's supporters agreed that some changes would need to be made to the ACA in the future. Opponents wanted to scrap the entire thing, and the U.S. House of Representatives, dominated by Republicans, had passed dozens of bills to repeal or defund aspects of the law. None were taken up by the Democrat-controlled Senate.

As of mid-2013, implementation of the ACA seemed a certainty. The expansion of Medicaid and federal subsidies for low-income individuals buying private health insurance promised to expand health insurance coverage to many of the uninsured. Policymakers continued to worry about how future costs would develop. In short, most experts believed this was only the first step, and future changes will be necessary to address the health insurance challenges facing this country.

Retirement Security

As discussed in Chapter 18, recent years have seen a shift from defined benefit to defined contribution retirement plans. A number of employers have terminated or frozen their defined benefit pension plans; many employers now offer 401(k) plans, in which employers match employee contributions to encourage participation but do not require it. This shift has placed greater responsibility on individuals to save adequately for retirement. At the same time, financial pressures in retirement are increasing because fewer employers are offering retiree health care benefits, investment returns have fallen, life expectancies are increasing, and there is much uncertainty about the future level of OASDI benefits.

As the baby boom generation enters retirement, many individuals have not prepared adequately for their retirement years. Many employees choose not to participate in the 401(k) plans offered by their employers. Others participate but then withdraw and spend their accumulated savings when they change employers. In 2013, it was estimated that only two-thirds of workers had saved for retirement, and nearly half of individuals age 45 and over had saved less than $25,000.³

Congressional attention has begun to focus on the need for increased retirement saving. The Pension Protection Act of 2006 (PPA-2006) created an automatic enrollment option for 401(k) plans, in which an employee would automatically participate unless he or she opted out. Automatic IRAs have also been proposed. Under these proposals, including one offered by President Obama in 2009, employers who do not offer a retirement plan would be required to automatically enroll employees in a payroll-deduction IRA, although employees would have the ability to opt out. In July 2013, the U.S. Chamber of Commerce and AARP issued a joint call for retirement policy reform, expanding access to qualified savings plans, and increasing tax incentives for saving.

Another way to promote savings is to help individuals understand the amount of savings they need. Many individuals underestimate the amount they need to save to provide a given income during retirement. In 2013, the U.S. Department of Labor proposed requiring pension plan benefit statements to include the estimated lifetime stream that could be provided with a retirement plan's account balance in addition to the account balance itself. Policymakers hope that translating the account balance to an equivalent life annuity will help participants assess how much more they need to save.

A second area of concern is the liquidation of the accumulated assets during an individual's retirement. As discussed in Chapter 18, annuities can be used to liquidate savings over an individual's life span, addressing the risk of outliving one's assets. Historically, however, it has been uncommon for individuals to annuitize their savings. Unless managed wisely, retirement savings may be exhausted before the need for those funds disappears. Even in the case of defined benefit pension plans, employees may be permitted to take a lump-sum withdrawal, giving up the longevity protection that defined benefit plans inherently provide. Thus, the risk exists that even though increased saving is encouraged, poor liquidation of those funds results in a continuing problem.

Current tax rules may act as a barrier to annuitization by limiting participant flexibility. In March 2012, the Internal Revenue Service (IRS) proposed two new rules to address the situation. REG-110980-10 would make it easier for plan participants to partially annuitize their retirement savings, i.e., receive a portion of their plan benefits in a lump sum and the remaining portion as an annuity. REG-115809-11 would permit participants to use up to 25 percent of their account balance (up to $100,000) to purchase a qualified longevity annuity contract (QLAC). A QLAC pays benefits at an advanced age, such as 80, but not later than age 85. If an individual purchases a QLAC, the value would be excluded from the account balance when calculating the required minimum distributions before the annuity begins. The Treasury Department estimated a $100,000 premium paid at age 70 would purchase an annual income between $26,000 and $42,000. As of mid-2013, these rules had not yet been finalized.

Other proposals go even further, including suggestions to automatically annuitize benefits unless the participant opts out.⁴ As policymakers and employers promote annuitization, the life insurance industry will play an even more important role in retirement security. Recognizing these trends, the NAIC is studying the need for additional regulatory protections, including the explicit recognition of longevity risk in risk-based capital requirements.

GLOBALIZATION OF INSURANCE

The United States is the world's largest insurance market, but its dominance has declined over the past four decades as other markets have become more important. In 1970, the United States represented 70 percent of the world premium volume. By 2011, the share had fallen to 26 percent.⁵ For the most part, this simply reflects the growth in the economies of foreign countries relative to the United States. As economic activity increases in a nation, the premiums written to protect assets against loss also increase. Thus, the trend results not from a decrease in U.S. premiums but from an increase in premiums in other nations.

As the U.S. share of global premiums has fallen, so has the share written by U.S. insurers. Individuals and businesses in a particular country tend to purchase their insurance from domestic insurers, and the growth of other economies has brought a corresponding growth in the insurance premiums in other countries. Many of the world's largest insurance groups are non-U.S. companies. In 2011, of the top 10 insurance groups, three were headquartered in the U.S., three in Japan, and four in Europe. All of these companies had significant operations outside their home country. Only one of the top five international insurance groups was a U.S. company.⁶

During the 1990s and early 2000s, non-U.S. insurers acquired U.S. companies and expanded their U.S. market share. By 2009, subsidiaries of non-U.S. insurers wrote $248 billion in premiums in the U.S., with a primary focus on life insurance (representing nearly 70 percent of their U.S. premiums). Meanwhile, U.S. insurers remained largely focused on the U.S. market, writing only $50 billion in premiums outside the U.S.

The global financial crisis and trends in accounting and regulation led many non-U.S. insurers to pull back from the U.S. market in 2010. While non-life premiums continued to rise, life premiums written by non-U.S. insurance groups dropped more than 20 percent between 2010 and 2011. Several insurers, particularly life insurers from Canada and Europe, subsequently divested their U.S operations.⁷ Reasons were varied, but one driving factor was developments in regulation and accounting in the insurers' home jurisdictions. The low interest rate environment also created challenges for life insurers, and several non-U.S. insurers determined their capital would be better allocated elsewhere (e.g., Asia). Experts predict further merger and acquisition activity in the near future, as companies readjust their strategies in the face of a changing economic and regulatory environment.

The globalization of insurance will undoubtedly continue. The 2008–2009 financial crisis resulted in some slowing of the trends, and firms are reevaluating their global strategies. That reevaluation, however, is not about whether to be internationally active; it is about which markets to be active in. In 2013, many international insurance groups, including some U.S. groups, were looking to Asia for their future growth. The impact of these trends on the U.S. insurance industry and U.S. insurance markets remain to be seen.

Multinational Corporations

A point that is sometimes ignored in the discussion of changing shares in the world insurance market is the role the growth of U.S. corporations abroad has had on the distribution of insurance expenditures. Many of what we think of as U.S. corporations are actually multinational corporations. A multinational corporation (MNC) is one that not only sells but also produces in foreign markets, in contrast with what may be called a limited international corporation, whose major activity in the world economy is exporting. The U.S. corporations operating overseas customarily do so through subsidiaries, often incorporated in the various countries where they carry on business. Although U.S. corporations abroad would often prefer to purchase their insurance from U.S. insurers, regulatory restrictions and trade barriers have sometimes prevented this. International insurance groups often establish local insurance subsidiaries or local branches to market in another country, which are separately capitalized and regulated by the local regulator.⁸ Regulatory barriers to cross-border reinsurance transactions are gradually disappearing, but direct-to-consumer business remains locally regulated in many countries.

Financial Services Trade Barriers

Governments worldwide are deregulating and privatizing, and with deregulation, barriers to trade are also falling. In 1997, a World Trade Organization (WTO) pact, known as the General Agreement on Trade in Services (GATS), further opened international markets for insurance and financial services generally. The pact was the first multilateral, legally enforceable agreement covering trade and investment in financial services. As such, it provided a framework for reducing or eliminating government barriers that prevent financial services from being freely provided across national borders or that discriminate against firms with foreign ownership.

Liberalization in many cases was phased in over several years after the agreement went into effect in 1999. Provisions of the WTO agreement became effective for China's insurance markets after the People's Republic of China became a member of the WTO in late 2001.

U.S. Insurers Abroad

Although fewer than 5 percent of the U.S. insurance industry's premium writing is generated in foreign countries, 60 to 70 insurers have established a significant presence abroad. Leading U.S. insurance groups with a significant presence in the overseas and international market include American International Group (AIG), MetLife, Prudential, Mass Mutual, CNA, Chubb, New York Life, Berkshire Hathaway, Principal Financial Group, Hartford, Liberty Mutual, and Travelers Insurance Company. One motivation is to establish an overseas presence is the desire to serve U.S. corporations operating abroad. An equally important goal is to participate in the premium growth that will occur in a number of foreign countries in the near future, which will by far exceed the growth in U.S. premiums. A number of countries have privatized or are considering privatizing their national retirement schemes, generating intense interest from some U.S. life insurers.

Major U.S. brokerage firms have also established a presence in many foreign countries and have contracts with foreign insurers. In fact, with a few exceptions, such as AIG, U.S. brokers have become international at a faster rate than U.S. insurers. Even brokers who do not have offices in foreign countries have established working relationships with affiliate agents abroad, giving them access to foreign markets and providing a network through which they can serve the foreign insurance needs of their U.S. clients.

The European Union

European countries have been working for years to promote competition across the continent by removing their various national trade barriers. The leader in this movement is the European Union (EU), whose 28 member nations have agreed to a common trade policy, with a phased-in mutual reduction of restrictive laws and regulations. For insurance and other financial services, the European Commission in Brussels has issued a series of directives aimed at harmonizing regulations in member countries and promoting a single European market. Directives issued in 1992 created a single market framework for the insurance sector, effective in 1994.⁹ Under this framework, insurance firms are authorized (i.e., licensed) and subject to financial oversight in their home country. Home country authorization provides a “single passport” that permits the insurer to do business in other EU countries.

Although the legal framework for a single market was put in place in 1994, most observers believe that, practically speaking, the market remains fragmented. Cultural, legal, tax, and other differences across countries make it difficult for insurers to do business across borders. For the past two decades, the European Commission has continued to pursue a series of initiatives aimed at promoting the single market in financial services, first with the Financial Services Action Plan (1999–2005), then with its Financial Services Policy goals for 2005 to 2010, and finally, with policy changes in response to the recent financial crisis, which has hit the European Union particularly hard.

One response to the financial crisis was to increase European authority in the process of supervision across banking, insurance, and securities. Three new European Supervisory Authorities (ESAs) were created: the European Banking Authority (EBA), European Securities and Markets Authority (ESMA), and European Insurance and Occupational Pensions Authority (EIOPA). EIOPA is governed by a board made up of national supervisors and has a full-time chair with a five-year term. Day-to-day supervision is left at the national level, but EIOPA plays an important role in developing and enforcing European standards. EIOPA is also a member of supervisory colleges where national supervisors cooperate in their oversight of cross-border insurers.

For nearly a decade, Europe has been developing a new system of prudential (i.e., solvency) regulation, known as Solvency II, which is intended to create a more consistent set of requirements across the EU. Current capital requirements (known as Solvency I) do not consider investment risks and have been criticized as not being sufficiently risk-based. In addition, accounting for insurer liabilities varies widely across member countries, resulting in very different measures of insurer capital. Because insurers can passport into other countries without complying with local rules, policymakers are concerned that companies from lesser regulated jurisdictions might have a competitive advantage.

Solvency II is a total balance sheet approach, considering risks on the asset and liability sides of the balance sheet. It is based on three pillars: Pillar 1 lays out common accounting and regulatory capital requirements; pillar II requires regulatory oversight of insurer risk management processes; and pillar III focuses on regulatory and public disclosure of important risk information. Under pillar II, insurers must complete an ORSA (own risk and solvency assessment), and regulators will evaluate the insurers' overall risk profiles, risk management, and governance systems. Pillar III requires insurers to disclose certain information publicly, with the expectation that improved transparency will put pressure on insurers to manage risks effectively (a concept known as “market discipline”).

Two key elements of Solvency II are a move toward market-consistent valuation of assets and liabilities, where the current market values of assets and liabilities are reported on insurer financial statements and used to measure how much capital the firm has, and regulatory reliance on internal models to determine capital needed. As the deadline for implementing Solvency II neared, some European life insurers began to sound alarms about the impact of market-consistent valuation, which could result in volatile measures of capital and earnings. Life insurers argued this volatility is artificial for long-term liabilities that are well-matched by long-term assets. Other criticisms of Solvency II are related to implementation costs and the internal model approval process. Small firms complained Solvency II would disadvantage them relative to the larger firms, and many experts were predicting increased consolidation in Europe's insurance markets as a result of the new regime.

Solvency II's implementation was delayed until 2016 or later while policymakers searched for a solution to the life insurance issues. EIOPA published a set of proposed solutions in June 2013, but it is not yet clear whether they will be accepted by the European Parliament, European Council, and European Commission, which must agree to the measures. In 2012, the Commission urged EIOPA and the national authorities to focus on speedy implementation of the aspects of Pillar II and public reporting requirements while the issues in Pillar I were being resolved.

Reinsurance

Reinsurance is the most global sector of the insurance industry. In 2011, fewer than half (42 percent) of the reinsurance premiums ceded by U.S. insurers went to U.S. reinsurers. The majority went to non-U.S. (or alien) reinsurers. Countries capturing the largest proportions of ceded premiums included Bermuda (37 percent) and the UK (18 percent), with most UK reinsurance written through Lloyd's of London. In addition, many U.S. reinsurers are owned by non-U.S. firms. When the ultimate parent is considered, nearly 90 percent of reinsurance premiums are ceded to reinsurers ultimately owned by a non-U.S. parent.¹⁰ Not surprisingly, given the large amount of reinsurance written across international borders, reinsurers have an intense interest in how cross-border transactions are regulated.

Historically, there have been two approaches to reinsurance regulation. Under the first approach, the reinsurer is not regulated directly. Ceding companies are treated as knowledgeable buyers, and regulators rely on the ceding companies to manage their reinsurance risk appropriately, including arranging coverage from financially viable reinsurers. Reinsurers are regulated only indirectly, through requirements placed on the ceding company. Under the second approach, the reinsurer is regulated directly. This means the reinsurer is subject to regulatory requirements for licensing, minimum capital, and financial reporting; regulatory oversight through analysis and examination; and other forms of solvency regulation.

The U.S. system of reinsurance regulation has historically recognized two types of reinsurers: authorized reinsurers, who have been licensed, accredited or otherwise approved by the state in which they are doing business, and unauthorized reinsurers. Authorized reinsurers are regulated directly, and a ceding company is permitted to take credit on its financial statements for qualified reinsurance purchased from an authorized reinsurer. For example, it may reduce its loss reserves in recognition of payments expected to be received from the reinsurer.¹¹ Until recently, a ceding company was not permitted to take credit for reinsurance purchased from an unauthorized reinsurer unless that reinsurer had fully collateralized its obligations to the ceding company, typically by placing assets in a trust or by providing a letter of credit, a requirement regulators deemed necessary to ensure the claims were paid.

Many non-U.S. reinsurers operate on a cross-border basis in the United States and some, particularly Lloyd's and other European reinsurers, objected to the U.S. collateral requirements. They complained the U.S. system gave an unfair advantage to U.S. reinsurers and essentially acted as a trade barrier. They also argued the requirements were excessive because they did not recognize reinsurance purchased by the reinsurer (retrocessions), sound regulatory requirements in other jurisdictions, and the financial strength of the reinsurer. Finally, they argued it was overly burdensome to require a non-U.S. reinsurer to obtain a license, become accredited or otherwise approved in every state in which it wants to do business to avoid the collateralization requirements. U.S. reinsurers, regulators, and many ceding companies responded that the collateral requirements are not trade barriers but rather a form of solvency regulation that applies to all U.S. and non-U.S. unauthorized reinsurers without discrimination Until recently, U.S. regulators strongly defended the collateralization requirements as necessary in light of the absence of direct regulation in many countries and the uncertain quality of the regulation that did exist. Most European countries had historically relied on indirect regulation, but that changed in 2006 after the European Commission adopted the Reinsurance Directive, which required direct regulation of reinsurers. The Commission called for the U.S. to embrace a system of mutual recognition, whereby U.S. regulators would rely on European regulation for European reinsurers doing business in the U.S.

In 2008, the NAIC adopted a Reinsurance Modernization Framework Proposal, which would relax collateral requirements under certain conditions where reinsurers are regulated by approved jurisdictions. In addition, a provision of the 2010 Dodd-Frank Act, entitled the Nonadmitted and Reinsurance Reform Act (NRRA), preempts the ability of states to apply their state credit for reinsurance law to nondomestic companies, thus leaving the decision on collateral solely to the domestic regulator of the ceding company. In 2012, the NAIC amended its Credit for Reinsurance Model Act and Regulation (as discussed in Chapter 8) and by August 2013, 18 states had enacted legislation permitting collateral reduction. The NAIC had a number of activities underway to promote the model's adoption and consistent implementation.

Offshore reinsurers, meanwhile, continued to be dissatisfied with the progress on collateral reform, and some were pushing for federal action to address the issue. The Dodd-Frank Act created the Federal Insurance Office with limited ability to preempt the states where state regulations conflicted with international “covered” agreements and discriminated against non-US insurers. (Most Washington insiders believe the Dodd-Frank preemption language was specifically aimed at the reinsurance collateral issue.) In 2013, some non-U.S. insurers were lobbying Treasury to enter into a covered agreement on reinsurance and preempt the states on reinsurance collateral. The road to a covered agreement and preemption is not easy, however, and requires the Federal Insurance Office (an office of the U.S. Treasury) to engage with another agency, the United States Trade Representative. Whether the Treasury would take such an action was unclear, but most experts predicted it was unlikely.

REGULATION

Although changes in insurance regulation are likely in several areas, two major issues relating to regulation dominate the current environment: international developments in insurance regulation and post-financial crisis efforts to address systemic risk. In addition, U.S. insurance regulators and the NAIC continue to modify the U.S. regulatory system in response to new issues.

Global Influences on Insurance Regulation

The International Association of Insurance Supervisors With the globalization of the insurance industry and increased cross-border activities, cooperation has increased between global insurance regulators (known as supervisors in many countries). The International Association of Insurance Supervisors (IAIS) was established in 1994 and represents insurance regulators from over 200 jurisdictions in nearly 140 countries. The IAIS develops international insurance principles, standards, and guidance papers and provides training and support on issues related to insurance supervision. Through the IAIS, insurance supervisors have developed a set of 26 core principles for insurance supervision (insurance core principles or ICPs), essentially laying out the critical elements of an effective regulatory system.

More recently, the IAIS has been working to develop the Common Framework for the Supervision of Internationally Active Insurance Groups (IAIGs), better known as ComFrame. The IAIS describes ComFrame as a set of international supervisory requirements which is built and expands upon the requirements and guidance in the ICPs. According to the IAIS, the complexity and international activity of IAIGs create a need for a more specific framework so supervisors can better coordinate their supervisory activity under the aegis of a groupwide supervisor. The development of ComFrame has been underway since 2010 and is scheduled for completion in 2013, with field testing in 2014 and final adoption in 2018.

ComFrame has been a controversial project. The IAIS argues that ComFrame will streamline the supervisory process and reduce reporting and compliance demands on IAIGs. Companies are skeptical. They forecast another layer of regulation at the group level, adding to, rather than reducing, their regulatory burden. U.S. insurers and regulators have also worried that ComFrame is an attempt to embed Solvency II into an international standard that all countries will have to meet.¹² Efforts by some countries (particularly European) to embed market-consistent valuation and a Solvency II-style capital standard into ComFrame have heightened this concern. Another concern is the role of the group supervisor of an IAIG. U.S. regulators worry that ComFrame is ultimately aimed at increasing the authority of the group supervisor at the expense of local supervisors.

While agreeing that IAIGs are complex and require a high degree of coordination, the NAIC has questioned whether a single uniform global standard can account for the wide difference in insurance markets across the world. U.S. regulators point to the difficulty the International Accounting Standards Board (IASB) has had in reaching agreement on how to value insurance liabilities, a necessary element of a uniform international capital standard. In 2011, the NAIC proposed the IAIS focus on developing a simple leverage ratio that compared capital to assets, as a starting point for supervisory discussions. The proposal was rejected as not being sufficiently risk sensitive.

U.S. insurance regulators and the NAIC have promoted a greater focus on supervision at the IAIS. At the urging of the NAIC, the IAIS created the Supervisory Forum, a group of senior supervisors who meet to share best practices on supervision. While the Supervisory Forum has been a positive development, most of the IAIS's attention has remained on the development of further standards and requirements for IAIGs. In July 2013, the Financial Stability Board (FSB), which is discussed below, reported it would reach agreement with the IAIS by December 2013 on a timeline to finalize a comprehensive, group-wide supervisory and regulatory framework for IAIGs, including a quantitative capital standard.

International Accounting Standards 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, all publicly traded companies were required to report under IFRS effective with their 2005 financial statements.

One of the most difficult projects undertaken by the IASB is the insurance contracts standard, which will govern the accounting for insurance products. The long-term nature of some insurance products raise difficult issues about how to account for risk-taking over time. When do the profits emerge? How should the liability for future promises be valued? The IASB had struggled with these and other insurance accounting questions for over a decade. In June 2013, the IASB exposed its revised proposals for accounting for insurance contracts, which built on proposals originally published in 2010.

The IASB has conducted its work jointly with the Financial Accounting Standards Board (FASB), which is responsible for U.S. public accounting requirements. Originally, the IASB and FASB were working toward a joint standard. Unfortunately, they were unable to reach agreement. While there is much similarity between the FASB and IASB proposals, there are some key differences.

Insurance regulators are following the work of the IASB closely since it will undoubtedly 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.

Other Countries In addition to the work at the IAIS, a number of countries around the world are in the process of revising their regulatory capital requirements, and certain themes have emerged. These include the use of risk-based capital systems that recognize a broad range of risks (including credit, market, insurance underwriting, and operational risk), regulatory capital requirements that permit or even require the use of internal models to assess capital needs under certain conditions, a range of control levels to trigger different degrees of regulatory intervention, and increased regulatoryfocus on an insurer's risk management and governance systems. The ORSA is emerging as an important tool, and supervisors everywhere are increasing their focus on group supervision. Supervisors have formed supervisory colleges for IAIGs to increase the coordination of their supervisory activities. The level of coordination has improved significantly, but much work remains to be done.

The Global Financial Crisis and Systemic Risk

The recent financial crisis has caused a flurry of activity domestically and internationally aimed at preventing a future financial crisis. One area of work was the identification of systemically important financial institutions (SIFIs), firms whose distress or disorderly failure could threaten the wider financial system and economic activity.

Financial Stability Board and Systemically Important Financial Institutions The G-7 Finance Ministers and Central Bank Governors created the Financial Stability Forum in 1999 to be a mechanism for coordinated discussion on financial stability issues. Following the financial crisis of 2008-2009, policymakers decided a more significant body was needed. In 2009, the G-20 formed the Financial Stability Board (FSB), with a permanent staff. The FSB is currently located in Basel, Switzerland, at the Bank for International Settlements. While it does not have any ability to compel the adoption of its recommendations, its activities have a strong influence on developments in individual countries. The FSB is strongly dominated by central bankers, bank regulators, and ministries of finance (such as the U.S. Department of the Treasury), and many insurance regulators and insurance companies object to its increasing influence in the insurance sector.

The FSB released its initial SIFI designations in 2011, 29 banks deemed to be global SIFIs. In July 2013, the FSB released its initial list of nine global systemically important insurers (G-SIIs) and the policy measures that will apply to them.¹³ Designated firms are supposed to be subject to heightened regulation and supervision by their national supervisors to reduce the probability and impact of failure. Policy measures for G-SIIs include enhanced supervision, effective resolution (i.e., winding down a troubled insurer), and higher capital requirements (known as “higher loss absorption capacity”). In its announcement, the FSB called for a “sound capital and supervisory framework” for the insurance sector as “essential for supporting financial stability,” essentially a call for the IAIS to develop an international capital standard for insurance companies.

The identification of G-SIIs and the policy measures were based on work undertaken by the IAIS, which worked closely with the FSB. The IAIS work distinguished between the traditional insurance, nontraditional insurance, and noninsurance activities. Generally, the IAIS believes traditional insurance activities do not pose systemic risk. Identification of the G-SIIs focused primarily on their nontraditional insurance and noninsurance activities. Further work is planned to assess the systemic risk of reinsurance companies.

Financial Stability Oversight Council The Financial Stability Oversight Council (FSOC) is the body responsible for identifying SIFIs in the United States. As discussed in Chapter 6, by July 2013, the FSOC had identified two insurance groups as systemically important (Prudential Financial and AIG), and MetLife was under consideration. Prudential was appealing its designation.

Designated firms will be subject to consolidated supervision and consolidated capital requirements by the Federal Reserve. The exact nature of the additional requirements are still unclear, and the Federal Reserve is struggling with how to apply the requirements of the Dodd-Frank Act to systemically important insurance groups. In December 2011, the Federal Reserve proposed rules for non-bank SIFIs capital requirements, but they were widely criticized for imposing bank-requirements on nonbank firms. As of July 2013, final rules have not yet been adopted.

As discussed in Chapter 6, the long-term implications of creating two sets of insurance companies (those designated systemic and those not) with two sets of regulatory requirements is not yet clear. The intention of the policy measures is to impose higher requirements on systemic institutions, placing them at a disadvantage and forcing them to reduce their risk profile. Ideally, the end result will be insurance groups exiting the SIFI list and a sector with no systemically important institutions. This approach favors onerous policy measures, however, and it is not clear that will be the approach taken. Scholars of regulation understand that regulation is, in part, a political process. Designated firms are likely to lobby hard against measures that would put them at a competitive disadvantage. If the measures are not sufficiently restrictive, there remains a concern that designated firms will unintentionally be branded as “too big to fail” and have a competitive advantage over other firms. Either way, the potential long-run implication for the insurance sector and the competitive balance between designated and non-designated firms is significant.

U.S. Insurance Regulation

The U.S. Insurance Regulatory System is constantly evolving as state insurance regulators and the NAIC respond to insurance market developments, changes in the investment markets, new federal laws, and increasingly, international developments. Most experts believe the insurance regulatory system in the U.S. performed well in the recent financial crisis, but lessons were learned and regulators are using those lessons to improve the system.¹⁴

Solvency Modernization Initiative The NAIC's solvency modernization initiative (SMI) was discussed in Chapter 6. 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. By mid-2013, progress had been made in all areas. Regulators were getting ready for the ORSA requirement to become effective in 2014, and they were developing corporate governance requirements. The NAIC also had work underway to promote effective implementation of reinsurance collateral reforms and principles-based reserving.

An important part of the SMI activity was aimed at enhancing group supervision. U.S. insurance regulators have included a review of the holding company system for decades, but AIG's near failure increased their appreciation of the risks that could be posed by a group's noninsurance activities. Insurance regulators decided they needed to do a better job, and the focus on group supervision has increased around the world. In the U.S., states were enacting amendments to the NAIC Model Holding Company Act aimed at improving group supervision, increasing their participation in supervisory colleges, and expanding their financial analysis of groups.

Group supervision may be described as direct or indirect. In some jurisdictions, the holding company is regulated directly. Regulators may order the holding company to hold additional capital or cease certain activities that are financially hazardous. In U.S. insurance regulation, the holding company is regulated indirectly through its relationships with the insurer. U.S. regulators have tools to address cases where the noninsurance operations might negatively affect the insurer, but some have questioned whether there is a need for more direct authority over all activities of the group.

The FSB requires all SIFIs to be subject to consolidated holding company regulation. As indicated earlier, the Federal Reserve is the consolidated regulator of firms designated by the FSOC. At the IAIS, indirect holding company regulation has long been an accepted approach, but by mid-2013, there was some evidence this might be changing. In August 2013, a FSB peer review of the U.S. financial regulation recommended regulators have direct regulatory power over insurance holding companies. The FSB also advocated uniformity in regulation as a central objective, and supported increased federal involvement to achieve uniformity.¹⁵

Other NAIC Modernization Efforts The NAIC has been working to improve the state system in other areas. Some of these areas are modernizing regulation of surplus lines insurance (consistent with the requirements of Dodd-Frank's NRRA), continuing to streamline producer licensing, and promoting adoption of the Interstate Insurance Product Regulation Compact. Montana became the 43rd state to join the compact in May 2013, but some important states had not yet joined (e.g., California, New York, Florida, and Connecticut).

Although much progress has been made in the past decade to make the system more efficient, reduce unnecessary duplication, and eliminate unimportant differences across the states, progress has been slower in the large states. There are a number of reasons for this, including different regulatory philosophies, large bureaucracies that make change difficult, information systems problems, and a more challenging political environment. Given these challenges, the regulatory practices of large states frequently deviate from those in other states. Many insurance companies continue to complain they are subject to unnecessary duplication and conflicting state requirements, and some call for the creation of a federal insurance regulator.

Repeal or Modification of McCarran-Ferguson Almost from the time it was enacted, there have been proposals for the repeal of the McCarran-Ferguson Act. Interest comes and goes and agitation for repeal or modification of McCarran-Ferguson Act is greater at some times than at others. Pressure for repeal was intense throughout the 1970s and 1980s but waned somewhat during the 1990s. In the 2000s, pressure to amend McCarran-Ferguson returned, with two different approaches to reform proposed.

The first approach targets McCarran-Ferguson's deference to state regulation and is aimed at creating an optional federal charter (OFC). This proposal is promoted primarily by regulated entities, including banks, insurance companies, and brokers. Banks began to take a greater interest in insurance regulation with the enactment of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (GLBA). Large national banks are accustomed to a dual regulatory system, in which state banking regulators coexist with national banking regulators, and banks have some freedom to elect the system they prefer. Many national banks have openly expressed their preference for a dual regulatory system over the current state-based insurance regulatory system, particularly given the inefficiencies they see in state regulation. Several influential insurance industry trade associations also adopted positions in support of an OFC, including the American Insurance Association, American Council of Life Insurers, and Council of Insurance Agents and Brokers. In 2007, bipartisan legislation to create an OFC, titled the National Insurance Act of 2007, was introduced in the House and the Senate.

Interest in a federal insurance charter waned in the aftermath of the global financial crisis. As insurers watched federally-chartered banks become subject to increasingly stringent requirements and realized any new federal insurance charter was unlikely to be optional, many concluded they would prefer to remain with the state system, at least for the time being. The Dodd-Frank Act effectively reaffirmed the existing state regulatory system, creating the Federal Insurance Office within the Treasury but explicitly stating it would not be a regulator.

The second approach to amending McCarran-Ferguson focuses on the limited antitrust exemption contained in the law. As was discussed in Chapter 6, the McCarran-Ferguson Act exempts the business of insurance from federal antitrust law to the extent it is regulated by the states, subject to an exception for boycott, intimidation, and coercion. In 2007, the Antitrust Modernization Commission, appointed in 2002 to undertake a comprehensive review of U.S. antitrust law, issued its report. Although the commission did not explicitly recommend repealing the industry's limited antitrust exemption, it questioned the need for it, arguing that if McCarran-Ferguson were repealed, insurance companies would have no greater risk than companies in other industries engaged in data sharing. The industry vehemently disagreed with this conclusion, arguing that repeal would create a high level of uncertainty and litigation to determine which practices would continue to be permitted.

In February 2007, legislation was introduced in both the House and the Senate that would repeal the limited antitrust exemption provided by McCarran-Ferguson.¹⁶ Some of the momentum for the legislation arose out of the dissatisfaction with insurers' handing of Hurricane Katrina claims. In fact, one of the cosponsors (Senator Lott, R-MS) lost his house in Hurricane Katrina and became a harsh critic of the industry's claims practices.

The insurance industry strongly opposed the bills repealing the antitrust exemption. Opponents note that the limited antitrust exemption permits insurers to share loss data, standardize policy language, and engage in other cooperative industry activities, thus enabling smaller insurers to participate in the market. Smaller insurers view the exemption as important to their survival; large and small insurers see it as intricately intertwined with the deference to state regulation. The exemption from federal antitrust law enables the states to craft a state-based balance of regulation and antitrust that is appropriate for the insurance industry, without interference from federal law.¹⁷ Although amending McCarran-Ferguson's antitrust exemption may make sense in the context of broader reform (such as the creation of a federal regulator), as long as there is a system of state regulation, it seems logical for the states to determine the level of antitrust enforcement.

Erosion of State Regulatory Authority Regardless of what happens with respect to McCarran-Ferguson, there are other developments that have the potential to significantly diminish the states' authority to regulate insurance. These developments involve a type of creeping federal regulation created by Congress and, in some cases, by the courts. The erosion of state authority has resulted from legislation that preempts state authority in specific limited areas and court decisions that give federal agencies preeminence in resolving state-versus-federal jurisdiction conflicts.

One area that illustrates the potential for erosion of state authority involves the regulation of the insurance-related activities of commercial banks. Although this threat has diminished with the enactment of the GLBA, it illustrates the ways in which state authority can slip away. During the 1990s, two U.S. Supreme Court decisions ruled that the Office of the Comptroller of the Currency, the federal regulator of national banks, had primary authority for regulating certain insurance-related activities of national banks. GLBA mandated functional regulation in the financial services industry, meaning generally that banks will be regulated by banking authorities, securities firms will be regulated by the Securities Exchange Commission (SEC), and the states will retain their traditional role as regulators of insurance. More important, GLBA ended the deference to federal regulators that had threatened to make McCarran-Ferguson moot when it came to the activities of national banks.

A second area in which the authority of the states to regulate insurance has been eroded is in health insurance. The enactment of Employee Retirement Income Security Act of 1974 (ERISA) created a dual regulatory structure in this country for health insurance and health benefits. Although subsequent legislation gave states authority to regulate multi-employer welfare arrangements (MEWAs), self-insured, single-employer plans that cover an estimated 50 million persons remain exempt from state regulation under ERISA. One result of the 2010 federal health insurance reform law (the ACA) is an explosion in the level of federal involvement in health insurance regulation.

Other agencies in the federal bureaucracy that have oversight of private insurers and private insurance markets include the Federal Emergency Management Agency (flood insurance), the Department of Agriculture (federal crop insurance), the Department of Treasury (federal terrorism reinsurance), and the SEC (variable life insurance and annuity products).

The Dodd-Frank Act's NRRA had a significant impact on the way reinsurance and surplus lines are regulated and may hint at how the Congress is likely to approach future issues in state insurance regulation. The NRRA preempts extraterritorial regulation in reinsurance and surplus lines insurance. In reinsurance, decisions on credit for reinsurance are now the sole responsibility of the ceding company's domestic regulator. If an Illinois-domiciled insurer seeks to do business in California, the California regulator may not question the company's reinsurance, as long as Illinois is accredited or meets substantially similar requirements. The NAIC opposed the provision, arguing the threat another state might object creates a healthy incentive to maintain high standards and guards against a “race to the bottom” in regulation. Under NRRA, surplus-lines insurers and brokers are regulated only by the home state of the insured, rather than all states in which the insured has business activities. The surplus lines provision was widely supported by insurers, brokers, regulators, and insureds.

In mid-2013, Congress was considering the enactment of the National Association of Registered Agents and Brokers (NARAB) Reform Act, which would create the NARAB, a mechanism for multistate producer licensing.¹⁸ The bill builds on a provision in GLBA that would have created NARAB if the states failed to achieve the necessary degree of reciprocity or uniformity in producer licensing by November 2012. The states met GLBA's reciprocity requirements, however, and NARAB was never created. Because the current version builds on the earlier version of NARAB but is slightly different, the current proposal is known as NARAB II. The bill would establish a nonprofit, independent board to issue nonresident licenses to qualified individuals. States would retain their regulatory jurisdiction over consumer protection, market conduct and unfair trade practices, as well as the setting of licensing fees for insurance producers.

The NRRA and NARAB II illustrate a targeted approach to federal reform of the state system. They are aimed at specific areas that complicate interstate insurance activity, and the main focus is to reduce duplicative and potentially conflicting regulation. Even without repeal of McCarran-Ferguson, it is likely that state insurance regulation will continue to see its authority diminish over time through a gradual preemption of that authority by the courts and Congress.

The Federal Insurance Office The implication of the creation of the Federal Insurance Office (FIO) is unclear. While the FIO does not have supervisory or regulatory authority over the business of insurance, it could be an important voice in U.S. regulatory policy. Since its creation, the FIO has been active in international regulatory dialogues and as a member of the IAIS, and the FIO Director advises the Secretary of the Treasury on major domestic and international prudential insurance matters. The FIO is charged with monitoring all aspects of the insurance sector, and the FIO Director serves as a non-voting member of the FSOC.

One likely FIO role is to serve as a bully-pulpit to promote effective regulation and regulatory modernization. The Dodd-Frank Act charged FIO with publishing a variety of reports, including a report on U.S. insurance regulation. The report was due by January 23, 2012, and was anxiously awaited by opponents and supporters of state regulation. By the beginning of September 2013, however, it had not yet been published.

Given that the states remain responsible for insurance regulation, including the standards and policies that apply, the FIO's ability to influence state regulation is limited. International standards agreed to by FIO will generally not become effective unless the states agree to implement them. As a result, the NAIC maintains its own active international presence as the voice of the regulatory system. Ideally, FIO and the NAIC would be partners. In practice, it is not always the case.

PROTECTION FOR CATASTROPHE EXPOSURE

The industry has long recognized that increased population density and concentration of economic activity in certain geographic areas was increasing the potential for catastrophe losses. Insurers have become increasingly concerned as the magnitude of catastrophe losses has increased. According to Swiss Re, the three largest catastrophes in history (in 2012 dollars) have occurred in the last 10 years— Hurricane Katrina in 2005, the Japan earthquake and tsunami of 2011, and Hurricane Sandy in 2012. Six of the 10 most costly insurance disasters since 1970 have occurred since 2005, including four in 2011 and 2012. Even more troubling, Swiss Re reports that Hurricane Sandy was not an anomaly. A simulation of insured losses from historical storms using current property values shows that a loss like hurricane Sandy is expected to occur about once every 5 years in the U.S.¹⁹

Much has been written about whether fundamental climate changes are affecting the frequency and severity of hurricanes and, hence, the industry's catastrophe exposure. Although there is disagreement on its cause, there is general agreement that the global climate is going through a period of warming. Regardless of the cause, insurers are interested in the implications for the risks they underwrite. One particular area of interest is the relationship between global warming and the frequency and severity of catastrophic events, particularly hurricanes.²⁰

Current models suggest a loss potential of $100 billion or more from hurricane or earthquake losses. The population continues to migrate to coastal areas, and real estate continues to be developed. With the increased concentration of values in coastal, hurricane-prone areas, it is reasonable to expect continued catastrophic losses. Every earthquake and hurricane that occurs is inevitably followed by dire predictions that “the next one could be worse.”

State Solutions In the wake of devastating natural disaster losses suffered in the first half of the 1990s, California, Florida, and Hawaii created state catastrophe funds to provide direct insurance or reinsurance for hurricane and/or earthquake losses. The Hawaii catastrophe fund, created in 1993 (the year after Hurricane Iniki), provided hurricane insurance directly to consumers, via a separate policy. The Florida catastrophe fund was created in 1994 as a reinsurance mechanism to reimburse insurance companies when disaster-related losses exceed certain levels. The California program, the California Earthquake Authority (CEA), was created in 1996 to write residential earthquake coverage for the policyholders of insurers that contributed capital to fund the program.²¹

Today, states use a variety of approaches to address availability problems related to catastrophes. Florida and Louisiana have state-run insurance companies. Florida has a state-run reinsurance program for hurricane loss, and California offers earthquake insurance through the CEA. Hawaii phased out its catastrophe fund in 2001 and now relies on the private market. A number of states have beach and windstorm plans, and over half of the states have FAIR plans that act as residual market mechanisms providing property insurance to homeowners unable to obtain insurance.

Federal Proposals The first proposal for a federal disaster reinsurance program came in 1990, the year after the Loma Prieta earthquake in California. Not surprisingly, this proposal was for an earthquake reinsurance program, structured as a public/private partnership between the insurance industry and the federal government. Legislation to create a program of this type was introduced in 1991 and again in 1992. In 1993, the year following the $15.5 billion Hurricane Andrew, the bill was changed from a national earthquake initiative to a national disaster one. National disaster plan initiatives have been introduced in every session of Congress since that time.

Interest in the creation of a federal disaster fund increased again following Hurricane Katrina. The Homeowners Defense Act was first introduced in 2007, and it has been reintroduced in every session of Congress since. The Act would provide federal assistance to state-sponsored catastrophe insurance and reinsurance programs. State-sponsored funds would be permitted to pool their catastrophe risk through a National Catastrophe Risk Consortium. The consortium would be permitted to transfer that risk by issuing securities in the capital markets and obtaining reinsurance. In addition, the bill provides for low-interest federal loans to qualified state and regional reinsurance programs, and to other state programs under certain conditions.

To supporters, including some segments of the insurance industry, this approach would limit cross-subsidies across states and federal outlays by providing for voluntary state participation and reliance on the capital markets. Opponents, including many in the insurance industry, argue that the private insurance industry is capable of bearing this risk and that federal involvement would create an implicit federal subsidy that would lead to systematic underpricing of catastrophe risk in coastal areas. In 2013, it seemed unlikely the bill would pass.

The National Flood Insurance Program was another area of concern. The financial challenges facing the program and recent reforms were discussed in Chapter 25. Hurricane Katrina in 2005 produced large losses for the program; Hurricane Sandy added to the problem. The program was $24 billion in debt to the U.S. Treasury in mid-2013. The Biggert-Waters Flood Insurance Reform Act of 2012 was an effort to address the financial challenges facing the program. It phased out premium subsidies for certain properties, including second homes, business properties, and severe repetitive loss properties. The law also requires FEMA to update its flood maps to reflect the true flood risk. As the new flood maps were released and premiums began to rise in 2013, the backlash began. Some premiums in flood-prone areas were scheduled to increase 10-fold or more, and bills were proposed that would delay implementation of the rate adjustments. Whether the rate increases would be delayed was unclear, but the debate was an outstanding example of the public choice theory discussed in Chapter 6.²²

One innovative suggestion is the creation of Long-term flood insurance contracts tied to the property rather than the owner, a proposal intended to counter the problem of property owners underinvesting in flood mitigation.²³ According to Professors Kunreuther and Michel-Kerjan, one reason property owners underinvest is that the up-front cost is too high compared with premium reduction in the short-term. Kunreuther and Michel-Kerjan propose the NFIP offer insurance contracts with a term tied to the length of the property's mortgage. In addition, homeowners could obtain long-term home improvement loans to cover mitigation costs. So, for example, a homeowner with a 20-year mortgage and a 20-year flood insurance policy could obtain a 20-year home improvement loan. Where mitigation measures are cost-effective, the annual loan payments would be below the flood insurance premium reduction, essentially offering a rebate for engaging in risk mitigation. If a resident moved to another location, the flood insurance policy would remain with the property and automatically transfer to the new owner. Flood insurance premiums must be fully risk-based to encourage cost-effective mitigation, and assistance to low income insureds would be provided through general public revenues and not through the insurance mechanism.

An alternative approach to addressing catastrophe risk at the federal level would amend the Internal Revenue Code to allow insurers to establish pretax reserves for future catastrophes. Income allocated to the catastrophe reserves would be taxable as income only when withdrawn for the payment of losses. This approach received considerable attention following Hurricane Andrew, and was introduced in Congress in the Policyholder Disaster Protection Act of 2001 but failed to pass. It received attention again following Hurricane Katrina, with strong support from the NAIC and segments of the insurance industry. Given the federal deficit, however, concerns about the loss of federal tax revenues are a barrier to the creation of tax-deferred catastrophe reserves.

Terrorism It has been said, without exaggeration, that the events of September 11, 2001, forever changed America. Like so many other sectors of the economy, the insurance industry faces new problems as a result of the September 11 attack. Shortly after the event, the insurance industry began to react to the existence of the potentially catastrophic exposure from terrorism, previously unrecognized in insurance underwriting and pricing. Although many forms of insurance exclude acts of war, legal precedent holds that acts of terrorism do not fall within the war exclusion. Almost immediately after the attack, reinsurers worldwide announced that they would exclude terrorism from their reinsurance contracts in the future. Faced with the prospect of catastrophic losses from future attacks, the insurance industry lobbied Congress for some type of backstop reinsurance program that would cap insurance industry losses from terrorism in the future. The federal Terrorism Risk Insurance Act (TRIA) was passed in 2002 and renewed, with some changes, with the passage of the Terrorism Risk Insurance Extension Act (TRIEA) in 2005. In 2007, the Congress enacted the Terrorism Risk Insurance Program Reauthorization Act (TRIPRA), which is scheduled to expire in December 2014. In mid-2013, industry attention was focused on the renewal of the federal terrorism risk insurance program.

Since the enactment of TRIA in 2002, there has been considerable debate about the need for long-term federal reinsurance for terrorism-related insurance losses. When TRIA was originally enacted, some experts predicted that the terrorism insurance problem was temporary and that private markets would develop to make terrorism insurance widely available. They argued that insurers would learn how to price the risk and that instruments would develop to enable insurers to transfer potentially catastrophic losses to the capital markets (such as catastrophe bonds). Furthermore, they argued, the federal subsidy inherent in TRIA reduces insurance premiums for high-risk properties, thus reducing incentives for businesses to mitigate that risk. A good example of this perspective is found in a January 2005 report issued by the Congressional Budget Office. The report suggested that the federal program was slowing the development of the private insurance market and the expiration of TRIA would result in more efforts to mitigate terrorism risk and in the development of alternatives to terrorism insurance, including mutual insurance pools and capital markets instruments.

The alternative perspective focuses on the fundamental differences between terrorism and other insurable risks, particularly terrorism's dependence on the behavior of terrorists. Terrorists act intentionally to create maximum damage, change their behavior in response to loss-prevention efforts, and constantly search for new ways to cause loss. Given the dynamic nature of this risk, how can insurers ever price and manage this risk? There is little activity in reinsurance markets or catastrophe bonds, even though TRIA is structured to require primary insurers to retain significant terrorism risk. To proponents of federal involvement, this suggests that these markets are not likely to evolve. Without federal subsidies, only high-risk properties would want to purchase terrorism insurance, and it would be difficult to spread the risk over a sufficiently large number of insureds. In short, according to this view, terrorism is not an insurable risk, and the country needs a long-term solution.

In September 2006, the President's Working Group on Financial Markets (President's Working Group) submitted its report on the long-term availability and affordability of insurance for terrorism risk, which had been mandated by Congress. The report concluded that the availability and affordability of terrorism risk insurance had improved somewhat since 2001 and that reinsurers were somewhat more willing to offer coverage. A high percentage purchase coverage. Insurers were able to do a better job of assessing the concentration of their terrorism exposures and to model loss severity under different scenarios. This enabled insurers to avoid accumulating too much risk in a given location. Although insurers were able to model severity of terrorism losses, estimating frequency continued to be problematic, given its dependence on the behavior of terrorists. Finally, the report concluded that coverage for terrorism risk in group life insurance remained generally available, whereas coverage for chemical, nuclear, biological, and radiological terrorism was not.

The President's Working Group updated its study in 2010 and concluded the availability and affordability of terrorism insurance continued to improve after 2006. Insurance for high-risk properties and locations remained limited, however, and some commercial policyholders in high risk areas had difficulty obtaining adequate coverage. In July 2013, the President's Working Group requested public comments on the availability and affordability of terrorism insurance for an updated report.

In mid-2013, legislation to renew the federal terrorism program had been introduced in the Congress, but the prospects for passage were unclear. Many insurers, particularly smaller insurers, supported renewal, but concerns about the federal deficit dampened enthusiasm for the program. In August, Fitch, a rating agency, reported that the failure to renew the program would significantly affect insurer underwriting practices.

CHANGES IN THE LEGAL ENVIRONMENT

Changes in the laws of society have always had a significant impact on the insurance industry, and will continue to do so in the coming decades. To a large extent, the growth of the insurance industry will be determined by the legal environment in which it operates. Legislation in many areas affects the need for security and the manner in which that security is provided.

Changes in the Tort System

The automobile no-fault laws enacted during the 1970s are an example of how legislation can influence the insurance industry. Not only did these laws alter the structure of the benefits payable for automobile accidents, thereby affecting insurer losses, but they also created a legal requirement for automobile insurance where none had previously existed. Before 1971, only three states had compulsory automobile liability insurance. Today, nearly all of them do. During the 1990s, the notion of no-fault legislation was resurrected at the federal level in the form of choice no-fault, discussed in Chapter 29. Congressional response was lukewarm, and nothing significant occurred on this front. In this century, dissatisfaction with no-fault laws have been more pronounced, with concerns about fraud and the failure of no-fault to reduce auto insurance costs. In 2003, Colorado repealed its no-fault law, and, more recently, Florida enacted major reforms, some of which are currently being fought in the courts.

In the 1980s, the debate over tort reform moved from no-fault to other areas. In the 1990s, almost every state enacted some type of tort reform, usually involving limitations on joint and several liability, pain and suffering, and punitive damages. Almost immediately, the constitutionality of these reforms was challenged in court. The challenges to state reform statutes intensified the efforts of those who believe that tort reform is required at the federal level. In 2005, Congress enacted the Class Action Fairness Act, which addressed abuses with class-action lawsuits, as discussed in Chapter 28.²⁴ Pressure for federal reform in the tort system (and resistance to that pressure) will undoubtedly continue. Two common major areas of focus are products liability and medical malpractice.²⁵

The debate over tort reform will continue, and changes will undoubtedly occur at the state level. Although public sentiment seems to support national tort reform, plaintiffs' lawyers and some consumer advocates have taken the lead in opposing legal reform. They argue the current system gives those who are injured access to the court system that they might otherwise be denied. The eventual resolution of the debate over the tort system will have an important effect on the price and availability of liability insurance for these exposures.²⁶

Federal Tax Laws

Provisions of the federal tax laws—especially those relating to the taxation of life and health insurance, annuities, pensions, and other qualified retirement programs—have important implications for the insurance industry and insurance consumers. A major topic of discussion in 2013 was reform of the federal tax code, which will undoubtedly have implications for the insurance industry. There are a number of proposals aimed at improving retirement security and streamlining tax rules in that area. Some of these were discussed earlier. In addition, some proposals deal with the taxation of life insurance and annuity policies and with health insurance.

Since the federal income tax was created in 1913, life insurance products have been granted special tax status, with taxes on the increase in the policy's cash value deferred until the funds are received by the policyholder. There have been a number of attempts to eliminate this tax deferral over the years, but none has been successful. In 2005, President Bush's Advisory Panel on Federal Tax Reform proposed changes to the tax treatment of life insurance.²⁷ Since then, others have continued to point to life insurance products as a potential source of additional federal revenues. There have been proposals to currently tax the inside build-up in both life insurance and annuity policies. In the health insurance area, proposals have been made to limit or even gradually eliminate the employer deduction for health insurance.

Implementation of any of these or the myriad of other insurance-related proposals would undoubtedly have a significant effect on the industry and on product design. Not surprisingly, as Congress searches for revenues to address the federal deficit, the insurance industry is watching closely and actively involved in the discussions.²⁸

CHANGES IN THE INSURANCE INDUSTRY

Not only will the environment within which the insurance industry functions change in the future, but the industry itself will undoubtedly also undergo change. From the consumer's perspective, the most significant changes within the industry are likely to be continued changes in industry structure and the development of new forms of protection.

Changes in Industry Structure

The number of insurance companies continues to change and will undoubtedly change in the future. During the past two decades, there have been a number of mergers, acquisitions, and consolidations that have been defining events in the insurance industry. Consolidations have been not only national but also international. Besides decreasing in numbers, some insurers have changed their organizational structure, either by demutualizing or reorganizing under mutual insurance holding laws enacted by the states. It is likely that the number of insurers in both the life insurance field and in the property and liability field will continue to decline as mergers and consolidations continue.

Many experts predicted a wave of mergers between banks and insurance companies in the United States after the enactment of the GLBA in 1999, but there was little movement in that direction. The debate over the combination of banking and insurance in the United States occurred against a backdrop of a convergence of financial services globally. U.S. banks and insurers were not permitted to affiliate before the GLBA, but few other countries had similar laws. Thus, in many countries the consolidation of banking and insurance operations was more advanced. In the current environment, that trend seems to be reversing, at least in the United States and Europe. Even today, however, many life insurance groups have sizable asset management operations in addition to their traditional life and annuity business. They are also expanding these operations internationally.

Changes in Company Operations

Developments in technology have permitted insurers to improve many of their business operations. Some important developments include improved enterprise risk management and increased use of data analytics for underwriting, pricing, and fraud detection.

Enterprise Risk Management Risk management has long been a feature of the insurance industry. After all, insurers are in the business of taking risk. Over the years, they have managed that risk through underwriting and investment policies that aimed to reduce or eliminate risk concentrations.

In recent years, more attention has been paid to enterprise risk management, and regulatory developments are encouraging that trend. Firms are expected to articulate their risk appetites and maintain systems to keep risk taking within those appetites. Catastrophe models have become an important tool for property-liability insurers to manage their exposure to windstorm and earthquake. Firms do stress testing and scenario testing to determine how a major loss event will affect them and to ensure they have sufficient resources to withstand the losses. Increasingly, property-liability insurers are considering the impact of a loss event on both their assets and liabilities. A major hurricane in Florida could impact not only the policies they have written in Florida but also any investments they have made in Florida.

Life insurers have a long history of considering their assets and liabilities together. For many years, U.S. insurance regulators have required life insurers to conduct cash flow testing to ensure they have adequate cash flows under a variety of future investment scenarios. In the current low interest rate environment, this analysis has received increased scrutiny.

Technology As with all industries, changes in technology are changing the way insurers conduct their business. Some changes in insurance are similar to those in other industries: more customer service available online and 24/7, electronic premium billing and payment services, etc. Some insurers now provide proof of insurance electronically, and states are beginning to make the legislative changes needed for mobile proof of insurance to be acceptable. Some insurers have created mobile apps that policyholders can use when they have an accident, allowing them to collect the necessary information and begin the claims process immediately.

Beyond these rather typical developments, however, improved technology is permitting greater data analysis and driving changes in underwriting, pricing, and other practices of insurers. The industry's increasing use of predictive analytics was discussed in Chapter 7. The insurance industry has long been among the most intense in its collection and analysis of data. Even before the advent of computers, insurers collected extensive information about insureds and their loss experience and tried to leverage that information to better underwrite and price. With improvements in the ability to store and process data, however, it is now possible to use much more information from a variety of sources. The wealth of information can be used to produce increasingly refined rates, with rating factors that go far beyond the traditional factors. Today, this trend is particularly evident in homeowners and automobile insurance, but it is likely to expand to other areas in the future. Many insurers now hire Ph.D. statisticians along with actuaries to do their data analysis. Predictive analytics are also used in the claims process to identify unusual claims patterns and detect fraud. Telematics, or usage-based insurance, which was discussed in Chapter 29, is a related development. While usage-based insurance is not yet widespread, its use is growing, and it is likely to further segment the automobile insurance market, increasing the degree to which an individual's own expected loss is recognized in the rates.

Changes in Forms of Coverage

The future will undoubtedly witness a variety of new forms of coverage to address emerging and still unrecognized exposures. Even today, insurers are introducing new policies in response to increased recognition of risks faced by their customers.

Cyber Liability Insurance The growth in e-commerce has produced a variety of new risks, both for businesses and individuals. The Internet, by design, is inherently insecure, which facilitates the flow of information between computers, but this design allows knowledgeable people who have the proper tools to intercept and modify data during transmission. In addition, the interconnectivity of the system exposes data storage systems to compromise. Risks related to the Internet and e-commerce include the destruction, altering, or theft of data by hackers, unscrupulous vendors, and former or present disgruntled employees. They also include viruses and other malicious programs that can infect the data storage and operating systems and cause enormous loss.²⁹

The Internet also raises the specter of a whole range of new potential e-commerce liability claims. Businesses operating through the Web are in the publishing business, whether or not they realize it. This means that they are subject to the same exposures that were previously limited to traditional publishing companies: copyright and trademark infringement, libel, and invasion of privacy.

Cyber liability insurance, which was discussed in Chapter 32, is one of the industry's fastest growing lines of insurance. This is new territory for insurers, in which the full nature and scope of the exposures are still emerging. The challenges in meeting these risks will undoubtedly involve a period of trial and error and some experimentation. Because the old risks will remain, the period of challenge will also be a period of enormous opportunity for the industry.

Business Interruption Globalization has impacted the business interruption exposure firms face. An excellent example of the impact can be seen from the massive flooding in Thailand in 2011. Thai suppliers reportedly produced 40 percent of the world's computer hard drives, a critical component for computer manufacturers. Faced with the loss of this key input, PC manufacturers were forced to reduce production and limit shipments in 2012.³⁰

These developments have increased the appreciation of supply chain risk by both insurers and businesses and led to new forms of business interruption (BI) and contingent business interruption (CBI) insurance coverage. ISO's 2012 revisions to its Commercial Property Policy added a new option to cover certain secondary dependencies, such as when a firm's supplier cannot deliver a necessary component because of an interruption to one of its suppliers. In July 2013, the ISO introduced a new suite of mobile BI endorsements to cover the BI exposures of vehicles and mobile equipment while they are away from the insured's location. This could be attractive to firms that conduct much of their operations off-site, such as mobile auto repair businesses or landscapers.

Some insurers offer BI and CBI coverage for perils beyond those traditionally been covered. Recall that the standard property policy requires property damage in order to trigger BI or CBI coverage. Firms may suffer an interruption for other reasons, such as a disruption in utility service, a labor strike, or the bankruptcy of a supplier. Policies are increasingly available to cover these other risks.³¹

Nanotechnology The term nanotechnology refers to technology using extremely small particles, that is, those less than 100 nanometers in size, where a nanometer is one-billionth of a meter. Researchers have found that when a material is reduced to such a small size, its physical and chemical properties change, and it behaves much differently. Nanoparticles are more reactive, for example. Many scientists believe nanotechnology is the next great technological breakthrough, with potential uses in virtually every industry. Nanoparticles are now used in manufacturing, and products that use this technology are being sold to consuemers. Although some 200 products currently use nanotechnology, consumers are generally not aware that the technology has been used.

For the insurance industry, any new technology will raise questions about its risks, and nanotechnology is no exception. Nanotechnology risks are covered under a variety of insurance policies, including workers compensation, products liability, general liability, and professional liability. Insurers and reinsurers are studying the potential risks, asking questions such as: Given the size of the particles, what happens if they are inhaled or otherwise enter the body? Can nanoparticles be absorbed through the skin? What are the risks if they are released into the environment? What is the potential for property damage and bodily injury to workers and the public? Answers to these questions will undoubtedly affect the basis on which the industry provides coverage for nanotechnology risks in the future.

Annuities Following the financial crisis, many life insurers made changes to their annuity products, increasing prices and reducing guarantees. Significant changes have been made to the living benefit guarantees previously offered in variable annuity products following insurer losses on the business, and future variable annuity products are likely to be much different from those that existed previously.

Fixed index annuities are becoming more popular, and some life insurers are exiting the variable annuity business in favor of fixed index annuities. Two other products have emerged in recent years, but it is still too early to determine their prospects. Some insurers are offering contingent deferred annuities, which (as described in Chapter 18), wrap a mutual fund to provide longevity protection. Another innovation is the longevity annuity, or longevity insurance, which provides an income stream beginning at an advanced age, such as 80. This product may become more popular if the tax rules governing qualified pension plans are revised to encourage their purchase.

Changes in Forms of Compensation

Although the practice has been restricted primarily to larger accounts, there is a movement within the industry toward a fee system of compensating agents and brokers for their services in lieu of the traditional commission system. The concept has met opposition from some quarters, but for larger accounts, it has considerable merit. The traditional compensation system ties the agent's compensation to the hazard faced by the insured, which seems illogical. It seems difficult to justify a higher compensation to the agent for handling one account simply because the insured has a frame building when the work involved is no greater (and may be less) than that done for another account where the insured owns a brick building.

Traditionally, many insurance brokers or agents received two forms of compensation: a commission payment for the individual policy written and a contingent commission based, not on the individual transaction, but on all of the activity placed with the insurer. The contingent commission could be a function of premium volume placed with the insurer, growth in premiums, profitability of the business, or some combination of these measures. As large customers began to demand fee-based compensation arrangements with brokers in lieu of the individual policy commission, they also began to demand that brokers disclose other compensation arrangements they had with insurers. In 2004, the Risk and Insurance Management Society (RIMS) adopted a policy encouraging insurers to disclose all forms of compensation, direct and indirect, without the client's request.

In October 2004, the insurance world was rocked when New York Attorney General (later Governor) Eliott Spitzer filed fraud charges against Marsh and McLennan, the world's largest insurance broker. Spitzer charged that Marsh had (1) engaged in bid-rigging and (2) illegally steered clients to insurers that paid the highest commissions. Spitzer blamed the existence of contingent commissions, which, he argued, created a conflict of interest for the broker in serving the insured. Over the next year, the four largest U.S. brokers entered into settlement agreements under which they agreed, among other things, to cease accepting contingent commissions. The concern over compensation practices spread to other jurisdictions, illustrating the increasing globalization of the industry and regulation.³²

Efforts by the Attorneys General reduced the use of contingent commissions, particularly by large brokers and for large policyholders. However, contingent commissions continued to be used widely in other parts of the insurance market. Furthermore, most regulators and economists agree that contingent commissions, particularly those based on the profitability of the business written, can be beneficial to insurance markets. They help to address the problem of adverse selection by giving the agent or broker an incentive to provide accurate information to the insurance company. Rather than ban contingent commissions, most insurance regulators support effective disclosure as the preferred solution to the conflict-of-interest problem. In December 2004, the NAIC developed a model requiring detailed compensation disclosure by brokers or anyone who receives compensation from both a customer and an insurer when placing business.

The four brokers' restrictions against accepting contingent commissions had expired or been lifted by 2010. Since then, they have begun accepting contingent commissions again under some circumstances, with enhanced disclosure. Each broker's policy regarding when it will accept contingent commissioners is slightly different.

Alternative Risk Transfer

Since the emergence of catastrophe bonds (cat bonds) in the 1990s, the market for insurance-linked securities has continued to grow. Cat bonds and other arrangements to transfer risk to the capital markets were discussed in Chapter 8. These financial instruments are no longer an innovation; they have become an accepted mechanism for risk management. In recent years, new classes of investors have been attracted to the market, and institutional investors like pension plans, mutual funds, and university endowments have invested in insurance-linked securities. To date, most cat bonds have been sold by insurance or reinsurance companies.

In addition to their use by insurers and reinsurers, some cat bonds have been sold by businesses or governments, a phenomenon that could increase. In August 2013, New York's Metropolitan Transit Authority (MTA), which manages New York's subways and other public transportation, announced it had purchased $200 million in coverage through a cat bond offering. The MTA had suffered $4.75 billion in damage from Hurricane Sandy in 2012, in large part from a storm surge that inundated rail stations and subway tunnels. When its insurance came up for renewal in May 2013, it had difficulty finding adequate coverage, and it turned to the capital markets to arrange coverage. According to one author, this “demonstrates the challenges faced by large insureds to secure adequate insurance coverage in catastrophe-prone regions, as well as the ability of insurance-linked securities to augment or even replace traditional insurance and reinsurance coverages.³³

The MTA bond covers storm surge and was written to benefit the MTA's captive insurance company. It has a parametric trigger based on data from tidal gauges around New York City and is reportedly the first cat bond to cover only storm surge.

Other governmental agencies have also used cat bonds to address their catastrophe exposure, most of them state-run insurance pools. In April 2013, the North Carolina Joint Underwriting Association and the North Carolina Insurance Underwriters Association, two state pools, co-sponsored a $500 million bond covering hurricane losses in North Carolina. The California Earthquake Authority completed its second cat bond offering in 2012, at which time about 10 percent of CEA's total $3 billion risk transfer program was funded through the capital markets.

It is unlikely the capital markets will displace traditional insurance and reinsurance. These transactions are cost-effective only for very large insureds. However, as the market continues to develop and costs continue to fall, insurance-linked securities will become an increasingly important part of a risk manager's toolbox.

SOME PERSISTENT PROBLEMS

Genetic Testing

Researchers have made great strides in understanding the structure of human DNA and, in particular, identifying genes that contribute or cause physical conditions. With this increased information, it becomes possible for insurers to use genetic testing to identify individuals likely to contract particular diseases. The potential impact on insurance underwriting is enormous.

Some critics argue that insurers should not be permitted to use the information gathered from genetic testing in their underwriting decisions. Their rationale is similar to that used by some states when they attempted to prohibit insures from testing for the AIDS virus. If life insurers have access to information that identifies a genetic disorder, they may charge a higher premium, exclude coverage for the condition, or reject the application. In addition to the affordability and availability implications, there are confidentiality concerns when third parties have access to the results of a genetic test.

When insurers are denied access to this information, of course, significant adverse selection will result, as individuals who have undergone genetic testing and become aware that they face a high risk of illness will seek to buy large amounts of insurance. Without access to that same information, the insurer would not be able to calculate the premium commensurate with the risk being assumed. The result would be inadequate pricing and cross-subsidization between those with and without genetic disorders.

Crime and Its Associated Costs

Because much of the property that is damaged by vandalism, arson, and looting is covered by insurance, crime is a major concern for the property and liability insurance industry.³⁴

Arson According to the National Fire Protection Association, roughly 300,000 intentional fires are reported to U.S. fire departments each year. Of those, 18 percent involve structures, and 8 percent occur in vehicles. Some of these fires were intentionally set to defraud insurers, but others were set by persons with no direct financial interest in the property. In fact, fewer than 15 percent of arson suspects are motivated by a desire to defraud an insurer. The major cause of arson is vandalism, which is attested to by the fact that the majority of those arrested for arson are young people.³⁵

Crimes Against Property Property crime, such as burglary, robbery, and theft, is growing faster than the population. In addition to the loss of property that is taken or destroyed, many criminal acts also result in bodily injury to the victims of the crime. Damage and theft of property and the attendant bodily injuries inflate insurers' loss ratios and account for a significant part of total insurance claims.

Insurance Fraud In addition to criminal acts against property such as arson and theft, insurers also suffer losses as a result of fraudulent claims by professional criminals. Insurance fraud has been rampant in the area of health insurance, where unethical physicians collaborate with the criminals to document fictitious claims. Staged automobile accidents are another scam that has been prevalent in some parts of the country.

Although criminal acts are clearly a problem for insurers, they are also a problem for insurance buyers. Based on what the reader has learned about the way in which insurance operates, it should be clear that the increased loss costs that result from criminal activity such as arson, vehicle theft, and crimes against property are passed on to insureds by insurance companies in the form of higher rates. Policyholders pay for losses resulting from these criminal acts in the same way they pay for the inflated claims by ordinary policyholders who exaggerate their claims. Law-abiding citizens who would never think of stealing sometimes have no qualms about inflating property damage claims so the recovery will be sufficient to cover the deductible that would otherwise apply. For insurers and their policyholders, the result is the same as the losses occasioned by arson and other overt criminal acts.

Availability and Affordability of Insurance

Another troublesome issue facing the property and liability insurance industry today is the high cost of insurance for some segments of the insurance-buying public and the response that this high cost has generated among those buyers and among certain other groups. Increasingly, the demand is heard that insurance must be made available to all who want and need it and that it must be made available at affordable rates.

Although the main issue for some people today is still the question of the method we should use to provide the subsidy to those who demand availability and affordability, the entire debate has prompted a reappraisal of the systems that have been used in the past to subsidize some buyers. Increasingly, it is recognized that the distinctions among the approaches to subsidization are artificial, and in the last analysis it makes little difference if the subsidy is granted through an industry pool, through the tax system, or through the rating system. In each case, one group of society pays a part of the costs that would, without government interference—fall on another group. This remains a little-understood subject.

Lack of Consumer Sophistication

Another persistent problem facing the insurance industry is the lack of sophistication on the part of consumers. Although many insurance buyers have become more knowledgeable over the past few decades, the majority of consumers still misunderstand the purpose of insurance, and this misunderstanding creates widespread difficulties for the insurance industry. Many insurance purchase decisions are poorly made.

The emerging field of behavioral economics provides some explanation of why consumer insurance purchase decisions are often flawed. Behavioral economists look at consumer decisions through the lens of psychology, taking into account emotions, biases, and simplified decision rules known as heuristics. Decision-making in insurance is complicated by the tendency of individuals to misestimate probability, the relatively infrequent times the decision is made, and the long time lag between decisions and feedback. According to some behavioral economists, decisions are particularly likely to be flawed when the decision has a delayed effect, is difficult, is made infrequently, and provides poor feedback. Unfortunately, these characteristics are a perfect description of the insurance purchase decision.³⁶

Much of the consumer dissatisfaction with insurance is based on a faulty idea of insurance and how it operates. With little notion of the way insurance works or the principles of risk management, many consumers feel that an insurance policy is not worthwhile unless it covers every possible small loss. They find buying insurance a frustrating experience and are frequently disappointed or dissatisfied with their purchase. They complain that the cost of insurance is too high, deductibles are a scheme developed by insurers to get out of paying their just claims, and the entire insurance mechanism is some sort of rip-off.

By this time, it is hoped that the reader has gained a sufficient understanding to see why many criticisms are unjustified. As we have learned, insurance operates on a simple principle: Individuals exposed to loss contribute to a fund and those who suffer losses are compensated out of this fund. Cutting away the complicated details of the mechanism, it is a system in which the losses of a few are shared by the many. There is nothing magical or mysterious about it unless one considers the law of averages to be magical or mysterious. When losses are high, rates must also be high. The insurance industry is very much like a conduit or pipe. Money is paid into one end of the conduit and flows out the other. Most of the complaints have focused on the amount of money going in, ignoring that the money going in is a function of the money going out. In a sense, insurance is merely a mirror that reflects the loss experience throughout the economy. Although considerable progress has been made in consumer education, much remains to be done.

Unwarranted Criticism of the Insurance Industry

The insurance industry is a convenient target, and criticism of the industry abounds. Much of this criticism is contradictory. Some complain that the insurance industry makes excessive profits; others complain that many insurers are on the brink of insolvency; still others allege both, apparently oblivious to the contradiction.

The most common contradiction is the allegation that property and liability insurers operate as a cartel, fixing prices and raising rates with impunity. This theory is exemplified in the following comments of one industry critic:

Industry critics are particularly fond of the charge that because of its exemption from the federal antitrust laws, the industry operates as a cartel, engaging in conspiracies to increase prices. The allegation ignores the obvious fact that if insurers conspire to increase rates, they must also conspire to decrease them. Periods in which insurance prices increase usually follow periods of intense price cutting, when competition drives rates below their actuarial level. When insurance prices decrease below actuarially sound levels, insurers are accused of mismanagement. When premiums increase during the hard phase of the cycle, they are accused of gouging consumers or of conspiracy.

The conspiracy idea is a favorite explanation of industry critics for high insurance costs, availability problems, and underwriting cycles, which they attribute to collusion and intrigue within the insurance industry. There is a much simpler and more believable explanation: The industry is fiercely competitive and it, therefore, exhibits the characteristics of a competitive industry. The most frustrating complaint for many within the industry is the criticism directed at the industry when it attempts to price its products on an actuarial basis. Many types of insurance are demonstrably unprofitable for insurers. Given the choice between insuring exposures on which they are almost always guaranteed to lose money and those on which they can reasonably expect to earn money, insurance companies logically choose the latter. One criticism of which some critics are especially fond is that “insurance companies refuse to write some types of insurance because those lines are unprofitable.” It is a commentary on the complexity of the issues and the confusion in which society finds itself that this criticism goes unanswered.

Those who criticize the reluctance of insurers to write unprofitable classes of business when their overall profitability is satisfactory are, in effect, arguing for cross-subsidies. They would like to make the insurance industry a mechanism for taxing and redistributing wealth. The question is whether insurers should overcharge buyers of homeowners insurance to subsidize the cost of product liability insurance or whether premiums for fire and marine insurance should be loaded to cover losses under malpractice insurance. These questions involve complex value judgments that should not be made lightly.

The insurance industry, like nearly all segments of society, includes some ethically challenged individuals who have few qualms about engaging in dishonest or unquestionable practices detrimental to consumers. Identifying and eliminating these undesirables is an important responsibility, for regulators and other members of the industry. It is of no help, in this respect, when bogus criticism of legitimate business strategies, based on the law of averages, are mischaracterized as a nefarious conspiracy to exploit consumers. When the misplaced criticism stems from ignorance on the part of critics about how insurance works or from some hidden agenda, it obstructs and interferes with efforts to deal with the real crimes and misdemeanors that may actually occur.

CAREER OPPORTUNITIES IN INSURANCE

U.S. gross domestic product (GDP) has grown dramatically over the past two decades, fueled by increases in productivity. Economists predict continued increases in GDP and personal income over the next two decades, with corresponding increases in per capita income. Given the long-range growth expected throughout the economy, with new advances in technology, new products, and high personal incomes, the continued expansion of the insurance industry seems assured. Regardless of possible inroads by government, the future of the industry appears bright indeed. Increased security needs and the ability to pay for them point to a tremendous growth for the insurance business. This growth, coupled with an aging industry work force, will lead to an increase in the industry's employment needs, and the nation's insurers will be offering thousands of career opportunities to college graduates.

Today's insurers carry on a growing number of activities: rehabilitation of the insured, product safety, industrial hygiene, and medical research. It would be difficult to find another industry that offers such diversified positions as mathematician, nurse, lawyer, IT specialist, data analyst, and engineer in addition to the more traditional insurance careers in sales, investments, underwriting, and claims. Regardless of whether the individual's academic work has been in business administration, engineering, economics, mathematics, or computer applications, he or she is likely to find an attractive career in the highly diversified insurance industry.

Broadly speaking, employment opportunities in the insurance industry may be divided into two major categories: sales and nonsales. Positions within each of these categories exist in the property and liability industry and the life and health insurance fields. In addition to jobs within the insurance industry proper, employment opportunities also can be found in the growing field of risk management and corporate insurance buying.

Opportunities in the Insurance Sales Field

Sales positions in the property and liability field exist with the direct-writing companies and with independent agencies. Most direct-writing companies recruit on college campuses, seeking sales representatives at the same time they hire other specialists. Although independent agencies have a continuing need for personal lines and commercial lines producers, most agencies do not have a sophis-ticated personnel recruitment program and so do not recruit on college campuses. Positions with independent agencies therefore must be sought out by the prospective applicant.

Life insurance general agents and district sales managers generally conduct intensive recruiting campaigns on college campuses. Because the turnover rate in life insurance sales is high, there is a constant need for new agents. Many companies have had moderate success in reducing the turnover rate through more intensive selection procedures and better training.

Sales positions in the insurance field demand a high degree of expertise. Insurance agents do not sell a standard tangible product but a special kind of financial security that must be tailored to meet the needs of the individual policyholder. In many situations, the role of the agent is far removed from the stereotype of the high-pressure, fast-talking sales type. The professional agent functions as an adviser to his or her clients, filling a role similar to that of an attorney or accountant.

Although the demands on those who enter the field of insurance sales are great, so also are the rewards. Insurance sales positions with pay based on commission rather than salary rank among the highest in the nation in potential earnings. Compensation tends to increase rapidly with experience.

Nonsales Opportunities in the Insurance Industry

Although many insurance agencies employ nonsales personnel, the person seeking a nonsales position within the insurance industry would be best advised to seek employment with an insurance company.

In the property and liability field, insurance companies recruit actuaries,³⁷ underwriters, claims personnel, and marketing representatives in addition to the more traditional noninsurance positions found in every business. Underwriters, as the reader will recall, are charged with the responsibility of deciding which of the various applicants for insurance should be accepted. Claims persons handle the delicate problem of loss adjustment. Marketing representatives generally serve as a link between the company and its agency force, although in the case of direct-writing companies, the marketing representative may deal directly with the consumer.

Life insurance companies offer positions similar to those of the property and liability firms. Many life insurance companies have their own staff of actuaries. Special marketing representatives are also employed by the life insurance companies to deal with group programs and pension plans and to assist the company's agents in the technical details of more complicated life insurance cases.

Positions with property and liability insurers and life insurers are challenging and rewarding. Increasingly, the insurance company employee is performing a decision-oriented job, requiring independent judgment and a greater degree of individual responsibility at every level. Executives in the insurance field have traditionally risen from within the industry. This practice of internal promotion is an additional advantage to people choosing the insurance business as a career. Capable people have a greater probability of rapid promotion because of the great expansion the industry foresees during the next 20 years, which is going to result in a shortage of managerial personnel. Salary levels in the property and liability field and in the life and health insurance field vary with each company and in each region of the country. These positions typically pay less than insurance sales positions, but the U.S. Department of Labor reports that salaries for professional workers in the insurance industry are generally comparable to those for similar positions in other industries. In addition, insurance companies tend to offer attractive employee benefits.

Another important factor to most employees is the industry's stability. Insurance buyers regard insurance as a necessity even during periods of economic recession, and to a large measure the insurance industry is immune to the up-and-down fluctuations in the economy.

Opportunities in the Risk Management Field

The risk management field is also a growing area of opportunity. Best corporate governance practices now demand that boards of directors and management regularly assess their company's risks and manage them effectively. Many regulators now require that regulated entities proactively manage risk. Even where not required by law, the management of risks is now recognized as a critical part of the management of a business. Health care organizations, utilities, banks, and insurance companies are examples of organizations that emphasize risk management.

Risk managers must have a wide range of skills and understand the industry in which they are operating. For that reason, risk management positions are sometimes difficult for the new college graduate to obtain. Many companies seeking to fill staff risk management positions prefer to hire seasoned and experience personnel, often from the insurance industry itself. Although occasionally the risk management department of a large corporation will hire a trainee, these positions, like those in independent agencies, must generally be sought out by the applicant.

CONCLUDING OBSERVATION

The field of insurance continues to be an exciting one. It constantly faces new problems and challenges, somehow coping with each and surviving to go on to meet new problems. The changing nature of the industry makes it all the more attractive as a field of endeavor. Few industries hold out the opportunity and excitement of a career in insurance today. Besides the challenging and rewarding work itself, the industry also offers many of the intangible factors that young men and women are seeking: the opportunity to render a worthwhile service to society, a socially useful career with high prestige, and greater-than-average personal rewards.

IMPORTANT CONCEPTS TO REMEMBER

navigators

partial annuitization

Qualified Longevity Annuity Contract

General Agreement on Trade in Services

European Insurance and Occupational Pension Authority

Financial Stability Board

NARAB II

Long-term flood insurance contract

QUESTIONS FOR REVIEW

1. Explain the problems facing the Social Security system, Medicare, and health insurance in the future. In what ways are the problems related?

2. Describe the reasons for concern about the adequacy of retirement savings, and identify possible solutions.

3. Identify and describe the factors that are contributing to the globalization of insurance.

4. Describe the basic framework for insurance regulation in the European Union and key elements of Solvency II.

5. Describe the activities underway in the United States and internationally to identify systemically important insurance groups.

6. Identify the arguments for and against the federal terrorism reinsurance program.

7. Identify the possible changes in federal tax law discussed in the chapter and explain how they would affect the demand for insurance.

8. What are the significant changes that may be expected in the regulation of insurance during the next decade?

9. Describe the issues that face the life and health insurance industry as a result of advances in genetic testing.

10. What is the impact of crime and fraud on the insurance industry?

QUESTIONS FOR DISCUSSION

1. Which of the factors discussed in this chapter do you personally believe will have the greatest impact on the insurance industry during the next decade?

2. One of the chronic problems facing the industry is the lack of consumer sophistication and the misconceptions on the part of insurance buyers regarding the purpose of insurance. What, in your opinion, can the insurance industry do to remedy this problem?

3. Do you think that there is a solution to the conflict between “capital's need for an adequate return and the public's entitlement to the security of the insurance product”? Should insurance companies be permitted to refuse to write those lines of insurance that are unprofitable?

4. What do you think of the employment outlook in the insurance industry? Do you think that it will be better, about the same, or worse than the situation in other fields?

5. What do you think is the most important principle you have learned in this course? Why?

SUGGESTIONS FOR ADDITIONAL READING

Brockmeier, Warren G., ed. The Impact of Consumer Activism on the Insurance Industry. Malvern, Pa.: Society of CPCU, 1991.

Cooper, Robert W. “Spitzer's Allegations of the Anticompetitive Effects of Contingent Commissions: A Shot Truly Heard Around the World.” Journal of Insurance Regulation, Fall 2007.

Cummins, J. D., Neil Doherty, Gerald Ray, and Terri Vaughan. “The Insurance Brokerage Industry Post-October 2004.” Risk Management and Insurance Review 9(2), 2006.

Dixon, Lloyd, et al. The Federal Role in Terrorism Insurance Evaluating Alternatives in an Uncertain World (Santa Monica, Ca.: Rand Corporation, 2007).

Guy Carpenter, Inc. Nanotechnology: The Plastics of the 21st Century? New York: Guy Carpenter, 2006.

Hett, Annabelle. Swiss Re on Risk: Nanotechnology. Swiss Reinsurance America Corporation, 2004.

Kunreuther, Howard C., Mark V. Pauly, and Stacey McMorrow. Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry. Cambridge University Press, 2012).

Kwon, W. Jean. Human Capital and Talent Management Issues in the Insurance Market: Public Policy, Industry and Collegiate Education Perspectives. International Insurance Society, 2013.

Lewis, Angelo John. “New Trends in Cat Bonds.” Best's Review, August 2013.

Wharton Risk Management and Decision Processes Center. Managing Large-Scale Risks in a New Era of Catastrophes, October 2007).

WEB SITES TO EXPLORE

Bureau of Labor Statistics. Insurance Carriers and Related Activities.	http://www.bls.gov/iag/tgs/iag524.htm
Coalition Against Insurance Fraud	www.insurancefraud.org
Financial Stability Board	www.financialstabilityboard.org
European Insurance and Occupational Pensions Authority	eiopa.europa.eu
European Commission—Solvency II	ec.europa.eu/internal_market/insurance/solvency
Insurance Information Institute	www.iii.org
International Association of Insurance Supervisors	www.iaisweb.org
National Association of Insurance Commissioners	www.naic.org
National Insurance Crime Bureau	www.nicb.com

¹2013 Medicare Trustees' Report. This makes the questionable assumption that Congress will allow a significant cut to physician compensation (over 30 percent) to take effect in 2014. When faced with similar cuts in prior years, Congress has always enacted a “doc fix” to prevent the cut from taking place. Thus, the real problem is likely much worse.

²U.S. Government Accountability Office, Patient Protection and Affordable Care Act: Status of CMS Efforts to Establish Federally Facilitated Health Insurance Exchanges (GAO-13-601), Jun 19, 2013.

³Helman, Ruth, et.al., The 2013 Retirement Confidence Survey: Perceived Savings Needs Outpace Reality for Many. Employee Benefit Research Institute Issue Brief, March 2013.

⁴John, David C., J. Mark Iwry, Lina Walker, and William G. Gale. Increasing Annuitization of 401(k) Plans with Automatic Trial Income. The Hamilton Project Policy Brief No. 2008-02, June 2008.

⁵Insurance Information Institute, 2013 Insurance Fact Book.

⁶Ibid.

⁷In 2013, Sun Life of Canada sold its U.S life and annuity business, Aviva (a UK insurance group) sold its U.S. operations, and Generali (an Italian group) sold its U.S. life reinsurance operations. AXA (a French insurance group) transferred a block of its U.S. life business to Protective Life. ING, a Dutch firm, sold its U.S. group reinsurance business in 2010 and spun off its remaining insurance operations in an IPO in 2013. The new company is named Voya Financial.

⁸In 2013, the International Association of Insurance Commissioners was studying the use of branches by international insurance groups and their regulation. See International Association of Insurance Supervisors, Draft Issues Paper on Supervision of Cross-Border Operations Through Branches, July 2013.

⁹The second phase of the EU occurred in January 1999, when it became the European Monetary Union (EMU) and the participating countries began to adopt a common monetary unit, the euro. The euro has been adopted by 13 EU member states.

¹⁰Reinsurance Association of America. Offshore Reinsurance in the U.S. Market, 2011 Data.

¹¹Qualified reinsurance transfers an adequate amount of underwriting and timing risk, and it is only those contracts for which a ceding insurer may reduce its loss reserve. If the reinsurance is not qualified, the ceding insurer must use deposit accounting.

¹²ComFrame is the outgrowth of a 2007 effort to develop an international capital standard for insurers. After some IAIS members objected, calling for more study before the decision was made and a greater focus on supervision of IAIGs, the IAIS transformed the capital standards project into ComFrame. See, e.g., Common Structure Paper for Assessment of Insurer Solvency, March 7, 2007, and related papers.

¹³The nine insurers are Allianz, AIG, Assicuranzioni Generali, Aviva, Axa, MetLife, Ping An Insurance Company of China, Prudential Financial (US), and Prudential (UK). The list will be updated each year in November.

¹⁴In July 2013, the GAO released a report concluding the effects of the financial crisis on insurers and policyholders were generally limited and actions by state and federal regulators and the NAIC helped limit the effects of the crisis. See. U.S. GAO, Insurance Markets: Impacts of and Regulatory Response to the 2007-2009 Financial Crisis (GAO-13-583), June 2013.

¹⁵It is worth noting that the process of group supervision is somewhat more complicated in the U.S. than in other countries. Some countries have integrated supervisors, where a single agency is responsible for supervising banking, insurance, and securities firms. In the U.S., there are multiple agencies that remain responsible for regulating each of the regulated legal entities.

¹⁶The Senate bill, titled the Insurance Industry Competition Act of 2007, was introduced by Senators Patrick Leahy, D-VT; Arlen Specter, R-PA; Senate Majority Leader Harry Reid, D-NV; Mary Landrieu, D-LA; and Trent Lott, R-MS.

¹⁷The insurance industry cites examples in the banking and securities sector, where the courts have a history of deferring to federal regulators when there is conflict between antitrust law and regulation.

¹⁸The NAIC supports the Senate version of the bill, the National Association of Registered Agents and Brokers Reform Act of 2013 (S. 534).

¹⁹Swiss Re, Natural Catastrophes and Man-Made Disasters in 2012, Swiss Re Sigma 2/2013, March 2013.

²⁰Climate change implications go beyond hurricanes and floods. Other issues include an increased possibility for “brownouts”, increased mortality from heat waves, increases in forest fires, and increased respiratory and asthmatic problems.

²¹An earlier California state-operated earthquake insurance program, created in 1990, was repealed effective January 1, 1993, shortly before the massive Northridge quake of 1994.

²²A July 28 New York Times headline is an example of the tone in press reports: “Outrage as Homeowners Prepare for Substantially Higher Flood Insurance Rates.” Louisiana's congressional delegation called for the increases to be delayed at least a year to give time to rewrite the law and focus on affordability of flood insurance premiums. FEMA Associate Administrator David Miller told Louisiana: “(T)hese huge increases in insurance may reflect risk, but in doing that, what does it do to property values, the structure of community, to current and future homeowners? That's part of our affordability discussion.” Schleifstein, Mark. “Southeast Louisiana Officials Urge FEMA to halt flood insurance Rate Increase,” Times-Picayune, Aug. 8, 2013.

²³Kunreuther, Howard and Erwann Michel-Kerjan. Encouraging Adaptation to Climate Change: Long-Term Flood Insurance. Resources for the Future Issue Brief 09-13, Dec. 2009.

²⁴Class-action lawsuits have been subject to particularly strong criticism. In 2006, prosecutors charged Milberg Weiss, the leading class-action law firm, with paying kickbacks to clients who agreed to act as plaintiffs. In connection with the case, William Lerach, a leading attorney specializing in securities class actions who formerly worked at Milberg Weiss, pleaded guilty in 2007, agreeing to a prison term and an $8 million fine.

²⁵In 2007, critics of the tort system pointed to the case of Roy Pearson, a DC administrative law judge, who sued the owners of a Washington, DC, dry cleaner that had lost his pants. Pearson sought $67 million from the owners, including amounts for emotional damages, legal fees, costs to use a different dry cleaner, and penalties for violating Washington's consumer protection law ($1500 per day per violation). Although the judge ruled against Mr. Pearson, the cleaner's owners incurred more than $100,000 in legal expenses.

²⁶A 2012 paper by Martin Grace and J. Tyler Leverty examined the effects of reforms that were eventually declared unconstitutional (temporary) and those that were unchallenged or upheld (permanent). The concluded permanent tort reforms lower medical malpractice insurance losses and premiums and increase insurer profitability, in contrast to temporary reforms. See Grace, Martn F. and J. Tyler Leverty, “How Tort ReformAffects Insurance Markets.” Journal of Law, Economics, and Organization, 2012.

²⁷Specifically, the Panel recommended consolidating the numerous tax-qualified savings vehicles into two plans: Save at Work plans and Save for Retirement accounts. Life insurance would retain its tax deferral within those plans, but the tax deferral would be eliminated for other life insurance policies, significantly reducing the tax advantages of life insurance. Not surprisingly, this provision was aggressively opposed by the life insurance industry. The panel also recommended capping the tax advantage given to employer-provided health insurance and extending those same advantages to all taxpayers, including those purchasing insurance individually.

²⁸In May 2013, the Senate Finance Committee released an excellent summary of the various proposals that had been made to modify the tax codes in areas affecting economic security (e.g., retirement savings, health insurance, life and annuities). See www.finance.senate.gov/issue/?id=2135a2c34-707e-4468-8088-c34b8b63.

²⁹According to a report by Swiss reinsurance, of the $10.6 billion in catastrophe losses incurred by the insurance industry in the United States in 2000, nearly one-fourth resulted from a single human-caused event—the “I love you” computer virus.

³⁰Romero, Joshua J. “The Lessons of Thailand's Flood: The hard drive industry shows that responding to disasters can be more important than preventing them” IEE Spectrum, Nov. 1, 2012.

³¹See, e.g, Allianz Global Corporate and Specialty. Managing Disruptions: Supply Chain Risk, An Insurer's Perspective, Nov. 2012. Available at: www.agcs.allianz.com/assets/PDFs/white%20papers/AGCS%20Managing%20disruptions%20Nov2012.pdf.

³²The Australia Securities and Investment Commission and the European Commission each conducted investigations. For an analysis of their findings, see Cooper, Robert W. “Spitzer's Allegations of the Anticompetitive Effects of Contingent Commissions: A Shot Truly Heard Around the World.” Journal of Insurance Regulation, Fall 2007.

³³Kenealy, Bill. “New York's MTA buys $200 million cat bond to avoid storm surge losses.” Business Insurance, August 11, 2013.

³⁴Interestingly, FBI statistics show that arson and other property crimes have been dropping for the past 10 years, as have violent crimes such as murder. The reasons are unclear. Explanations have included demographic changes, improved law enforcement practices, a drop in illegal drug use, decreases in lead poisoning, availability of legal abortion, and a shift to other areas of crime such as identity fraud.

³⁵Although insurers rightfully deny payment to arsonists when arson can be proved, the provisions of property policies related to mortgagees that we discussed in Chapter 24 allow the mortgagee or other lender to collect for a loss even when it is established that the owner torched the property. In addition, a NAIC model law aimed at preventing discrimination against domestic abuse victims requires an insurers to pay claims to an innocent abuse victim for intentional property damage caused by a third party, even when that party was a coinsured under the homeowners policy.

³⁶See, e.g., Thaler, Richard H and Cass R. Sunstein. Nudge: Improving Decisions About Health, Wealth, and Happiness. Penguin Books, 2009.

³⁷Larger property and liability insurers have their own staff of actuaries, whereas smaller companies usually use actuarial consultants.