The Regulation of Insurance, 1st ed

The Regulation of Insurance

The Regulation of Insurance Justin L. Brady, CPCU Vice President & Manager Government and Industry Services Factory Mutual Service Bureau

Joyce Hall Mellinger, JD, CPCU, CLU, ChFC, AFSB Vice President and Associate General Counsel The Maryland Insurance Group

Kenneth N. Scoles, Jr., Ph.D. Assistant Director of Curriculum Insurance Institute of America Coordinating Author

Karen L. Hamilton, Ph.D., CPCU

E

TITUTE O INS F

HAEC STUDIA ADOLESCENTIAM ALUNT

ERICA AM

INSURANC

Director of Curriculum Insurance Institute of America

1924

First Edition • 1995 Insurance Institute of America 720 Providence Road, Malvern, Pennsylvania 19355-0770

© 1995 Insurance Institute of America All rights reserved. This book or any part thereof may not be reproduced without the written permission of the publisher. First Edition • July 1995 Library of Congress Catalog Number 95-77159 International Standard Book Number 0-89462-092-4

Printed in the United States of America on recycled paper.

Foreword The American Institute for Chartered Property Casualty Underwriters and the Insurance Institute of America are independent, nonprofit, educational organizations serving the needs of the property and liability insurance business. The Institutes develop a wide range of programs—curricula, study materials, and examinations—in response to the educational requirements of various elements of the business. The American Institute confers the Chartered Property Casualty Underwriter (CPCU®) professional designation on those who meet the Institute’s experience, ethics, and examination requirements. The Insurance Institute of America offers associate designations and certificate programs in the following technical and managerial disciplines: Accredited Adviser in Insurance (AAI®) Associate in Claims (AIC) Associate in Underwriting (AU) Associate in Risk Management (ARM) Associate in Loss Control Management (ALCM®) Associate in Premium Auditing (APA®) Associate in Management (AIM) Associate in Research and Planning (ARP®) Associate in Insurance Accounting and Finance (AIAF) Associate in Automation Management (AAM®) Associate in Marine Insurance Management (AMIM®) Associate in Reinsurance (ARe) Associate in Fidelity and Surety Bonding (AFSB) Associate in Insurance Services (AIS) Certificate in General Insurance Certificate in Insurance Regulation v

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Foreword Certificate in Supervisory Management Certificate in Introduction to Underwriting Certificate in Introduction to Claims Certificate in Introduction to Property and Liability Insurance Certificate in Business Writing The Institutes began publishing textbooks in 1976 to help students meet the national examination standards. Since that time, we have produced more than seventy-five individual textbook volumes. Despite the vast differences in the subjects and purposes of these volumes, they all have much in common. First, each book is specifically designed to increase knowledge and develop skills that can improve job performance and help students achieve the educational objectives of the course for which it is assigned. Second, all of the manuscripts of our texts are widely reviewed before publication, by both insurance business practitioners and members of the academic community. In addition, all of our texts and course guides reflect the work of Institute staff members. These writing or editing duties are seen as an integral part of their professional responsibilities, and no one earns a royalty based on the sale of our texts. We have proceeded in this way to avoid even the appearance of any conflict of interests. Finally, the revisions of our texts often incorporate improvements suggested by students and course leaders. We welcome criticisms of and suggestions for improving our publications. It is only with such constructive comments that we can hope to improve the quality of our study materials. Please direct any comments you may have on this text to the Curriculum Department of the Institutes. Norman A. Baglini, Ph.D., CPCU, CLU President and Chief Executive Officer

Preface Many insurance professionals deal with insurance regulation, either through its constraints on and requirements for their own positions or in helping their employers to better understand and deal with regulatory intervention. The Insurance Institute of America designed IR 201, Insurance Regulation, to provide students with valuable information that will help them on a professional level. It can be a stand-alone course, for which students receive a certificate of completion when they pass the national examination. In addition, IR 201 satisfies the CPCU 10/Related Studies requirement for the CPCU program. The Regulation of Insurance, one of the texts used for the IR 201 curriculum, provides an overview of the entire system of insurance regulation. It introduces students to the principles of regulation and describes how insurance regulation fits into regulation theory. The evolution of insurance regulation, with an emphasis on the trends in its history, is discussed. The various components of the system of insurance regulation are also described, from state insurance departments and state legislatures to federal intervention and the roles of such groups as industry trade associations, regulatory professional associations, and consumer groups. Many reviewers contributed a substantial amount of time and effort to develop a text that is accurate, up-to-date, and readable. The following reviewers’ constructive comments and suggestions are greatly appreciated: Gordon C. Amini Senior Vice President and General Counsel C.L. Frates & Company

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Preface Kevin T. Cronin Washington Counsel Director of Government and International Relations National Association of Insurance Commissioners Robert J. Gibbons, Ph.D., CPCU, CLU Jerome B. Haddox, CPCU, CLU Attorney at Law and Principal—Insurance Management Advisors Rick Hammond, JD, CLU Attorney Chuhak & Tecson, P.C. Donald W. Hardigree, Ph.D. NIEF Chair of Insurance Director, IIRM University of Nevada, Las Vegas Robert W. Klein, Ph.D. Director of Research National Association of Insurance Commissioners Keith E. Langan, JD, CPCU Assistant Vice President and Assistant General Counsel Fireman’s Fund Insurance Company Claude C. Lilly, III, Ph.D., CPCU, CLU The Joseph F. Freeman Distinguished Professor of Risk Management and Insurance Appalachian State University Kay Maluegge, CPCU, ASF Director—Personal Lines Church Mutual Insurance Company Raymond E. Rathert Janet L. Shemanske Assistant Vice President Government & Industry Relations Great Divide Insurance Company David B. Simmons Executive Vice President National Association of Insurance Commissioners

Preface

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Richard W. Simpson, CPCU Black, Davis & Shue, Inc. Michael S. Smith, CPCU, ARM, AIAF Senior Insurance Services Specialist GROWMARK, Inc. David Taylor, CPCU President Business and Regulatory Insurance Consultants, Inc. Barbara Wintrup, JD, CPCU Corporate Counsel EQE Earthquake Insurance Group, Inc. Sue Zeider, CPCU, CLU, ChFC, AIC, SCLA, CPIW Claims Customer Relations and Legislation Manager Farmers Insurance Group Special thanks go to Norman A. Baglini, President and Chief Executive Officer, Insurance Institute of America; Michael W. Elliott, Assistant Vice President, Insurance Institute of America; Warren Hope, Vice President, Insurance Institute of America; Christine L. Lewis, Vice President—Curriculum, Insurance Institute of America; James J. Markham, Vice President—Personnel, Insurance Institute of America; Karen K. Porter, Assistant Director of Curriculum, Insurance Institute of America; and Lowell S. Young, Director of Curriculum, Insurance Institute of America, for their useful suggestions and assistance. Special thanks also go the Executive Committee for the Regulatory and Legislative Section of the CPCU Society, the National Association of Insurance Commissioners staff, and members of the Society of State Filers. The text has benefited from their interest, support, and guidance. Our goal is to help develop an understanding of insurance regulation that will sufficiently prepare students for the future. In order to reach this goal, we must pay close attention to reader responses. Your comments regarding this text are welcome and extremely valuable. In preparation for the next edition, we need any suggestions or advice you might offer. Please write or call the Curriculum Department of the Insurance Institute of America to give your input. Justin L. Brady Joyce Hall Mellinger Kenneth N. Scoles, Jr.

Contents 1 2

Introduction to Regulation

1

Principles of Regulation

2

Theories of Regulation

17

Justification for Regulation

27

Summary

29

The Evolution of Insurance Regulation

4

State Legislatures as Insurance Regulators NAIC Summary

5

33

Developments Before the SouthEastern Underwriters Association Decision 34

101 101 110 130

The Federal Government’s Role in Insurance Regulation 133 The Usual Allocation of Powers Between State and Federal Governments

The South-Eastern Underwriters Association Decision and the McCarran-Ferguson Act 43

3

The Influence of State Legislatures and the NAIC

134

The Era Since McCarran

49

Recurring Issues in Insurance Regulation

The Allocation of Insurance Regulation Between State and Federal Governments 134

53

Summary

57

Federal Intervention in the “Business of Insurance”

141

Federal Regulation of the Insurance Industry

144

Summary

154

An Overview of State Insurance Departments The Insurance Commissioner Regulatory Departments and Functions

63

6

64

The Influence of the Courts Influence of the Insurance Industry Consumer Groups Other Interest Groups Summary

74

Regulatory Communications

86

Regulatory Funding

89

Regulatory Budgeting

91

Regulatory Hiring

92

Regulatory Commissions

93

Summary

97

The Role of Others in Insurance Regulation 159

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159 163 167 172 177

Bibliography

181

Index

185

Chapter 1

Introduction to Regulation Regulation is a mechanism for controlling the behavior of individuals and business entities. As a producer of services and a consumer of resources, it is also subject to supply and demand forces like any other market participant. Operating in this dual capacity, regulation assumes the traits of both an economic and a political process. Insurance regulation is the mechanism used to control the behavior of participants in the insurance industry. The system of insurance regulation, however, is not limited to state insurance departments and the National Association of Insurance Commissioners (NAIC). It also encompasses the courts, state legislatures and Congress, the executive branch of state and federal governments, the insurance industry, and other interested parties, such as consumers. Each of these groups directly or indirectly affects, with the state insurance departments and the NAIC, the behavior of participants in the insurance industry. In this chapter, a structural definition of regulation is developed and a broad understanding of the subject is achieved by examining regulation as a system integral to the market. However, because the definition and system of regulation are influenced by markets and their characteristics, a basic understanding of market structures, how they operate, and why they might fail will be discussed. This chapter then analyzes how regulation operates by considering several economic and political viewpoints. The chapter closes by returning to the justification for regulation. In covering each topic, the general subject

1

2 The Regulation of Insurance matter is first introduced and then it is applied to insurance markets and insurance regulation, usually by examples.

Principles of Regulation To fully understand the different views of insurance regulation, it is necessary to look first at regulation as it applies to any industry. The following quotation describes the scope of regulation and how it affects individuals and businesses participating in a market. [A]ll markets and transactions are in practice regulated by some kind of government laws or regulations, and without regulations of any kind, most markets and types of transaction would cease to exist. Without laws, the terms of many types of agreement and transaction between individuals would be unenforceable and would cease. The choice facing individuals and society is not between regulation and no regulation; it is how much regulation and what kinds of regulation are desirable.1

This description portrays regulation as fully encompassing the systems of government and law with the power to control all markets and transactions. Economists and politicians would typically take a much narrower view of regulation, concentrating more on the targets of regulatory action or the regulatory process itself. An economist, focusing on the target of regulatory action, might describe regulation as government policy that exerts control over a firm to elicit a desired behavior as a producer of goods or employer of labor.2 An economist or politician focusing on the regulatory process, however, might express a view similar to the following: Through regulation, society attempts to substitute the decision-making process of a regulatory commission for the actions of the market mechanism. . . . It is clear that the “process” of regulation is to substitute administrative judgment for market-place judgment. In effect, an economic environment of legal rules and regulations is used as a surrogate for the free market, and economic decisions are made by a political process.3

The above description portrays regulation as a political process, substituting administrative judgment for marketplace judgment. The description identifies the important interaction between regulation and the market and raises an important issue: When, if at all, should marketplace judgment be replaced with administrative judgment? Various answers to this question have been proposed. Of primary importance is the market being considered. Different markets require different amounts and types of regulation. The answers to the above question also depend on the

Chapter 1 / Introduction to Regulation 3 view of regulation and the definition of regulation supported by the person answering the question. Thus, to better understand the issues involved in regulation, the basic principles of market structure must be understood and a working definition of regulation must be developed.

Principles of Market Structure A market is an environment in which buyers and sellers interact. It does not have any particular physical characteristics—that is, a market could exist in a store, on a street corner, or over a television channel. However, a market does have certain features that must be met to varying degrees: • •

•

•

Sellers have ownership rights to the goods or services that they are willing to transfer to buyers who offer or are willing to pay sellers’ asking prices. The monetary unit has a stable and predictable amount of purchasing power associated with it that both buyers and sellers are aware of and agree on. In the United States, the dollar is an efficient monetary unit. Buyers and sellers choose freely to buy and sell the products and services available. This freedom allows the products and services to be allocated to those who want them by those who want to sell them. Neither sellers nor buyers unduly control market prices. Competitive market prices equal the costs of producing products and services, and they provide competitive returns to investors in the production process. Sellers cannot inflate their asking prices to increase their profits if buyers can find the same products or services at lower competitive market prices from other sellers. And, buyers cannot force sellers to lower prices to below competitive market-price levels. The prices for products and services are determined by the supply and demand in the market.4

Consider the insurance market, in which buyers and sellers of insurance interact. Insurance companies have ownership rights to the policies they sell to insureds. Once insureds purchase policies, they have rights to the promises made within the policies, subject to the conditions within the policies. To bind coverage, insureds pay premiums as required by the insurers, and in the United States, the premiums are expressed in dollars. In many cases, the selling and purchasing of insurance is voluntary. However, this is not always the case, because some types of insurance are mandatory—such as personal auto liability insurance in most states. Finally, insurance sellers and insurance buyers generally do not directly control the prices of insurance products and services. Prices reflect the costs associated with insuring losses (such as the amount to repair or replace damaged property), the willingness of insurers to cover those losses (that is, the supply of coverage), and the number of people and entities desiring coverage (that is, the demand for coverage).

4 The Regulation of Insurance

Competitive Markets An ideal market is characterized by perfect competition. Under perfect competition (if a perfectly competitive market existed) each of the following conditions would be met: •

•

•

•

Large number of buyers and sellers. With a large number of buyers and sellers, no single seller or buyer or small group of sellers or buyers can control the prices of products and services in the market. The prices are solely determined by supply and demand. Homogeneous products and services. When all the products or all the services are similar, buyers do not show brand loyalty. Under these circumstances, buyers purchase the products or services having the lowest prices. Perfect information. All buyers and sellers have all the information about a market’s products and services and about other market participants. Sellers cannot limit buyers’ access to information to increase the competitive market price; likewise, buyers cannot limit sellers’ access to information to decrease the competitive market price. Free entry into and exit from the market. Buyers and sellers can easily enter and exit the market. And, because competitors can easily enter the market when prices are above the competitive market price to sell their own products or services at the lower competitive market price, sellers cannot sustain their prices above the competitive market price. Likewise, buyers who are not willing to pay the market prices can leave the market and buyers who are willing to pay can enter the market.

Noncompetitive Markets and Market Failure Most markets, however, are not perfectly competitive. Imperfect competition and market failure are prevalent.

Imperfect Competition Imperfect competition arises when sellers have the ability to charge more for their products and services than the costs to produce those products and services, including a competitive return—that is, sellers have market power. In a perfect market, sellers do not have market power, because competitors can easily enter the market and charge the lower, competitive market price, eventually removing the sellers’ ability to earn excess profits. In an imperfectly competitive market, competitors are unable to do this for the following reasons: •

Few sellers. When few sellers are in the market, the sellers are more likely to cooperate with each other and to set prices at levels above the competi-

Chapter 1 / Introduction to Regulation 5 tive market price. Since all sellers act in concert or agree to set prices at these higher levels, buyers will not find a lower price elsewhere and will have to make their purchases at the inflated prices. •

Nonhomogeneous products and services. If products and services are different or are perceived to be different, buyers can develop brand loyalty. Thus, buyers will base their decisions not only on price but also on quality— whether the difference is perceived or real.

•

Imperfect information. When buyers have perfect information, they can make fully-informed decisions. However, if sellers keep buyers from obtaining information about items such as production cost and availability, the sellers can inflate their prices because they have controlled the buyers’ knowledge. Thus, buyers would be induced to pay more than the competitive market prices for the products and services. For insurance, imperfect information can come from the buyers. When insureds do not reveal information that materially increases their risks, insurers do not charge the correct, higher premiums to those insureds. This is referred to as adverse selection.

•

Barriers to market entry or exit. In some cases, competitors cannot easily enter the market because the costs to do so are too great. This barrier is often the result of regulatory limits placed on sellers when entering or operating within the market. For example, to operate in a state, prospective insurers must furnish proof of capital and surplus at or above that state’s minimum requirements. If an insurer cannot satisfy those requirements, it cannot become a licensed insurer in that state. In other cases, market participants cannot readily exit the market because of obligations or costs that must be met before exiting. For example, insurance companies cannot simply stop writing insurance and cease to operate because of the possibility that future claims will occur under coverage provided by policies already written. Insurers must post a bond that guarantees they will cover future losses or insurers must transfer their exposure to other insurers that will continue to operate.

•

Existence of a natural monopoly. In some cases, a single firm can produce a product or service at a lower cost than two or more firms—a natural monopoly. A natural monopoly often occurs when the efficiency of one firm’s equipment to generate the product or service is so great that that firm supplies the entire market and prevents competitors from entering the market. Furthermore, the existing firm can cover its costs at a price that buyers are willing to pay. For example, electric utilities were once considered natural monopolies. The cost of duplicating power-generating and delivery systems prohibited competition from entering the electric

6 The Regulation of Insurance utility market. However, some large companies can now generate and deliver electricity. •

Higher transportation, transaction, and information costs. The costs to transport products from their place of manufacture to their place of distribution can increase a seller’s costs so that no profits can be made at the market price; thus, the seller must exit the market. Transaction and information costs can also be so great that sellers cannot provide their products and services at the market price and cannot continue to earn a profit in the long run. These sellers cannot effectively compete and therefore exit the market. Generally, sellers who are closer to the distribution area and have lower transportation, transaction, and information costs have greater market power.

The insurance market is generally characterized by imperfect competition. Products and services can be differentiated. For example, purchasing decisions are often based on factors other than cost, such as the willingness of an insurer or an agent or broker to work with the potential insured to meet insurance needs or the dependability of the insurer in paying claims. Information is not perfect. Consumers often do not understand their insurance policies and, in some cases, insurers are not aware of the real level of an insured’s risk. Barriers to entry can keep potential insurers from entering a state or a market.

Market Failure When a market fails to allocate resources efficiently, market failure occurs. In some situations, market failure means that buyers cannot purchase as much of particular products and services as they would like at a given price, and in other cases, it means that sellers cannot sell as much of their products and services as they would like at a given price. Market failure can result from imperfect competition. Market failure can also occur because of externalities—costs and benefits of products and services that are transferred to people who are not involved in buy-sell transactions. Furthermore, social benefits and social costs are often not considered. For example, when a family maintains its residential property—by regularly mowing the lawn and painting the house—the entire neighborhood benefits, not just the family. The neighborhood might not have shared in the decision to maintain the property and did not incur the maintenance costs, but the neighborhood’s value is enhanced by the well-kept property of the individual neighborhood members. While the above example is a positive externality, negative externalities can also occur. For example, if a company decides to cease operations for economic reasons, both the company and the community can suffer. The community

Chapter 1 / Introduction to Regulation 7 might be faced with an empty and poorly maintained corporate facility, a lower tax base, and an increase in unemployment. The community did not participate in the company’s decision, but the community can suffer a loss that the company might not have considered in its decision to close. Externalities cause the allocation of resources to be different from what is socially efficient. If buyers do not receive all of the benefits—including the social benefits—of their purchases, they will not be as willing to make their purchases. If sellers do not receive all of the benefits—including the social benefits—of their sales, they will not be as willing to sell their products and services. In addition, if sellers do not recognize all of the costs involved— including the social costs—in their decisions, they will be willing to sell more than they otherwise would and, since prices would be lower than the true costs, buyers would be more willing to make purchases. In addition, buyers’ and sellers’ decisions can be privately efficient while being socially inefficient, as indicated in the company example above. The insurance market is characterized by externalities, including the following examples: •

•

The availability of social insurance and social programs. In some cases, the true costs of activities are not realized because social insurance or other social programs that pay part or all of the costs of the decision are available. For example, many high-risk drivers continue to drive because they can obtain insurance through state-mandated auto insurance pools or similar shared-market mechanisms. The true cost of allowing these drivers to continue driving is borne not solely by these drivers, but by all insured drivers. Classification plans. Private insurance is based on individual equity—each insured pays for the amount of risk he or she represents to the insurer. However, true individual equity is generally not achieved. Insurers usually cannot predict the losses of one insured; insurers group insureds into classes of similar risks based on certain socially acceptable characteristics. Insureds are then charged the same rate based on the experience of the group. The better risks in the group help to pay the losses of the poor risks in the group—in other words, the better risks pay more than is individually equitable. In addition, some factors cannot be used to classify risks. For example, in some states, sex cannot be used as a rating factor for auto insurance. Historically, women have had lower auto-related loss experience than men have had. In those states, however, men and women are charged the same rates. Thus, women pay more than individually equitable, and men pay less. (However, this inequity is gradually decreasing as

8 The Regulation of Insurance women represent an increasing percentage of the driving population and their auto-related loss experience continues to increase.)

Remedies for Imperfect Competition and Market Failure Because imperfect competition and market failure result in limited choices for consumers and in inefficient allocation of resources, remedies to these problems are needed. Markets can change and improve. Government intervention can also play a role. Each of these remedies is discussed below.

Changing and Improving the Market For a market to operate efficiently, all information about the costs and benefits of products and services, including the social costs and social benefits, must be incorporated into market prices in the appropriate market. This might require extending property ownership or internalizing costs and benefits. When property ownership is extended, ownership of public goods (items that are generally decreed to be property of the public, not of a particular individual or entity) is assigned to private parties. These parties then determine how to use their resources. However, some resources, such as an ocean or unenclosed air, which are considered communal resources, cannot be owned by a private entity. Internalizing costs and benefits can incorporate those social costs and social benefits in the prices for products and services. Incorporating those costs allows competitive markets to determine the market price, which considers all benefits and costs, through supply and demand. This might be the most viable option for communal resources. For example, an acceptable level of pollution could be determined, and a tax could be levied that promotes production levels that limit pollution to acceptable levels. In addition, positive externalities, such as education, can be subsidized and, thus, encouraged. The insurance market can be changed and improved to address the problems of imperfect competition and other market failures. For example, one of the problems in the insurance market is the lack of understanding consumers have about insurance. A way to change this and improve the market is to educate consumers about insurance products and services.

Government Intervention in the Market Sometimes markets cannot be changed or improved to permit workable competition (while perfect competition is the ideal, it is generally not possible). Thus, government becomes involved in regulating the market. For example, the government might impose a price restriction above which sellers cannot sell. The restriction is typically set at a level that the government perceives to be the competitive market price. For example, the Social Security

Chapter 1 / Introduction to Regulation 9 Administration sets the maximum amount of coverage for Medicare at a specified level of usual, customary, and reasonable costs for each covered treatment. State insurance departments also reject rate increases deemed to be excessive. The government might also impose or remove barriers to market entry. For example, tariffs on imported goods help domestic manufacturers by increasing the price of foreign goods. Removing the tariffs makes the domestic market more competitive. For the insurance market, government can establish financial standards for alien insurers (insurers domiciled in other countries) to meet in order to be admitted into the United States. Government intervention can take many forms, including regulation. Insurance regulation can be used for the following reasons (among others): •

•

•

•

To control price and type of product. State insurance regulators generally review rates and policy forms to ensure that rates are fair, adequate, and not excessive and that policies are beneficial to consumers and insurers. To prohibit certain activities by sellers. For example, the Sherman Act prohibits insurers from using boycott, coercion, and intimidation when selling insurance. To improve access to information. For example, the National Association of Insurance Commissioners (NAIC) and many state insurance departments make consumer information brochures available primarily to individual consumers and small business owners. The brochures provide information on policy types and characteristics and tips on how to find the insurance coverages that best meet the consumers’ needs. To create barriers to market entry or exit. For example, state insurance regulators require that insurance agents pass licensing examinations to prove that they are knowledgeable about their products and services. Insurance agents cannot sell insurance without licenses.

Since regulation is the focus of this chapter, the remaining discussion here concentrates on developing a working definition of regulation and on examining different views that exist about regulation.

Defining Regulation Regulation is one of the means by which government attempts to improve market efficiency. However, many different theories and views of regulation exist. This diversity of opinion about regulation makes it difficult to develop a commonly accepted definition. Several different definitions of regulation are provided in Exhibit 1-1.

10 The Regulation of Insurance

Exhibit 1-1 Different Definitions of Regulation Regulation is. . . A. “. . .the intentional restriction of a subject’s choice of activity, by an entity not directly party to or involved in that activity.” B. “. . .the policing, with respect to a goal, of a subject’s choice of activity, by an entity not directly party to or involved in that activity.” C. “. . .the policing, with respect to a rule, of a subject’s choice of activity, by an entity not directly party to or involved in that activity.” D. “. . .the public administrative policing of a private activity with respect to a rule prescribed in the public interest.” The Political Economy of Regulation by Barry M. Mitnick, pp. 5-7. Copyright © 1980 by Columbia University Press. Reprinted with permission of the publisher.

The definitions are arranged in order, from most liberal to most strict. In definition A, regulation is “the intentional restriction” while in definition D, regulation is “the public administrative policing.” Definitions B and C define regulation only as “the policing.” Thus, under definition A, any intentional restriction, whether it occurs once or on a continual basis, can be regulation (subject to the remainder of the definition). Definitions B, C, and D require policing, which implies continual oversight. Definition D requires that the policing be done by public administrators. Thus, policing done by a private organization, such as a watchdog group, might be regulation under definitions B and C but would not be regulation under definition D. In definition A, the restriction is on a subject’s choice of activity, without qualification such as a goal or a rule as required under definitions B, C, and D. Definition D further qualifies that the rule be prescribed in the public interest. Definitions A, B, and C agree that the entity that is regulating not be directly involved in the activity being regulated nor be directly party to that activity. However, definition D requires that the activity be performed by a private entity. Thus, if a court determines that a particular activity performed by a municipal government is in violation of a particular rule, this would not be regulation as defined in definition D. However, it might be considered regulation under definitions A, B, or C. These definitions revolve around three issues:

Chapter 1 / Introduction to Regulation 11 1. Who or what is regulating: any entity or a public entity not involved in or party to the activity being regulated 2. Why regulation is occurring: any reason, for a goal, under a rule, under a rule in the public interest 3. Who or what is being regulated: any entity or a private entity Several characteristics have been identified that appear to be common among different views of regulation. Regulation implies control or some sort of restriction on activity. Regulation involves an entity that does not take part in the regulated activity—although the entity need not be a government or a governmental agency. Additionally, regulation has a purpose—to achieve a goal or to uphold a rule. However, those common characteristics do not seem adequate, considering the diversity of regulatory activity. Those characteristics portray regulation as a static and inflexible process without benefit of evaluative judgment. These latter characteristics are not typical of regulation. Regulation generally evolves as regulators seek to address new issues that arise regarding the activity being regulated or the environment in which the regulation occurs. Like the activities on which regulation is imposed, regulation adjusts to events, such as changes in the economy, new products and services in the market, and new technology. For example, improvements and innovation in computer technology and telecommunications have significantly affected insurance regulation. State insurance departments and the NAIC have established telecommunication and computer networks that allow rapid and immediate transferral of messages and information. This lets state insurance regulators deal more effectively and efficiently with such items as agent and broker licensing and continuing education requirements, financial examination scheduling and information transfer, and fraud detection.5 In addition, regulation might be modified or withdrawn if it does not produce the desired effect. In many cases, the outcome of particular regulation is not as expected, and more harm than good results. Thus, regulation is changed as necessary in order to achieve its goals. For example, when state insurance regulation was criticized in the 1980s for failing to prevent several large insurance company insolvencies, the NAIC established a plan to improve solvency regulation. To that end, the NAIC developed and implemented such programs as risk-based-capital and accreditation. Furthermore, regulation is usually not imposed lightly. Much thought goes into developing and implementing regulatory controls, whether they be goals, rules, or other controls (such as industry norms or court decisions).

12 The Regulation of Insurance Thus, a comprehensive definition of regulation should include mention of the following characteristics: •

Supervision and control of an activity by an entity not directly involved in the activity

•

Supervision and control of an activity for a purpose—either general or specific

•

Supervision and control that evolve with changes in the regulated activity or changes in the general environment and that correct for unintended consequences

•

Supervision and control that are developed in a thoughtful manner

Given these characteristics, the following provides the definition of regulation used in this text: The supervision and control of an activity for a well-developed purpose by an entity that is not directly involved in or party to the activity. The supervision, control, and purpose of regulation evolve as the activity and the environment change.

Thus, the definition of insurance regulation follows: The supervision and control of insurance and insurance-related activities for a well-developed purpose by an entity that is not directly involved in or party to insurance and insurance-related activities. The supervision, control, and purpose of insurance regulation evolve as insurance and insurance-related activities and the insurance and the general environments change.

A System of Regulation Regulation can be viewed as a system. It involves not only the specific regulatory agency but also state and federal governments and governmental agencies (other than the regulatory body), state and federal legislatures, the court system, firms in the regulated industry and other industries, consumers, and other interested parties. Exhibit 1-2 provides a diagram of a hypothetical regulatory system. Each of the entities identified in Exhibit 1-2 is involved in some way in regulation. The regulatory agency is the entity that is generally charged with the responsibility of regulating a designated activity. The agency’s function as a regulator is influenced directly or indirectly by the other entities shown in the exhibit. For example, the legislature passes the laws granting authority to the regulatory agency and specifying how regulatory activities will be fi-

Chapter 1 / Introduction to Regulation 13 nanced. The executive branch might determine who will be in charge of the regulation. Firms, whether within or outside the regulated industry, might influence how the regulatory agency regulates. Consumers and other interest groups might influence which activities are subject to the most regulatory emphasis. Exhibit 1-2 The Regulatory System

Courts

Legislature

Executive/Bureaus Justice/Commerce/Labor Other Regulatory

Regulatory Agency

Firms

Consumers

Other Interest Groups

= entities that control = entities that are controlled Shading = entities that could be viewed as part of the market The Political Economy of Regulation by Barry M. Mitnick, p. 35. Copyright © 1980 by Columbia University Press. Reprinted with permission of the publisher.

Consider how insurance regulation fits into this system. The primary regulatory agency is the state insurance department. It is given its regulatory authority by state and federal laws that are passed by state legislatures and Congress. The insurance commissioner and the insurance department are also subject to the influence of the state executive branch. The governor might appoint the commissioner and prescribe the method by which the department is managed. Insurance companies meet with insurance regulators to discuss the effect of regulation on the insurers’ operations. In addition, consumers and

14 The Regulation of Insurance insurance industry trade associations make their positions known to insurance commissioners through public hearings, direct contact or correspondence, and the media. The courts help to define the scope of insurance regulation through certain decisions, such as when the court upholds a regulatory action. In addition to influencing the regulatory agency, the entities identified can influence each other. For example, the legislature might be persuaded to pass a particular law if consumers, industry trade associations, or individual firms endorse such a bill. The court might directly regulate insurers, such as when the court changes its interpretation of particular policy wording. Earlier in this chapter, regulation was described as one of the ways government can intervene in markets. Further discussion revealed that regulation can be viewed as more than government intervention. It is a system of supervision and control by various entities of a particular activity for an identified purpose. Within this system, regulation can be promoted as a means of controlling and correcting those conditions perceived to cause failure in an otherwise competitive or efficient market. Also within this system, regulation can play a role as a market participant.

Regulation as a Controlling and Correcting Mechanism Typically when regulation is viewed as a controlling and correcting mechanism, the regulatory system described above and pictured in Exhibit 1-2 is divided into two groups: •

•

The entities that control, represented by ovals in the exhibit. The entities that control and change market results—in other words, the regulators— include not only the regulatory agency, but also the courts, the legislatures, and the executive and judicial branches of government. These are the entities that develop and implement the regulation that is designed to correct and control market imperfections such as market failure. The entities that are controlled, represented by rectangles in the exhibit. Those who are subject to the regulation—that is, the regulated—include firms within the regulated market and other markets, consumers, and other interest groups. These entities must abide by regulation implemented by the regulators.

In this view of regulation, referred to as an exogenous perspective, the regulators are considered entities that are independent from the market entities in terms of influences. In other words, the events that influence regulators do not necessarily influence the regulated, at least not in the same way. For example, when the governor of a state is newly elected, the executive branch of the government, including the state insurance department, is likely to feel the

Chapter 1 / Introduction to Regulation 15 political effects through changes in department heads and other personnel. Regarding the state insurance department, an insurance commissioner appointed by the newly elected governor’s predecessor is likely to be replaced with an insurance commissioner appointed by the new governor in those states where an insurance commissioner is appointed by the governor. In addition, the perspective of the executive branch might change—such as from a pro-business attitude to a pro-consumer attitude. Under the new governor, then, the insurance department will likely adopt the new governor’s pro-consumer attitude in its regulatory activities. Although the insurance industry would be subject to the new direction of insurance regulation, the change of governor would not affect the insurance industry as directly as it affects the insurance regulators.

Regulation as a Market Participant So far, this chapter has focused on regulation as a controlling mechanism. However, regulation can also be perceived as a market participant. When viewed in this light, the regulatory agency becomes part of the market. Exhibit 1-2 illustrates this by shading all those entities that could be viewed as part of the market. While the courts, the legislature, and the executive and judicial branches continue to control the market although they remain outside the market, the regulatory agency is a market participant. As a market participant, the regulatory agency is subject to the same supply and demand influences as other market participants. Regulation requires capital and labor, applies technology, and so on. The regulatory agency faces resource shortages just as other firms in the market do, and when resources are constrained, the price of regulation must be increased or the supply of regulation will be reduced. For example, suppose a state insurance department has a high demand for consumer protection and assurance of insurer solvency. The regulatory agency, however, might not be able to supply adequate services to meet that demand because it lacks technology, has inadequate manpower, or is inadequately funded. Thus, the insurance department will have to raise its prices (such as raising fees for license applications) to increase its funding so that it can better protect consumers and prevent insurer insolvencies. Or, the insurance department will have to reduce the amount of resources it devotes to consumer protection and insolvency detection, which means that regulation will not be as effective in dealing with either of its goals. As a market participant, the regulatory agency, according to the regulatory system in Exhibit 1-2, is affected by external market influences, such as the

16 The Regulation of Insurance courts, the legislature, and the executive and judicial branches of government. These entities can constrain the regulatory agency’s resources or its products. For example, the legislature might budget an inadequate amount of funding to support its state insurance department, or the courts might determine that a particular regulatory action taken by the insurance department is unconstitutional and cannot be enforced. Either of these actions can create a situation in which the insurance department cannot meet its regulatory objectives. In this view of regulation, referred to as an endogenous perspective, the regulators and the regulated entities are significantly and mutually affected by the same market influences. So, if the level of wages increases in the state, both insurance departments and insurance companies will be expected to increase the salaries of their employees. In addition, the insurance departments and insurance companies might compete for dedicated, experienced, and educated employees.

The System of Insurance Regulation Insurance regulation, when viewed in terms of the regulatory system shown in Exhibit 1-2, is a system that results in control of the activities of firms, consumers, and other interest groups in the insurance industry by state insurance departments, courts, legislatures (state and federal), and the executive and judicial branches of state and federal governments. State insurance departments are the regulatory agencies but they are not the sole regulators. Nor are state insurance departments, the courts, the legislatures, and the executive and judicial branches beyond the influence of the market participants. Participants in the insurance industry also interact with each other to effect some form of control on each of their activities and to influence the regulatory bodies. The role of state insurance departments in this system can be described from two perspectives, as indicated above: as entities external to the insurance market or as participants in the insurance market. In reality, the system of insurance regulation has the characteristics of both perspectives. State insurance departments control the insurance market in several ways, including the following: •

•

The prices charged for insurance products and services provided by insurance companies and producers must generally be approved by state insurance regulators (with some exceptions, such as when a state has an open competition rating law that allows insurers to use rates without the approval of the state insurance department). Agents, brokers, and insurance companies typically must be licensed by a particular stated insurance department before they can do business in the

Chapter 1 / Introduction to Regulation 17

•

state (with some noted exceptions, such as nonadmitted carriers that are not required to get a license to do business in the state). The types of assets and investments held by insurance companies must generally meet regulatory requirements.

In addition to their market control responsibilities, state insurance departments also participate in the insurance market, as the following examples indicate: • •

Court decisions and legislative proceedings affect how state insurance regulation is performed. State insurance departments, the NAIC, insurance companies, insurance agencies, and other organizations compete for skilled employees.

In summary, it is important to recognize that state insurance departments as regulatory agencies are part of a system of insurance regulation. They are not the only regulators of insurance; they are aided by courts, state legislatures and Congress, and the executive and judicial branches of state and federal governments. In addition, state insurance departments are subject to control by courts, legislatures, and executive and judicial branches of government. State insurance departments are also influenced by market participants and, in some situations, can be considered part of the insurance market.

Theories of Regulation Several theories have been proposed to explain why regulation exists and what purposes it serves. Understanding the theories and how they apply to insurance regulation can help those in the system of insurance regulation understand how insurance regulatory policy develops and how to work within the system of insurance regulation to achieve regulatory policy that produces the desired effects in the insurance market. The theories of regulation can be divided into two groups: • •

Economic theories that focus on how regulation affects and is affected by the market Political theories that view regulation as a political process with political, rather than economic, goals

Economic Theories of Regulation Economic theories of regulation view regulation as a way of solving market imperfections such as internalities, imperfect competition, and so on. Economic theories can be classified either as public interest theories or public

18 The Regulation of Insurance choice theories. These classes of economic theories differ in their perceptions of regulators’ goals. Public interest theories suggest that regulation is implemented to protect the public interest. Public choice theories consider regulation to be the product of lobbying efforts and representations of the interests of powerful market forces.

Public Interest Theories Public interest theories portray regulation as necessary to ensure that the public’s interest is not overlooked in market transactions. In fact, it is often said that insurance regulation is needed to protect the public’s interests in the insurance market. However, a definition of public interest is not readily discernible and is the subject of much debate. Many researchers have recorded their views as to what constitutes public interest. These definitions are summarized below: •

•

•

•

•

Public interest can be viewed as a balancing concept in which several different particularistic interests are simultaneously satisfied. “The balancing result gives satisfaction to interests that may to some extent be contending or competing.”6 Insurance regulators must balance consumer demands for lower premiums with insurers’ needs to charge adequate premiums that cover their costs. Public interest can be defined as a compromising concept in which “. . .particularistic interests are made to concede part of what they desire so that the overall result is in the ‘public interest.’ ”7 Public interest can be perceived as a “. . .trade-off concept in which particularistic interests affected by regulation are made to provide some costly service or other benefit judged to be in the public interest in exchange for certain private benefits to them.”8 For example, auto insurance assigned risk pools ensure that all drivers are able to get auto liability insurance, but the costs of providing such coverage are also shared by standard drivers. Public interest can be promoted as an “. . .overriding national or social goals concept in which certain social, societal, or national objectives are held to be in the public interest and to supersede private interests.”9 For example, some argue that auto insurance rates should be suppressed in urban areas so that the number of uninsured motorists is minimized. This protects society, and the victims of negligent drivers, by providing a source of funds (insurance) other than tax dollars to pay for the victims’ losses. Public interest can be a “. . .particularistic, paternalistic, or personally dictated concept. . .in which the public interest is equated with the preferences of a particular person, group or organization, or system. These preferences

Chapter 1 / Introduction to Regulation 19 which may, for example, be those of a charismatic leader or dictator or a political party, can be any of the previously listed types, e.g., a national or social goal. The distinctive feature of this concept, however, is its attachment to, or equation with, the preferences of a particular entity, whatever its level (person to system).”10 For example, it might be suggested that the NAIC is acting in the public interest by establishing and enforcing its accreditation program that requires states to incorporate certain specific insurance laws and regulations into their insurance codes to better prevent insurer insolvencies. The above list indicates the broad spectrum of views concerning the meaning of “public interest.” While the goals tend to differ, the disparity of views suggests that public interest is characterized by the following factors: • •

A large segment of the public is affected by the activity which is, or will be, subject to regulation. The regulatory goal, whether it is the goal of a particular individual or entity or a national or social goal, is important to the welfare of the general public.

Thus, public interest theories perceive regulation as a necessary mechanism to protect the public from market failure. Public interest theories can be used to explain much of the insurance regulation that controls insurer activity and purportedly provides insurance market stability. For example, it is commonly considered that maintaining insurer solvency is in the public interest because if an insurer becomes insolvent, insureds are left unprotected against loss exposures they believed to be insured. Furthermore, premiums paid in advance might not be recoverable. Since insurer solvency is against the public interest, it must be prevented through insurance regulation. Examples of insurance regulation aimed at preventing insurer insolvency include the following: • • •

Insurance companies are required to maintain reserves to be used to pay for losses and to cover unearned premiums. Insurance companies are required to undergo periodic financial conditions examinations. Insurers’ investments are restricted to primarily low risk securities.

Public Choice Theories The inability of the public interest theories to explain observed phenomena in regulated industries led to the development of a second body of economic theory of regulation. Distinguished from public interest theory, public choice theories view regulation “. . .not as the use of governmental authority to

20 The Regulation of Insurance protect the general public from the exercise of private power, but instead as the enlistment of government by powerful private interests to confer on them the ability to exploit the public.”11 Since regulators are elected officials, or agents appointed by elected officials, presuming that their regulatory policy decisions are not influenced by pressures of various groups lobbying for government support is unrealistic.12 Four public choice theories are discussed below: • • • •

Capture theory Political support theory Conflict minimization theory Bureaucratic theory

Capture Theory Capture theory suggests that regulation is affected by the interests of the regulated parties. The entities subject to the regulation “capture” the regulatory mechanism and use it for their own purposes rather than to promote public interest. The term “capture” is actually used in several ways related to this view. “Capture” is said to occur if the regulated interest controls the regulation and the regulatory agency; or if the regulated parties succeed in coordinating the regulatory body’s activities with their activities so that their private interest is satisfied; or if the regulated party somehow manages to neutralize or insure nonperformance (or mediocre performance) by the regulating body; or if in a subtle process of interaction with the regulators, the regulated party succeeds (perhaps not even deliberately) in coopting the regulators into seeing things from their own perspective and thus giving them the regulation they want; or if, quite independently of the formal or conscious desires of either the regulators or the regulated parties the basic structure of the reward system leads neither venal nor incompetent regulators inevitably to a community of interests with the regulated party.13

Four regulatory policies might be promoted by an industry or occupation: • • • •

A direct subsidy of money Control over entry of new rivals Control over substitutes for and complements to products and services Price fixing14

As indicated above, the benefits derived by those seeking favor of regulatory policy are increased profits and reduced competition. If an industry or occupation can get regulators to implement any of the four policies identified,

Chapter 1 / Introduction to Regulation 21 imperfect competition can thrive, and the industry participants can control market prices. With control over market prices, the industry participants can increase their profits and reduce their competition. The capitalization requirements that insurers must satisfy before they are issued a license to operate in a state lend support to the capture theory. Arguably, such requirements are a form of control over the potential competitors entering the market. Existing insurers have been able to get state insurance regulators to develop and enforce those requirements. Capitalization requirements, however, are generally so low that they do not serve to restrict market entry, particularly when capitalization requirements are compared to various manufacturing industries.15

Political Support Theory Political support theory hypothesizes that regulators tend to maximize political support, indicating that regulatory policy should favor the interest groups with the greatest constituency and influence.16 In contrast to capture theory, political support theory suggests that regulators’ interests are not captured by a single economic interest. Instead, regulators seek to achieve an equilibrium in a market in which benefits are allocated to the market participants in such a way that the regulators’ political returns are maximized. Consequently, regulators often suppress some economic forces that might otherwise affect the allocation through the market’s price structure.17 Maximizing political support might not increase profitability for industry members in all cases. Price regulation might produce a structure of price discrimination that provides rewards to some consumers while taxing others— in other words, subsidizing one group of consumers at the expense of another group.18 This subsidization might benefit the greatest number of consumers, but not without other consumers incurring added cost.19 Furthermore, a firm that engages in internal subsidization (uses profits from a successful product or department to help fund a less profitable product or department) can argue forcefully to the regulatory agency that the agency should not permit, or at least should strictly limit, the entry of competitors into those markets where the firm makes large profits, because those profits—which new entrants would erode—are necessary in order to cover the losses in the subsidized markets.20 Some insurance regulators have been perceived as acting in accordance with the political support theory. The proponents of this view argue that those regulators are most interested in generating political support in hopes of gaining higher political offices in the future. For example, some supporters of this allege that an insurance commissioner might adopt several pro-consumer initiatives to generate political support among state voters so that when the

22 The Regulation of Insurance commissioner seeks a more prestigious elective office, the voters will elect him or her.

Conflict Minimization Theory Distinguished from capture theory and political support theory, conflict minimization theory recognizes that regulatory policy might be influenced directly by pressure from regulated groups and indirectly by “. . .binding legal and procedural constraints imposed by the legislature and the courts.”21 Together, political support and conflict minimization theories can be referred to as interest group theory. The conflict minimization theory, similar to the political support theory, views regulation as seeking a political equilibrium that balances the pressures exerted by varying interests. In contrast to public interest theory, however, the conflict minimization theory views regulation as extremely passive. “Regulators take no action regarding prices unless major increases or structural changes are initiated by the firms under its jurisdiction.”22 The conflict minimization theory was developed to explain the regulatory process affecting public utility prices. This regulatory process is based on laws that do not establish how to arrive at prices for public utilities. The laws simply require that public utility prices be fair, as established by certain standards. For example, these standards indicate that prices must allow a public utility to earn a competitive rate of return for its owners (its stockholders), so that the owners will continue to invest in and supply capital to the firm. However, prices for public utilities cannot be unfairly burdensome to the public utility consumers. Thus, as explained by conflict minimization theory, public utility rate regulators must balance the mandate of reasonable returns for the owners with the requirement that the public utility prices not be an unfair burden to some consumers.23 Insurance rate regulation can also be explained by conflict minimization theory. Insurance regulators face concerns similar to those of public utility rate regulators: Insurance rates must be high enough to cover insurers’ costs and losses and to provide competitive returns to insurance company stockholders. However, insurance rates must also be affordable to insurance consumers. Thus, as suggested by conflict minimization theory, insurance regulators must balance those two requirements.

Bureaucratic Theory Each of the three public choice theories discussed thus far considers regulators as neutral government parties that respond to pressures of external interests, either individuals or groups. In contrast, the bureaucratic theory of regulation hypothesizes that regulators might, instead, be implementing regulatory policy

Chapter 1 / Introduction to Regulation 23 in their own self-interests. Regulators might come from or expect to subsequently enter into employment in the industry they govern. Several typical behaviors of regulators follow from this situation. Notably, regulators who serve finite terms must be expected to take a short-run approach to most problems. A standard complaint against regulatory commissions is that they are inadequate planning bodies.24

Individuals could be expected to reflect the perspectives and biases of the interest groups with which they have been associated. Future employment prospects could also affect the regulatory process as regulators attempt to win the favor of potential employers. Regulators’ objectives might vary depending on whether they come from the regulated industry, intend to enter the regulated industry when they leave their regulatory positions, or occupy elected or appointed positions. “. . .[R]egulators who view the regulatory position as a career in itself would be expected to regulate differently from those who view the position as a stepping stone to another job.”25 Research validates the hypothesis that a considerable number of regulators come from, or eventually enter, employment in the industry they regulate. Data for the Civil Aeronautics Board (CAB), the Federal Communications Commission (FCC), and the Interstate Commerce Commission (ICC), are shown in Exhibit 1-3, and lend support to this hypothesis. Exhibit 1-3 Precommission and Postcommission Career Matrix for All 174 Members of the CAB, FCC, and ICC Combined Through December 31, 1977 PRECOMMISSION CAREER POSTCOMMISSION

Private-Sector Related

Public-Sector Related

Not Related

Total

Private Sector

17 9.8%

32 18.4%

23 13.2%

72 41.4%

Public Sector

4 2.3%

5 2.9%

7 4.0%

16 9.2%

13 7.5%

24 13.8%

17 9.8%

54 31.0%

Died in Office

0 0.0%

10 5.7%

3 1.7%

13 7.5%

Remained in Office

3 1.7%

13 7.5%

3 1.7%

19 10.9%

37 21.3%

84 48.3%

53 30.5%

174 100.0%

Not Related

Total

Summary of Table 1 from “The Life Cycle of Regulatory Commissioners” by Ross D. Eckert, in The Journal of Law and Economics, vol. 23, April 1981, pp. 113-120.

24 The Regulation of Insurance The employment choices of insurance commissioners, particularly following their terms in office, might appear to support the bureaucratic theory. Insurance commissioners often find work in the insurance industry as regulatory consultants or as regulatory or legislative attorneys once they leave their regulatory posts.

Political Theory of Regulation The second major classification of regulation theories, referred to as the political theory of regulation, differs markedly from public interest theory, but only subtly from public choice theories. The political theory of regulation recognizes, as do public choice theories, that regulation is developed and implemented in a political environment, and that various special interests, referred to as political institutions, influence regulatory policy. Also similar to some public choice theories, political theory views regulators as active participants in the development and implementation of regulation, with their own goals for regulation.26 In the political theory of regulation, regulatory policy is viewed as resulting from “. . .the interaction of ‘political institutions’ within an environment that influences the abilities of these institutions to use their political resources effectively.”27 Four major political institutions, or political actors, interact to formulate regulatory policy: • • • •

The regulatory agency The regulated industry Nonindustry interests (such as consumer groups) Political elites (legislators, chief executives, and federal officials)28

Perhaps the greatest contribution of the political theory of regulation is its view that success or failure of political actors in effecting regulatory policy stems from the salience and complexity of regulatory issues. A salient policy issue is one for which many people feel that the issue affects them and that the political system is a way to address the issue. A complex issue [emphasis added] is one in which specialized knowledge is required to understand the policy question. . . .Issue complexity affects which actors can effectively participate in policy discussions because a lack of knowledge limits the contribution that an actor can make. . . . Issue salience affects the rewards of the policy process; the greater the salience of a public issue, the greater the potential political benefits that can accrue to a policy actor who influences public policy.29

Although salience and complexity are alluded to in earlier economic theories

Chapter 1 / Introduction to Regulation 25 of regulation, they are clearly identified by the political theory of regulation as critical factors affecting development of regulatory policy. The system of insurance regulation upholds the political theory. The political actors involved in insurance regulation (insurance regulators, insurance companies and others in the industry, consumer groups and other noninsurance companies, and state and federal legislators, among other entities) often interact to formulate insurance regulation. Furthermore, insurance regulation is characterized by many salient and complex issues. For example, the availability and affordability of insurance, especially in urban areas, is an extremely important, salient issue. Consumer groups representing people in urban areas who feel they are unfairly discriminated against brought the availability and affordability issue to the forefront of insurance regulatory concerns. Insurance regulators in Illinois responded by working with the industry and consumer groups to identify the problems and to develop solutions. The insurance commissioner of the District of Columbia held public hearings on the issue and called for the investigation of certain companies alleged to practice redlining. The interaction of those political actors on a significant issue follows the political theory.

The Theories of Regulation and Insurance Regulation Each of the theories discussed can be used to describe certain areas of insurance regulation. Historically, the public interest theories have been the theories most often used to describe insurance regulation. The line of reasoning is as follows: It is in the public interest to maintain insurer solvency and to protect insurance consumers; therefore, insurance regulation is justified. In recent years, however, support has been growing to use the political theory of regulation to describe insurance regulation. As with public interest theories, the political theory recognizes that various interest groups can influence regulatory policy. But, the political theory does not agree that regulators are passive enforcers of that regulatory policy. Recall that the political theory of regulation established that four political actors—the regulatory agency, the regulated industry, nonindustry interests, and political elites—interact to develop regulatory policy. Furthermore, political theory suggests that salient issues are most compelling to the political actors, although the complexity of these issues can affect the results achieved by regulatory policy. The system of insurance regulation described earlier in this chapter fits neatly into the framework established by the political theory: •

The regulatory agency in the system is also the regulatory agency for the political theory framework—the state insurance department.

26 The Regulation of Insurance • •

•

Some of the firms and other interest groups identified in the system make up the regulated industry of the political theory framework. Consumer groups and some of the other interest groups identified in the system represent the nonindustry interests of the political theory framework. The courts, legislatures, and the executive and judicial branches of the system are the political elites of the political theory.

In addition, the issues dealt with in insurance regulation can be categorized by their salience and complexity, as shown in Exhibit 1-4. Of the more compelling issues to political actors are availability and affordability of insurance, the detection and prevention of fraud, the creation of some form of national catastrophe plan, risk-based capital, a producer database, and a continuing education clearinghouse. While each of these issues is highly salient, the latter four issues can be complex. Regulators, industry representatives, political elites and nonindustry representatives must have expertise in these areas to have a role in the regulatory policies developed to address the issues. While the issues with low salience are important to insurance regulation, they are not as attractive to political actors. These less salient issues generally are given lower priority than those issues attractive to all political actors. Exhibit 1-4 Salience-Complexity Matrix for Insurance Regulation Issues

H i S g a h l i e n c L e o w

Availability and Affordability Fraud Database

Risk Based Capital Producer Database Continuing Education Clearinghouse National Catastrophe Act

Insurance Company Licensing Policy Wording

Annual Statement Changes Rate and Form Filing

Low

High Complexity

Chapter 1 / Introduction to Regulation 27 Empirical research indicates that, as suggested by the political theory and as described earlier in the chapter, it is the interaction of these political actors, or the parts of the system, that produces insurance regulation. Empirical research also indicates the following about insurance regulation as described by the political theory of regulation: •

When complex issues are not salient, only insurance regulators and the industry members affected by regulatory policy in those issues are involved in developing regulatory policy for those issues.

•

The insurance industry has the most influence on regulatory policy, followed by insurance regulators. In addition, insurance regulators and political elites have acted contrary to industry desires in several instances, including adopting and modifying the federal government’s role in insurance regulation.

•

Political elites typically have an indirect, but important, effect on insurance regulation. For example, they pass legislation that sets insurance policy.

•

Consumer groups are least active regarding insurance regulation. However, their strength is increasing, particularly in states with strong consumer movements and in states with a receptive stance toward consumer groups.30

The political theory of regulation describes, to a significant degree, the way insurance regulatory policy is developed. Understanding this process helps political actors such as insurance company representatives, insurance agents and brokers, consumers, and other interested parties, work within the system of insurance regulation to promote and affect regulatory policy that best meets their needs.

Justification for Regulation The principles of markets, the principles of regulation, and the theories of regulation provide the necessary knowledge to discuss the justification for regulation. In the early sections of this chapter, it was established that regulation corrects market imperfections. The definition of regulation suggests that the goal of regulation might be broader than correcting market imperfections. The theories of regulation also imply that regulation might exist for reasons other than to correct or control market imperfections. So, why does regulation exist? What types of justification support the continued application of regulation to markets, including insurance markets?

28 The Regulation of Insurance Regulation is necessary to correct market imperfections, whether the imperfections result from externalities, imperfect information, transactions costs, or other causes. However, justifications for regulation depend on the market being regulated, the regulators’ perceptions, and the views of the people making the justifications. In other words, the common theme for justifying regulation is to correct and control the market. But, the justifications for regulation can differ—each market participant, each regulator, and each observer might offer different reasons for regulating a particular market. The common justifications for regulating the insurance industry are (1) the need to protect consumers who do not fully understand the insurance product and (2) to maintain insurer solvency. These are primarily market-based justifications: •

•

Consumers do not have complete information about the product of insurance, yet they need the product and must purchase it. Because of consumers’ imperfect information, insurance regulators must ensure that the products are beneficial to the consumers and that they are available at an equitable price. The solvency of insurers can be threatened by incomplete information, by destructive competition, and by mismanagement (among other things). Insurance regulation must be implemented and enforced to correct each of these market imperfections. If regulation can correct or reduce the effect of the market imperfections, the solvency of insurers can be maintained.

Regulation for Protecting Insurance Consumers When individuals make purchases of food, clothing, or furniture, they can inspect the items before purchase to ensure that the items are satisfactory and that they will meet the individuals’ needs. Insurance consumers are at a disadvantage when purchasing insurance because of the complex nature of the product. In addition, because insurance coverage is based on a contract that can be daunting, many insurance consumers do not understand the requirements and conditions that apply to the insurance product that they are purchasing. Even if consumers inspect the policies they purchase, they lack the expertise to evaluate coverage and they must depend on the insurance companies and insurance producers to help them understand whether the policy best meets their needs. Also of concern is the fact that insurance contacts are contingent on the occurrence of specific events—losses. Consumers might not collect under their insurance policies—either because insurance coverage has expired by the time the specific losses occur or because the insurance policies do not apply

Chapter 1 / Introduction to Regulation 29 to the types of losses that occur during the policy period. In the latter case, consumers might not discover that a loss is not covered until after the loss occurs—leaving them to face the consequences that they believed to be covered by their insurance policies. Regulation of insurance companies and insurance agents and brokers is designed to help ensure that insurance consumers are treated fairly and equitably, and that they are not misled about the policies they purchase. In effect, insurance regulation is justified by the need for insurance regulators to act on behalf of insurance consumers to inspect insurance coverages to determine that they are beneficial to consumers. Insurance regulators can do this by setting coverage standards or specifying policy language for certain insurance coverages, among other things.

Regulation for Preventing Insurer Insolvency Because insurance companies promise to pay for losses that have not yet occurred, insurance regulation can be justified as a means of ensuring that companies can pay the claims for which they are responsible under their insurance policies. In other words, insurance regulators want to prevent insurers from becoming insolvent. Insurance regulations help prevent insurer insolvency in a number of ways. For example, insurers’ financial positions and financial operations are examined periodically to ensure that they are meeting the conservative financial requirements established by insurance regulation. In addition, insurers are often required to submit their rates for approval by insurance regulators. The regulators determine whether the rates are adequate to cover the insurers’ expected losses and other operating expenses. Thus, these regulatory activities, among others, can be justified by the need to maintain insurer solvency. The goal of maintaining insurer solvency helps to fulfill the goal of protecting insurance consumers. Insurance consumers are benefited if the insurance companies from which they purchase insurance coverage are able to pay for losses that insureds suffer and that are covered by the insurance policies purchased. Thus, by preventing insurer insolvencies, insurance regulators can also protect consumers.

Summary This first chapter on the regulation of insurance has introduced the subject of regulation, providing a basis for further study of regulation as it applies to the insurance industry. Regulation primarily exists to correct market imperfec-

30 The Regulation of Insurance tions. Ideally, all markets would be perfectly competitive and all market participants would be treated equally. However, because of market imperfections, such as imperfect information, barriers to entry and exit, and externalities, markets are not perfectly competitive. Regulation is seen as a means of better achieving the market outcomes of perfect competition. Regulation does not simply come from a regulatory agency that imposes its will on the market. Regulation is a system of entities that influence one another. Although the regulatory agency is charged with the responsibility and authority for regulation, the agency is influenced by the market it regulates, interest groups within and external to the market, the courts, the legislature, and other executive and judicial branch entities. Many researchers have developed theories about the reasons for regulation. Insurance regulation, while supported as in the public interest, is most closely described by the political theory of regulation. By understanding how this theory applies to insurance regulation, political actors in insurance regulation can better influence regulatory policy to meet their own regulation objectives. Although insurance regulation closely fits with the political theory of regulation, insurance regulation continues to be justified as a means to protect consumers and to ensure insurance company solvency. The insurance market is made more efficient and operates more effectively when consumers are provided information to help them make better insurance decisions. The insurance market is also aided by the prevention of insurer insolvency.

Chapter Notes 1. Douglass Needham, The Economics and Politics of Regulation: A Behavioral Approach (Boston, MA: Little, Brown and Company, 1983), pp. 12-13. 2. Daniel F. Spulber, Regulation and Markets (Cambridge, MA: The MIT Press, 1989), p. 1. 3. Martin T. Farris and Stephen K. Happel, Modern Managerial Economics (Glenview, IL: Scott, Foresman and Company, 1987), p. 360. 4. In economics, supply and demand have distinct meanings. Supply of a product or service represents the market intentions of the sellers of that product or service. Supply is based on the quantity of the product or service sellers are willing to sell at given prices. Demand of a product or service represents the market intentions of the buyers of that product or service. Demand is based on the quantity of the product or service buyers are willing to buy at given prices. Where the supply of and demand for a product or service are equal, the sellers and buyers agree on the price and the quantity of the product or service. Thus, the price is determined by the supply of and by the demand for the product or service.

Chapter 1 / Introduction to Regulation 31 5. “Automation Enhancements to State Regulatory Efforts,” Issues 94 (Kansas City, MO: National Association of Insurance Commissioners, 1994), pp. 64-65. 6. Barry M. Mitnick, The Political Economy of Regulation: Creating, Designing and Removing Regulatory Reforms (New York, NY: Columbia University Press, 1980), pp. 92-93. 7. Mitnick, pp. 92-93. 8. Mitnick, pp. 92-93. 9. Mitnick, pp. 92-93. 10. Mitnick, pp. 92-93. 11. A. E. Kahn, “The Reform of Government Regulation: Recent Progress in the United States,” Vereniging voor Economie, Notulen Vijftiende Vlaams Wetenschappelijk Economisch Congres (1981). Quoted in Lutgart Van den Berghe, “(De)Regulation of Insurance Markets,” Risk, Information and Insurance, ed. Henri Loubergé (Boston: Kluwer Academic Publishers, 1990), p. 210. 12. Kenneth N. Scoles, Jr., An Empirical Study of the Effects of State Regulation on Price for Market Segments of the U.S. Property and Liability Insurance Market (Atlanta, GA: Georgia State University, 1993), p. 36. 13. Mitnick, pp. 94-96, 14. George J. Stigler, “The Theory of Economic Regulation,” The Bell Journal of Economics and Management Science, vol. 2, Spring 1971, pp. 4-6. 15. Paul L. Joskow, “Cartels, Competition and Regulation in the Property-Liability Insurance Industry,” The Bell Journal of Economics and Management Science, vol. 4, Autumn 1973, pp. 390-391. 16. Sam Peltzman, “Toward a More General Theory of Regulation,” The Journal of Law and Economics, vol. 19, August 1976, p. 231. 17. Sam Peltzman, “Toward a More General Theory of Regulation,” p. 231, and Sam Peltzman, “The Economic Theory of Regulation After a Decade of Deregulation,” Brookings Papers on Economic Activity: Microeconomics (Washington, DC: Brookings Institution, 1989), p. 9. 18. Sam Peltzman, “Toward a More General Theory of Regulation,” p. 236. 19. An exception would be when average costs are declining. This has not been shown to be the case in the insurance industry. 20. Richard A. Posner, “Taxation by Regulation,” The Bell Journal of Economics and Management Science, vol. 2, Spring 1971, pp. 27-28. 21. Paul L. Joskow, “Inflation and Environmental Concern: Structural Change in the Process of Public Utility Price Regulation,” The Journal of Law and Economics, vol. 17, October 1974, p. 297. 22. Joskow, “Inflation and Environmental Concern,” p. 298. 23. Joskow, “Inflation and Environmental Concern,” pp. 296-297. 24. George W. Hilton, “The Basic Behavior of Regulatory Commissions,” The American Economic Review, vol. 62, May 1972, p. 48. 25. Stephen P. D’Arcy, “Application of Economic Theories of Regulation to the Property-Liability Insurance Industry,” Journal of Insurance Regulation, vol. 7, September 1988, p. 24.

32 The Regulation of Insurance 26. Kenneth J. Meier, “The Politics of Insurance Regulation,” The Journal of Risk and Insurance, vol. 58, December 1991, p. 701. 27. Meier, p. 700. 28. Meier, p. 700. 29. Meier, pp. 708-709. 30. Kenneth J. Meier, The Political Economy of Regulation: The Case of Insurance (Albany, NY: State University of New York Press, 1988), pp. 138-142.

Chapter 2

The Evolution of Insurance Regulation Insurance regulation tends to react to developments in the insurance market. In other words, the events within the market determine the types of insurance laws, regulations, and rules that are adopted. And, as discussed in the previous chapter, regulation is often promoted as the means by which perceived market imperfections can be corrected. For insurance regulation, this correction focuses on protecting insurance consumers and on maintaining insurer solvency. Thus, insurance regulation is often developed to solve the problems within the insurance market that adversely affect insurance consumers or that can lead to an insurance company’s insolvency. Today’s insurance regulation is the result of an evolutionary process that has occurred over a period of more than two hundred years. As the insurance industry changed and grew, so did insurance regulation. And, with each occurrence or recurrence of turmoil within the insurance industry, insurance regulators tried to develop and implement regulation to better protect insurance consumers and to prevent insurance company insolvencies. It is important to understand the evolution of insurance regulation, because the issues dealt with in the past often reappear. The environment might be different or the details might have changed, but the issues often remain unresolved. Consider the federal-versus-state debate: Should insurance be regulated by the federal government, the state governments, or by a two-tiered system that combines the two levels? This debate has continued for many years. As early as 1865, state insurance commissioners in Massachusetts and

33

34 The Regulation of Insurance Connecticut suggested federal supervision because it was difficult to deal with various conflicting state laws and regulations.1 Companies fought state regulation in the Paul v. Virginia case, heard before the U.S. Supreme Court in 1869. The Court’s decision was that insurance regulation by the states was constitutional.2 The South-Eastern Underwriters Association (SEUA) case in 1944, also heard before the U.S. Supreme Court, determined that federal antitrust laws applied to the insurance industry.3 In 1945, Congress passed the McCarran-Ferguson Act in reaction to the SEUA decision that allowed state insurance regulation to continue, with certain limitations. In 1989 and 1990, attention focused once again on the issue of insurer solvency and the better governmental structure for regulation of insurer solvency. The issue continues to be debated. The evolution of insurance regulation is also important because the problems faced by insurers and their consumers today can result in the regulation of tomorrow. For example, consider risk-based capital requirements. In many cases, insurance regulators did not feel they had the proper tools to allow them to take over financially troubled insurance companies before the companies were under such severe financial constraints that the only option was liquidating the company and using guaranty funds, to the extent available, to cover the insureds’ resulting uncovered losses. To improve the chances of rehabilitating insurance companies and to reduce the losses to insureds, regulators developed the risk-based-capital system to provide them with the tools to take control of financially troubled companies before their only option was to liquidate the companies. Since this text concerns itself with insurance regulation in the United States, this section focuses on the evolution of insurance regulation in the United States. The development of insurance regulation can be divided into three time periods: 1. Developments before the South-Eastern Underwriters Association decision (that is, before 1944) 2. Developments related to the South-Eastern Underwriters Association decision and the McCarran-Ferguson Act (1944 to 1947) 3. Developments since the McCarran-Ferguson Act (that is, after 1947)

Developments Before the South-Eastern Underwriters Association Decision The beginning of insurance regulation in the United States dates back to the formation of the first insurance companies in the American colonies. At the

Chapter 2 / The Evolution of Insurance Regulation 35 time of their formation, those companies were still subject to British law. To be viewed as legitimate business concerns, insurance companies had to be chartered under the British Crown. Thus, the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire was incorporated under a Royal Charter in 1752. In 1792, Pennsylvania was the first state to charter insurance companies, with most other states also chartering insurance companies by 1797.4 Throughout the early 1800s, states sporadically enacted insurance regulations. Those regulations were state specific and addressed various problems, such as competition, consumer protection, and solvency. However, solvency appears to have been the primary concern of insurance regulators at the time. Insurers were subject to the regulation of the states in which they were chartered, and each state had its own regulations. If agents of insurers sold insurance in other states, they might have had to file information about the companies they represented with each additional state in which they operated.5

The Beginning of Insurance Regulation By the early 1800s, states were beginning to feel pressures to protect their domestic insurers (insurers originally incorporated and licensed in their states). Most notably, insurers chartered under English law were entering domestic markets and charging lower rates than the domestic insurers. Pennsylvania passed an act in 1810 that prohibited foreign insurers (at that time, insurers incorporated in another country)6 from writing business in Pennsylvania. Violators were fined up to $5,000. Maryland and New York soon followed suit.7 New York, however, claimed that such laws were also needed to protect insurance consumers, since in times of war, New York could not force foreign companies to pay claims, and this might have resulted in harm to the citizens of New York.8 These protectionist laws remained in effect for more than two decades. However, in 1835, both New York and Pennsylvania revoked their statutes. A great fire in New York had forced many of its domestic insurers into insolvency, and foreign insurers had to be permitted to operate in the New York market to increase the market’s capacity to provide fire insurance.9 In the 1800’s, New York was one of the leaders in developing and enacting insurance regulations: •

In 1814, New York established a process for the liquidation of insurers. Insurer insolvencies continually caught insurance regulators by surprise.

36 The Regulation of Insurance

•

•

•

•

•

The resulting losses affected insurance consumers who clamored for protection. Thus New York required that, if stockholders or directors of an insurance company believed that the insurer was in jeopardy of becoming insolvent, they were to report their beliefs to the Chancellor of New York. The Chancellor would then appoint three individuals to handle the insurer’s liquidation. In 1824, New York imposed a premium tax of 10 percent on fire insurers domiciled in other states. Soon, most other states were imposing their own retaliatory premium taxes (premium taxes imposed on insurers licensed but not domiciled in a state because that state’s domestic insurers were subject to premium taxes in other states), although New York did not actually pass a retaliatory tax law until 1965. However, in 1837 the tax was cut to 2 percent—probably to encourage insurers domiciled in other states to reenter the New York market following the 1835 fire.10 In 1827, New York began to require insurers to file annual statements with the state comptroller. Those statements provided answers to thirteen categories of questions, including insurers’ investments, premiums, and liabilities. By 1853, an annual statement had to be signed by insurance company officers and had to provide more detailed information about insurers’ operations. However, Massachusetts began to require a more detailed statement in 1837. The Massachusetts statement is important because it required insurers to include estimates of necessary reserves.11 In 1849, New York passed a separate statute under which insurance companies were incorporated. The statute required a company to be an insurer of a single line. In 1851, life insurance and health insurance were established as distinct lines of insurance and in 1853, fire insurance was made a distinct line of insurance.12 This is the origin of the monoline system that was in effect in the United States until the middle 1900s. In 1853, New York was the first state to implement an unearned premium reserve law.13 Insurers were required, under this law, to maintain reserves large enough to cover premiums that had not yet been earned. As early as 1853, New York required fire insurance companies to maintain liabilities large enough to cover all outstanding unexpired risks and to pay all reported losses. Michigan was the first state to actually set a minimum requirement for liability loss reserves.14

State Insurance Departments Until the 1850s, insurance regulation was overseen by state legislatures and various officers within state governments. Insurance departments did not exist. In 1859, New York was the first state to create an insurance department.

Chapter 2 / The Evolution of Insurance Regulation 37 The first regulatory bodies established specifically to oversee insurance regulation, however, were boards of commissioners. In 1851, New Hampshire was the first state to establish an insurance board. The board consisted of three members who each served a one-year term but who could be reappointed by the governor. The primary function of the board was to examine insurers at least once a year—more frequently if the governor requested it. Each member examined the condition and management of assigned companies.15 Vermont established its insurance board in 1852. The board was composed of four members—two insurance commissioners, the state secretary, and the state treasurer. The notable feature of Vermont’s first board is that it immediately enacted three laws: one each for health insurance, life insurance, and fire insurance. Those laws further strengthened the monoline approach.16 In 1855, Massachusetts became the third state to create an insurance board. Its board had three members who each served three-year, staggered terms. By 1866, the Massachusetts legislature had pared down the board to one member in charge of regulating insurers in Massachusetts.17 Most other states had established boards of insurance regulation by the time New York created its insurance department. Eventually, the other states followed suit and insurance boards were replaced by insurance commissioners.18

Paul v. Virginia State insurance regulation received its first major legal test in 1869. Samuel Paul wanted to become a licensed insurance agent in his home state of Virginia but wanted to represent New York insurers. His application for a license was denied because the insurers he wished to represent had not deposited a bond with the Virginia state treasurer as required of foreign insurers (by this time, “foreign” meant insurers domiciled in another state) who wanted to sell insurance in Virginia. Paul ignored his lack of a license and sold insurance for the companies. Paul was convicted and fined $50 by the Circuit Court of Virginia, and that decision was upheld by the Virginia Court of Appeals. Paul continued to fight the charge and in 1869, the U.S. Supreme Court reviewed the decision. Paul argued that only Congress could regulate interstate commerce under the United States Constitution; therefore, he considered the Virginia licensure law unconstitutional. The U.S. Supreme Court disagreed and affirmed the lower court’s upholding of Virginia law. The Court’s determination was that insurance was a contract that was delivered locally and was not interstate commerce. Virginia could continue to regulate its insurance market. Thus, the U.S. Supreme Court did not strike down state regulation of insurance.19

38 The Regulation of Insurance

The National Insurance Convention By 1869, many insurers were operating in more than one state. Insurers were not happy with the Paul decision, because they were having problems meeting the demands of the various states. And the states were having problems determining what areas of the industry needed to be regulated and how to implement such regulation. In May of 1871, at the request of New York’s insurance commissioner, regulatory representatives from nineteen states met for the first time at the National Insurance Convention (NIC) to find ways to solve their common problems.20 By the end of their first meeting, the NIC members had agreed to work on several initiatives: •

•

•

They established the Joint Statistical Commission to prepare a new mortality table on which United States’ life insurers could base their reserves and rates. The NIC members wanted to adopt a uniform accounting statement. Each state required insurers to file a different financial statement that varied among the states in the types and depth of the information required. A uniform statement would allow insurers to concentrate on one financial form. The NIC members were not going to require fire insurance companies to make deposits with state treasuries to protect insureds, but NIC members were going to require life insurers to make such deposits.21

By the end of their second meeting in October of 1871 (only five months after their first meeting), the NIC members had achieved the following: • • • •

They developed a constitution that set forth the goals of the regulators. They designed a uniform accounting statement. They adopted guidelines for insurance company taxation. They adopted the first model law that covered such items as the duties of an insurance commissioner and the regulation of fire insurers, life insurers, and marine insurers.22

By 1872, thirty states were members of the NIC and fourteen committees dealt with various issues and aspects of insurance regulation. Numerous improvements in insurance regulation were also being developed or considered.23

The Early 1900s Two events in the early twentieth century overshadowed all others: the enactment of the Appleton Rule and the Armstrong Investigation. New York

Chapter 2 / The Evolution of Insurance Regulation 39 enforced an administrative rule that came to be known as the Appleton Rule (which became law in 1940) and that required foreign insurers to “substantially comply” with New York’s domestic insurance laws in New York and in any other state in which those insurers operated to maintain approval to operate in New York. Although other states were extremely bothered by the rule at that time, it still exists today—although the meaning of “substantially comply” has become much more liberal.24 The second major event occurred in 1905, when a committee of the New York legislature—known as the Armstrong Committee, after the chair of the committee—investigated the New York insurance department and the New York insurance industry. The investigation uncovered many abuses within the department and within the insurance industry and resulted in a flood of legislation—eight laws or amendments in all—being passed by the New York legislature. Among the more notable of those legislative changes, the legislature did the following: • •

•

Amended the penal code to include penalties for perjury, misconduct by employees, and rebates and allowances by life insurers Modified the general corporate law to limit political contributions by companies to potential regulators and to limit the acquisition of real estate by life insurers Required the election of the directors of mutual insurers

The Armstrong Committee findings caused other states to investigate their own insurance departments and insurers through the next decade. Much legislation was enacted between 1905 and 1915 to solve the problems discovered in those investigations.25

Multiline Issues Insurers began to write auto insurance in the early 1900s, and regulators were forced to deal with the new issues that this product created. For example, to obtain both collision and liability damage protection, two separate policies had to be purchased from two different insurers because state insurance departments did not allow multiline companies. In 1907, New York addressed this issue by amending its insurance laws to allow a package policy that provided collision and auto liability coverage. However, two insurers still had to be involved—fire insurers and marine insurers could write all coverages but liability, and casualty insurers could write all coverages but fire and most marine coverages. Thus, two insurers would offer the package policy and share the premiums and the losses.26 In 1920, a committee of the National Convention of Insurance Commissioners (NCIC, the renamed NIC) determined that single lines were still a feasible

40 The Regulation of Insurance

structure. However, by 1923, the same committee voted to broaden coverages, although the Committee for Definition and Interpretation of Underwriting Powers was not established until 1933 to deal with the multiline issue. By 1933, insurance regulators were beginning to see the need for multiline insurers and began to ease up on their enforcement of monoline regulations.27 However, such legislation that would allow insurers to write multiple lines did not begin to be adopted until after 1945—several years after insurers had begun to provide policies that included coverage under several lines.

Underwriting Profit or Loss As insurance regulation moved into the second decade of the 1900s, regulators were becoming increasingly concerned about how to measure underwriting profit and loss. In 1919, the Fire Insurance Committee of the NCIC was asked to determine what underwriting profit was and how it should be calculated. In 1921, the committee released its findings: •

Underwriting profits equaled earned premium less incurred losses and incurred expenses associated with loss.

•

Investment income (called “banking profit” at the time) was not part of underwriting profit.

•

Reasonable underwriting profit was equal to 5 percent plus 3 percent for conflagrations, losses that amounted to more than $1 million.

The committee also released a plan to deal with conflagrations, which recommended that the first $1 million of a conflagration loss be charged to the insurers in the state in which the loss originated. The amounts above $1 million were to be prorated among the states (including the state of origin) based on the ratio of state premiums to total premiums. In effect, this was the first plan for dealing with catastrophic loss.28

Leading Up to the South-Eastern Underwriters Association Decision In the early to middle 1800s, many boards and associations had formed throughout the United States to try to control fire insurance rates. The insurance industry was characterized by periods of fierce competition that resulted in many insurer insolvencies. After those periods, insurers would band together to maintain adequate rates. However, insurers that were not party to the agreements underpriced the adequate rates, the competition began anew, and the cycle continued.29

Chapter 2 / The Evolution of Insurance Regulation 41 The boards and associations that existed before 1866 targeted small geographical areas, usually cities. Insurers who were members of boards and associations had to abide by different rates in each different locality. Those requirements further complicated an already complex system. In 1866, seventy-five fire insurers established the National Board of Fire Underwriters (NBFU). Those insurers felt that if they could control fire rates at a national level, they could alleviate the problems of the competitionbankruptcy cycle. The national rates could be set at levels that ensured enough advance premiums to cover expected losses, even in periods of competition. 30 Unfortunately, the NBFU agreement did not work. The NBFU was too far removed from the local arena and could not control the activities of local agents who continued to compete fiercely on price. By 1867, the NBFU had helped to establish more than 200 local boards to act as liaisons between local agents and the NBFU. That system grew to include more than 1,000 local boards by 1876.31 However, since the local boards could not control rates, another layer of boards was added. The NBFU divided the country into six regions and established regional boards to act as intermediaries between the local boards and the NBFU. Regional boards also did not work. In 1878, the NBFU gave up its efforts to control rates.32 With the demise of the NBFU, regional compacts and associations were formed. They were run by individuals who served as managers rather than by boards of insurance company members. Boards continued to provide guidance to the managers, but the managers were not controlled by any particular member. Managers could act in the best interests of all members. The system allowed adequate rates to be established and maintained.33 Just as it appeared that the insurance industry might be moving in the right direction, antitrust sentiments began to flourish in the United States between the 1880s and 1910s. Michigan introduced anticompact legislation in 1883, which eventually passed in 1887. Ohio passed an anticompact law in 1885. By 1912, twenty-three states in all passed anticompact legislation.34 That legislation was designed to prohibit insurer compacts or associations from controlling rates. Such associations were viewed as deterrents to open and free competition, which in effect they were. However, deterring open and free competition could be considered in the general public’s best interests because insurer insolvency could be prevented.35

42 The Regulation of Insurance The Sherman Act was passed by the federal government in 1890. While it gave impetus to states to pass their own antitrust legislation against insurer compacts, the Sherman Act did not directly apply to insurers, because insurance was still not considered interstate commerce.36 In 1888, Michigan’s anticompact law was tested in court. Hartford Fire Insurance Company had its license to operate in Michigan revoked because it was a member of a rating bureau. The insurer claimed that Michigan’s anticompact law was unconstitutional and asked that its license be reinstated. The court refused and supported the law as constitutional because states had the right to limit the activities of foreign insurers.37 At the same time that the states were implementing anticompact laws, state insurance regulators were promoting antidiscrimination legislation as a means of combating unhealthy competition within the insurance industry. Insurance regulators believed that one of the causes of the competition-bankruptcy cycle was that insurers were not classifying insureds into adequately homogeneous groups. Kansas enacted the first antidiscrimination-in-rating law in 1909. The Kansas rating law served two purposes: 1. It protected insurance consumers from excessive and unfairly discriminatory premiums by authorizing the insurance commissioner to require insurers to lower their rates if the commissioner determined that the rates were too high. 2. It also addressed insurer solvency by giving the commissioner the authority to require insurers to file reasonable rates if the insurers’ rates appeared inadequate for their financial safety. Many states soon followed Kansas’s lead. Unfortunately, many in the insurance industry felt that unfair discrimination could only be prevented through the now-illegal rating bureaus. Insurance companies continued on their competition-bankruptcy cycle.38 In 1911, Iowa’s anticompact law was successfully challenged. The court viewed compacts as a necessary evil. To control the anticompetitive nature of compacts, however, the court acknowledged that the state still had the right to regulate compacts’ activities although the state could not prohibit their formation.39 In 1923, the NCIC passed a resolution to bring about the repeal of state anticompact laws. Insurance regulators had reached the conclusion that for insurers to develop and maintain adequate rates and to avoid unfair discrimination, rate bureaus and insurer compacts or associations were necessary. By 1925, this movement to reinstate rate bureaus and compacts was supported by most insurance regulators, who were actively pursuing the repeal of their states’ anticompact laws.40

Chapter 2 / The Evolution of Insurance Regulation 43

The South-Eastern Underwriters Association Decision and the McCarran-Ferguson Act As state antitrust laws began to be repealed, insurer compacts—often subject to state regulation—once again began to take hold. Among these compacts was the SEUA. The SEUA comprised nearly 200 private stock insurers that controlled about 90 percent of the fire and allied (including coverage for marine and extended perils) lines insurance market in six southeastern states (Alabama, Florida, Georgia, North Carolina, South Carolina, and Virginia).41

The South-Eastern Underwriters Association Decision Although Missouri had no connection with SEUA, the state wanted a federal challenge to rating bureaus. Therefore, the attorney general of Missouri tried to stop the SEUA’s rate fixing. When he had no success at the state level, he filed a complaint with the Antitrust Division of the Department of Justice. A federal investigation ensued, and criminal indictments were brought against the SEUA, twenty-seven of its officers, and all of its members for the following activities: •

Continuing agreement and concert of action to take control of 90 percent of the fire and allied lines insurance market

•

Fixing premium rates and agents’ commissions

•

Using boycott and other forms of coercion and intimidation to force nonSEUA members to comply with SEUA rules

•

Withdrawing the rights of agents to represent SEUA members if the agents also represented non-SEUA companies

•

Threatening insurance consumers with boycott and loss of patronage if they did not purchase their insurance from SEUA members42

The District Court of the United States for the Northern District of Georgia dismissed the case based on the U.S. Supreme Court’s decision in Paul v. Virginia. On appeal, the U.S. Supreme Court agreed to hear the SEUA case in 1944. The Court noted that each of the activities, if performed by companies that were not insurers, would have been subject to prosecution under the Sherman Act, and that the SEUA was not denying this fact. The SEUA simply contended that it was not subject to the Sherman Act because of the Paul v. Virginia decision. In analyzing the case, the Court considered the following two questions:

44 The Regulation of Insurance

1. Was the Sherman Act intended to prohibit conduct of fire insurance companies, which restrains or monopolizes the interstate fire insurance trade? 2. If so, do fire insurance transactions that stretch across state lines constitute “Commerce among the several states” so as to make them subject to regulation by Congress under the Commerce Clause? 43

In answer to the first question, the Court determined that the Sherman Act was intended to prohibit the kinds of conduct exhibited by the interstate fire insurers and SEUA.44 Thus, the second question became a crucial one for the Court as well as for the insurance industry. The Court decided that insurance was commerce as referred to in the Commerce Clause of the Constitution and, as such, was subject to regulation by Congress. In making this determination, various arguments were advanced in favor of Congress’s regulation of insurance, including the following: •

•

•

•

Insurance is not a business that is distinct in each of the states, but is interrelated, interdependent, and integrated across the states. Individuals in several different states can obtain insurance from the same insurance company. The decisions made by insurers consider not only the environment of the state of domicile but also the states in which products are sold. Of the 200 or more members of SEUA, only eighteen were domiciled in one of the six SEUA states. All others were domiciled in Pennsylvania, New York, or Connecticut. Both before and after the Paul v. Virginia decision, intangible products, such as electrical impulses of telegraph transmissions, were subject to regulation by Congress. Other businesses make sales contracts in states where they are not headquartered, and these businesses are subject to regulation by Congress.45

Perhaps the Court’s entire argument for federal regulation of insurance can be best summed up by the following: No commercial enterprise of any kind which conducts its activities across state lines has been held to be wholly beyond the regulatory powers of Congress under the Commerce Clause. We cannot make an exception for the business of insurance.46

Aftermath of the South-Eastern Underwriters Association Decision The Supreme Court’s decision stunned state insurance regulators and the insurance industry. The system of insurance regulation that had existed for years and that regulators and regulated preferred was now in jeopardy. The National Association of Insurance Commissioners (NAIC; the NCIC was renamed in the 1930s) worked to fight federal regulation.

Chapter 2 / The Evolution of Insurance Regulation 45 The first activity undertaken by the NAIC was to delay the takeover by the federal government. The Committee to Study Federal Legislation adopted a resolution in which it asked state insurance commissioners to get their state attorneys general to cooperate with each other to have the U.S. Supreme Court rehear the South-Eastern Underwriters case. This failed.47 The NAIC’s second course of action was to assess the damage caused by the decision. The Subcommittee on Federal Legislation was charged with this responsibility.48 The immediate effect of the SEUA decision was that federal legislation now applied to insurance, including the following acts: •

The Sherman Act (1890). This act prohibits collusion in attempts to gain monopoly power. Any activity that restrains trade or commerce and any attempt to monopolize is illegal. Thus, insurance companies could no longer band together, as in the SEUA and similar groups, to control rates and coverages.

•

The Clayton Act (1914) and its amendment, the Robinson-Patman Act (1936). The Clayton Act identified and made illegal practices that lessened competition or created monopoly power. The types of activities declared illegal include price discrimination, tying (requiring the purchase of a product when purchasing another product) and exclusive dealing, and mergers between competitors. The Robinson-Patman Act limited price discrimination to only price differentials that could be shown to be due to differences in operating costs resulting from competing “in good faith.” Thus, insurers would no longer be able to cut premiums to drive out competition unless the insurers could prove that the drop in rates was due to increased efficiencies in operations. In addition, the sale of products could not be tied together.

•

The Federal Trade Commission (FTC) Act (1914). In addition to creating the FTC, the FTC Act identified and made illegal unfair methods of competition and unfair or deceptive trade practices. Thus, the act promoted competition and protected consumers.49

Together, those federal acts meant the end of business as usual for the insurance industry. State insurance regulators, as well as those in the industry, believed that some forms of cooperation, especially with respect to establishing the statistical base for adequate rates, were necessary. That was the principal momentum behind the following recommendations of the Subcommittee on Federal Legislation: •

Congress must be pressured to enact legislation under the Commerce Clause of the Constitution, which allows states to continue to regulate insurance.

46 The Regulation of Insurance •

•

The Sherman Act and the Clayton Act must be amended to allow cooperative arrangements that are required and incidental to establishing adequate rates, coverages, and related concerns. The FTC Act and the Robinson-Patman Act must be amended to exclude insurance from their provisions.50

The McCarran-Ferguson Act In 1945, the year following the SEUA decision, Congress passed the McCarran-Ferguson Act (McCarran). McCarran, which is reproduced in Exhibit 2-1, essentially gave the NAIC and the insurance industry what they wanted. Subject to certain conditions, McCarran returned regulation of the “business of insurance” to the states. Congress’s justification for such legislation was that it was “in the public interest” to have states continue to regulate the “business of insurance.” (The determination of what constitutes the “business of insurance” is discussed in detail in Chapter 6.) One condition of McCarran is of primary importance because if it is not met, Congress can take over the regulation of the “business of insurance.” Under sections 1012 and 1013 of McCarran, the Sherman Act, the Clayton Act, the FTC Act, and the Robinson-Patman Act do not apply to the “business of insurance” unless the states are not regulating the activities described in the acts. That condition, however, is subject to an exception with respect to the Sherman Act and an exception with respect to federal legislation that deals specifically with insurance. The Sherman Act continues to apply to the use of boycott, coercion, or intimidation by insurers. In other words, states must have their own antitrust legislation and their own unfair trade practices legislation if they want to prevent the federal government from enforcing the acts, with the exception that such state legislation will not supersede federal authority regarding boycott, coercion, and intimidation. Furthermore, if Congress passes a law that applies only to the insurance industry, not to all business in general, the federal law supersedes any state regulation in the areas addressed by the federal legislation. Note that Congress, in Section 1014 of McCarran, prevented states from controlling labor relations. Thus, insurers are still subject to federal regulation regarding labor relations under the National Labor Relations Act (1935), the Fair Labor Standards Act (1938), and the Merchant Marine Act (1920).

Following the McCarran-Ferguson Act With the passage of McCarran in 1945, the NAIC and state legislatures began an extremely busy period of developing and implementing various insurance laws that were designed more to allow cooperation in setting rates and to keep

Chapter 2 / The Evolution of Insurance Regulation 47

Exhibit 2-1 Text of the McCarran-Ferguson Act McCarran-Ferguson Act 15 U.S.C. Sections 1011-1015 March 9, 1945 Section 1011. The Congress hereby declares that the continued regulation and taxation by the several States of the business of insurance is in the public interest, and that silence on the part of the Congress shall not be construed to impose any barrier to the regulation or taxation of such business by the several States. Section 1012. (a) The business of insurance, and every person engaged therein, shall be subject to the laws of the several States which relate to the regulation or taxation of such business. (b) No act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, or which imposes a fee or a tax upon such business, unless such Act specifically relates to the business of insurance: Provided, that after June 30, 1948, the Act of July 2, 1890, as amended, known as the Sherman Act, and the Act of October 15, 1914, as amended, known as the Clayton Act, and the Act of September 26, 1914, known as the Federal Trade Commission Act, as amended, shall be applicable to the business of insurance to the extent that such business is not regulated by State law. Section 1013. (a) Until July 30, 1948, the Act of July 2, 1890, as amended, known as the Sherman Act, and the Act of October 15, 1914, as amended, known as the Clayton Act, and the Act of September 26, 1914, known as the Federal Trade Commission Act, as amended, and the Act of June 19, 1936, known as the Robinson-Patman Antidiscrimination Act, shall not apply to the business of insurance or to acts in the conduct thereof. (b) Nothing contained in this Act shall render the said Sherman Act inapplicable to any agreement to boycott, coerce, or intimidate, or act of boycott, coercion, or intimidation. Section 1014. Nothing contained in this Act shall be construed to affect in any manner the application to the business of insurance of the Act of July 5, 1935, as amended, known as the National Labor Relations Act, or the Act of June 25, 1938, as amended, known as the Fair Labor Standards Act of 1938, or the Act of June 5, 1920, known as the Merchant Marine Act, 1920. Section 1015. As used in this Act, the term “State” includes the several States, Alaska, Hawaii, Puerto Rico, Guam, and the District of Columbia.

48 The Regulation of Insurance Congress from interfering than to promote competition.51 Under McCarran, the states had until 1948 to pass legislation to regulate insurance and thus to limit federal regulation. The principal concerns for the NAIC were concerted ratemaking and unfair trade practices. In 1946, the NAIC approved two model rate regulation bills— one that applied to liability insurers and another that applied to fire, marine, and inland marine insurers. The purposes of those two bills were (1) to ensure that rates were not excessive, were not unfairly discriminatory, and were adequate and (2) to allow cooperation in setting rates, as long as it did not hinder competition. To achieve those purposes, the bills did the following: • • • •

Required prior approval of rates. Explained how to file rates. (Filing is the process used to submit rates and related information to insurance regulators for their approval.) Described the role of rating organizations. Recommended antirebating provisions in states that did not already have such laws. (Antirebating laws prohibit agents, brokers, and insurers from returning portions of premiums—that is, rebates—as incentive to applicants to purchase insurance.)

While most states enacted some form of rate regulation, many states did not closely follow the NAIC models. Many states preferred other means of rate regulation besides prior approval laws, and some states approved of rebating. However, the passage of such laws met the requirements under McCarran and as such preempted the provisions of the Robinson-Patman Act, the FTC Act, and the Sherman Act regarding cooperative ratemaking.52 In 1947, the NAIC adopted the Act Relating to Unfair Methods of Competition and Unfair Deceptive Acts and Practices in the Business of Insurance. The purpose of that act was primarily to preempt the application of the FTC Act to the insurance industry. The NAIC’s model described certain activities that were deemed to be methods of unfair competition or unfair and deceptive practices and acts. The prohibited activities included the following: • • • •

Misrepresentation and false advertising of policies. False information and false advertising in general. Defamation. Boycott, coercion, and intimidation. (Although this provision was recognized as overlapping with the provisions of the Sherman Act that still applied to insurers, the authors of the model act felt that also identifying such activities in state laws would reduce the amount of federal intervention.)

Chapter 2 / The Evolution of Insurance Regulation 49 • False financial statements. • Stock operations and advisory board contracts. • Unfair discrimination. • Rebating.53 Most states enacted laws that were quite similar to the NAIC model.54 By the end of 1947, the NAIC and the states felt that they had preempted the federal legislation that would have the most damaging effect on the insurance industry. Although those laws have been modified over the years, the objectives the NAIC set in the late 1940s are still met by the descendants of those acts.

The Era Since McCarran Other developments have occurred in insurance regulation since McCarran that are not directly related to the passage of the law. Many of these developments have had a major effect on insurance regulation and the insurance industry. For example, in 1972, the NAIC adopted the Unfair Claims Settlement Practices Act and added it to the Unfair Trade Practices Act (the descendant of the Act Relating to Unfair Methods of Competition and Unfair and Deceptive Acts and Practices in the Business of Insurance). The Unfair Claims Settlement Practices Act drew attention to those unfair trade practices that occurred during the claims settlement process. The two acts were separated into independent acts in 1990. As indicated in the introduction to this chapter, insurance regulation reacts to events in the insurance industry. When new forms of market failure or other market imperfections occur or when they reappear in insurance markets, new regulation is developed and enacted or existing regulation is modified to address the causes of the market failure or imperfection. Throughout its history, insurance regulation has been especially sensitive to certain types of market failures and market imperfections: • • •

Insurer insolvencies Unavailable and unaffordable insurance coverages Inequitable treatment of insurance consumers

Regulation has also been influenced by forces outside the insurance industry. The influence of these factors has continued in the period since McCarran was passed. The regulation enacted because of each of these factors is discussed below.

50 The Regulation of Insurance

Insurer Insolvencies Concern over insurer insolvencies is probably the primary motivator for much of the insurance regulation that currently exists. The following examples identify regulation resulting from insurer insolvencies that has been enacted since McCarran.

Guaranty Funds The NAIC adopted the Post-Assessment Property and Liability Insurance Guaranty Association Model Act in 1969 because auto insurer insolvencies had left insureds without coverage. The NAIC did not want drivers to be financially harmed because their auto insurer could no longer meet their insurance needs. However, the act was not limited to auto insurance. It applies to all property-liability lines. Most states quickly enacted similar post-assessment guaranty fund legislation.55 By the end of 1970, twenty-two states had enacted similar legislation. All states have guaranty funds today and all are postinsolvency guaranty funds (meaning that insurers are assessed after an insolvency has occurred) except New York’s, which is a preinsolvency guaranty fund (meaning that insurers pay into the fund annually so that money is available before an insolvency occurs).56

Early Detection In 1971, the NAIC implemented the Early Warning Tests. The tests were designed to detect companies in financial trouble early enough that insurance regulators could minimize the guaranty assessments needed in the wake of insurer insolvencies. The goal was to prevent the need for guaranty fund assessments by taking over the companies and returning them to active operation or merging them with other going concerns. The NAIC renamed the Early Warning Tests the Insurance Regulatory Information System (IRIS) in 1977.57 The ratios continue to be used by the NAIC today in conjunction with other insolvency detection techniques such as the Financial Analysis and Solvency Tracking (FAST) system. In 1989, the NAIC adopted its accreditation program that was developed to create similar financial solvency regulation standards in all states.58 By the end of 1994, forty-four state insurance departments had been accredited.

Unavailable and Unaffordable Insurance Coverages The unavailability and unaffordability of insurance has become an increasingly visible issue in recent years. Insurance markets have had periods within the last three decades in which they have not provided insurance coverage for

Chapter 2 / The Evolution of Insurance Regulation 51 some loss exposures and in which the premiums for other insurance coverages are too great for insureds to afford. Insurance regulators become concerned when consumers cannot obtain the insurance coverage they want and need at affordable prices. Various regulation has been enacted to address the affordability and availability issue.

Federal Programs In the middle to late 1960s, many homeowners and small businesses in inner cities were unable to obtain property insurance because of the risk of riot and civil commotion. The federal government, under the Urban Property Protection and Reinsurance Act of 1968, established a reinsurance program for private insurers that provided property insurance to inner city individuals, families, and businesses through state Fair Access to Insurance Requirements (FAIR) plans. If insurers do not participate in the state FAIR plans, they cannot seek funds from the federal reinsurance pool.59 In 1968, Congress also enacted the National Flood Insurance Act to provide flood insurance at a price that consumers could afford. Private insurers could not cover flood loss exposures because of the catastrophic nature of the peril. However, such coverage was needed and the federal government enacted legislation to meet the need.60

Risk Retention Acts Since the middle 1970s, insurers are increasingly called upon to pay for product liability losses that they had not anticipated. The product liability insurance market quickly dried up, making product liability insurance nearly impossible to obtain. Congress enacted the Risk Retention Act of 1981 to address this problem. The act allowed products liability risk retention groups to form in one state and operate in any state subject primarily to the regulation in the state of domicile with limited regulation applied in other states in which the groups are licensed. The act pertains specifically to the area of insurance and overrides any state regulation that addresses the operation of risk retention pools as stated in McCarran. In 1986, Congress amended the Risk Retention Act of 1981 to include additional types of commercial liability insurance and to allow risk purchasing groups the same privileges as risk retention groups. At the time, commercial liability insurance for some types of businesses was not available at affordable rates because of the potential frequency and severity of such losses. The NAIC adopted its own version of a risk retention act in 1983—the Model Risk Retention Act—and amended it in 1986 to address the areas that were not dealt with by the federal laws. 61

52 The Regulation of Insurance

Inequitable Treatment of Insurance Consumers Consumer protection is one of the goals of insurance regulation. When insurance consumers are not treated fairly and equitably by the insurance industry, insurance regulators enact legislation to better protect insurance consumers.

Cancellation Laws At one time insurance companies could cancel personal property and liability policies, including homeowners and auto policies, without providing the reasons for termination. It was difficult for insureds to argue the grounds of their cancellations because they did not have the correct information. Furthermore, it was difficult for insurance regulators to effectively intervene because they did not have ready access to the information in many cases. Insurance regulators, therefore, promoted regulation that required insureds to be given due notice of cancellation as well as the reasons for cancellation. Similar provisions were enacted in all states in the late 1970s and early 1980s.62

Collision Damage Waivers In 1986, the NAIC adopted a model act aimed at car-rental agencies’ use of collision damage waivers. The rental agencies were engaging in deceptive and unfair practices and were requiring unreasonable premiums for the coverage. The NAIC, and the states that enacted the legislation, wanted to give state insurance regulators some way to control the unfair practices used by the car rental agencies.63

Forces Outside the Insurance Industry By the late 1980s, insurance regulation was being actively influenced by entities other than state insurance regulators, Congress, and the insurance industry. In California, Proposition 103 was passed in the general election of 1988. This voter initiative received 51 percent of the vote, mandated 20 percent rollbacks in property-liability insurance rates, and limited insurers’ abilities to underwrite auto insurance risks. In 1989, the California Supreme Court substantially upheld Proposition 103 in the following areas: • • • • •

The prior approval of rates Reduced use of territories in rate setting The removal of an exemption from California’s antitrust law The entry of banks into insurance Elected insurance commissioner

Chapter 2 / The Evolution of Insurance Regulation 53

However, the Court had trouble with the 20 percent rate rollback because the rollback would not allow insurers a chance to earn a fair rate of return. For rollback purposes, a 10 percent rate of return was established as a lower boundary. Individual companies had the opportunity to prove that it penalized them. In August 1994, the California Supreme Court upheld the 10 percent rate rollback for rates used by one insurer before the referendum was originally passed.64 In March of 1988, state attorneys general for Alabama, California, Massachusetts, Minnesota, New York, West Virginia, and Wisconsin filed antitrust lawsuits in the Federal District Court of San Francisco, charging major insurance companies and industry associations with conspiring to create a global boycott of certain types of commercial general liability coverages—in particular, environmental damage resulting from pollution. Arizona, Arkansas, Colorado, Connecticut, Maryland, Michigan, Montana, New Jersey, Ohio, Pennsylvania, Texas, and Washington had joined the action by June of 1988. The attorneys general alleged that the restrictive language that the insurers and industry associations conspired to use and that was adopted by the Insurance Services Organization (ISO), led to the 1984-1985 liability insurance crisis.65 In October 1994, the case was finally settled. The insurers did not admit any wrongdoing. However, they agreed to contribute more than $20 million to a risk management educational organization. Furthermore, insurer representation on ISO’s board of directors was cut from eighteen of twenty-one members to four of eleven members, and insurance company employees were removed from most positions in which they could influence ISO policy language.66

Recurring Issues in Insurance Regulation As mentioned at the beginning of this chapter, some regulatory issues reappear from time to time. Certain issues seem never to be completely resolved and will probably continue to appear well into the future. Among the more notable issues in insurance regulation are the following: •

State supervision versus federal supervision of insurance regulation

•

Emphasis on insolvency prevention versus emphasis on consumer protection

•

Insurance regulation to regulate insurers versus regulation to promote social policy

54 The Regulation of Insurance Each of these issues has a major influence on the direction of insurance regulation during the periods in which it is a primary regulatory concern. These issues and their influences are discussed below.

State Supervision Versus Federal Supervision The issue of who should regulate the insurance industry dominates regulatory concerns periodically. It is a divisive issue—some in the insurance industry support state insurance regulation and some support federal regulation. State regulatory authority was not significantly tested until the 1869 Paul v. Virginia case. The resulting decision from the Paul v. Virginia case supported state insurance regulation. However, at the time the court handed down its decision, some insurance regulators would have preferred federal regulation. Insurers were beginning to branch out across state lines, and insurance regulators (as well as insurers) had to deal with regulators in other states and different requirements across jurisdictions. But, insurance regulation continued under state domain for another seventy-five years.67 By 1944, the insurance industry had settled into the state insurance regulation system and preferred state insurance regulation to the idea of federal regulation. But, the U.S. Supreme Court decided that insurance regulation should be the responsibility of Congress in its SEUA decision. A year later, Congress passed McCarran, giving in to many of the insurance industry’s and state insurance regulators’ demands and returning most of the control of insurance regulation to the states. Once McCarran passed, state insurance regulation began to fulfill its duties under McCarran and the state versus federal debate was put on the back burner—it did not entirely disappear. Some members of Congress and some insurance industry participants continued to press for federal insurance regulation. For example, Representative Jack Brooks proposed a bill allowing for federal solvency regulation each year between 1988 and 1994, inclusive.68 The state versus federal debate returned to the front burner in the late 1980s with the release of the Subcommittee on Oversight and Investigations of the House Committee on Energy and Commerce report “Failed Promises,” which chastised state insurance regulation. Federal solvency regulation was recommended as a way to prevent the insolvencies being witnessed in the insurance industry at the time. (The subcommittee followed up with the release of “Wishful Thinking” in 1994, which reached conclusions similar to those of “Failed Promises.”) The reappearance of the issue divided the insurance industry. Proponents of federal regulation worked with Congress in developing federal solvency legis-

Chapter 2 / The Evolution of Insurance Regulation 55 lation while proponents of state insurance regulation testified before Congress against the need for federal solvency regulation. Although the issue was overshadowed by the consumer protection issue discussed in the next subheading, it was not forgotten. Bills continue to be proposed for the federal regulation of solvency of the insurance industry.

Insolvency Prevention Versus Consumer Protection Emphasis of insurance regulation tends to fluctuate between solvency prevention and consumer protection. Both are continually addressed by insurance regulators, but primary focus of insurance regulation tends to move between the two. In the late 1960s, a crisis in the insurance market occurred. Consumers in inner cities could not get the crime or property insurance that they needed because insurers were concerned about the possibility of riot losses. Emphasis of insurance regulation at that time was to get insurance to those who wanted and needed the coverage. Congress enacted the Federal Crime Program, and states began to develop FAIR plans. By the 1970s, the primary concern of insurance regulators had turned to insurer solvency. The NAIC developed the Early Warning Tests, subsequently renamed the Insurance Regulatory Information System, to help determine which insurers were in jeopardy of becoming insolvent. The 1980s were characterized by tight insurance markets. Insurers had tightened their underwriting standards to the point at which many businesses could not get liability coverage or could not afford the available liability coverage. Insurance regulation concentrated on making insurance coverage available and affordable. Congress enacted the Risk Retention Act in 1981 and broadened its scope in 1986. This allowed alternative sources and mechanisms to enter (1) the pollution liability market in 1981 and (2) other commercial liability insurance markets in 1986. The development of such alternatives as risk retention groups increased the availability of liability coverage and reduced costs to more affordable levels. By the end of the 1980s, however, insurance regulation once again focused on solvency detection and insolvency prevention. At the time, the Subcommittee on Oversight and Investigations’ reports had created much concern in the economy about insurer stability. Many economists forecast that the insurance industry would follow the savings and loan industry into financial ruin and that taxpayers would be forced to finance an even greater bailout than experienced with the savings and loans. As mentioned earlier, bills appeared before Congress calling for federal solvency oversight of the insurance indus-

56 The Regulation of Insurance try. The NAIC had also developed the accreditation program to improve solvency regulation and make it more uniform across the states. In the early 1990s, as the rate of insurer insolvencies began to level off and then decrease, solvency regulation was overshadowed by availability and affordability concerns in inner cities and rural areas. Insurance regulators once again began to focus on how to get insurance to those who needed and wanted it. Consumer groups were demanding that something be done about the redlining that was allegedly occurring in both the inner cities and rural areas. In 1994, the NAIC charged its Insurance Availability and Affordability Task Force with determining the extent of the problem and deciding how to modify existing regulation or to develop new regulation to deal with the perceived problem. However, many in the insurance industry question whether anything can be done because, from their perspective, redlining is not occurring— fairly discriminatory underwriting is. The resulting debate is at the center of defining the nature of insurance, as discussed in the next section.

Regulation Versus Social Policy The issues being faced in the most recent consumer protection era of insurance regulation are some of the most difficult issues to deal with. Issues that are important to consumers—such as available and affordable insurance—often clash with the operation of for-profit private insurance companies and the amount and type of insurance regulation to which insurers should be subjected. One of the most troublesome questions concerns whether insurance is a private product available only to those who meet the underwriting standards and are able to afford it. Or, is insurance a social product that should be available to all consumers at affordable prices, regardless of the amount of risk each consumer represents for the insurer? Insurance regulators continually balance the role of regulation between regulation of private entities and regulation for the social good. The federal programs mentioned—FAIR plans and the National Flood Insurance Program—make insurance available to anyone who needs it within certain limits. Private insurers might sell the actual policies but only because the federal government reinsures unexpectedly high losses. States have created residual market mechanisms for auto insurance so that high-risk drivers who do not meet private insurers’ underwriting standards can get insurance to satisfy state financial responsibility laws. Some states also oversee beach and windstorm insurance programs so that homeowners and business owners in areas characterized by high possibilities of loss from these perils can get property insurance.

Chapter 2 / The Evolution of Insurance Regulation 57 The use of residual markets for insurance is a social aspect of insurance regulation. Consumers were not willing to go without insurance, and state insurance regulators and others in state and federal governments were required, or required insurers, to provide the desired coverage—although the risks assumed generally do not meet the underwriting requirements that private insurers set to control their loss exposure. The issue is of great concern, because it has now entered the area of homeowners insurance in the inner cities and in rural areas. Consumer groups have alleged that redlining still occurs. Insurers defend their reluctance to write insurance in these areas as maintaining appropriate underwriting standards. Insurance regulators are caught in the middle—there is a problem that needs to be solved, but most insurance regulators are reluctant to force insurers to write in areas that could lead to financial hardship. Progress on the issue is being made. The Illinois Insurance Department has been involved in a program that is designed to bring insurers voluntarily into the inner cities and the rural areas. Insurers have been invited to meet with regulators and, in some cases, with social workers and consumer representatives to discuss the risks of providing property insurance in inner cities and rural areas characterized by poor loss experience. Insurers are finding that some of the areas they assumed to be poor risks might actually allow for profitable business opportunities, and they are willing to enter the market voluntarily. Illinois has identified one method for addressing the issue. Other means of dealing with the issue of insurance as a right or as a privilege are likely to be developed. This issue will not, however, be resolved without the involvement of, and the cooperation from, insurance regulators, the insurance industry, and insurance consumers.

Summary Throughout its evolution in the United States, insurance regulation has primarily been the domain of the states. Federal insurance regulation has been threatened from time to time, and, in some areas, federal supervision exists. However, the state insurance departments are the primary regulators of the insurance industry. The McCarran-Ferguson Act (McCarran) is the act that continues to grant authority to the states to regulate the insurance industry. However, McCarran contains caveats that allow for federal intervention in certain areas—under the Sherman and Clayton Acts with respect to boycott, coercion, and intimidation and under labor laws. McCarran also allows the federal government to

58 The Regulation of Insurance enact legislation that is specific to the insurance industry and that supersedes state regulation. Federal regulation can also intervene if the states are not adequately regulating insurance. The evolution of insurance regulation has been varied and eventful. This chapter has pointed out that insurance regulation is constantly changing to address the new and different challenges presented by the insurance market. As new products and services have appeared, as new market imperfections and causes of market failure have been identified, and as the insurance industry has changed, insurance regulation has reacted to address the new problems that have also arisen. As insurance regulation has developed, certain factors have influenced it. The most notable of these are insurer insolvencies, availability and affordability problems, and inequitable treatment of insurance consumers. Several issues have also developed that continue to be debated: state or federal supervision, solvency detection versus consumer protection, and the use of insurance regulation to meet social goals.

Chapter Notes 1. Insurance Accounting and Systems Association, Inc. (IASA), Property-Liability Insurance Accounting, 5th ed. (Durham, NC: IASA, July 1991), p. 1-7. 2. Samuel B. Paul v. Commonwealth of Virginia, S.C., 8 Wall., 168-185 (1869). 3. United States v. South-Eastern Underwriters Association, et al., 322 U.S. 533 (1944). 4. Property-Liability Insurance Accounting, p. 1.5; Claude C. Lilly, “A History of Insurance Regulation in the United States,” CPCU Annals (June 1976), p. 99. 5. Lilly, pp. 99-100. 6. It was not until later that foreign came to mean domiciled in another state. 7. Laws of Maryland 1809, ch. 103; Laws of New York 1814, ch. 49. 8. Laws of New York 1814, ch. 49. 9. Lester W. Zartman, ed., Yale Readings in Insurance, Property Insurance, Marine and Fire (New Haven, CT: Yale University Press, 1926), p. 79. 10. Edwin Wilhite Patterson, The Insurance Commissioner in the United States (New York, NY: Johnson Reprint Corporation, 1968), p. 524; Laws of New York 1837, p. 21. 11. Lilly, pp. 100-101. 12. Laws of New York 1849, ch. 308; Laws of New York 1851, ch. 462; Laws of New York 1853, ch. 466. 13. IASA, Property-Liability Insurance Accounting, p. 1-7; Zartman, p. 73. 14. Property-Liability Insurance Accounting, pp. 1-7, 1-9.

Chapter 2 / The Evolution of Insurance Regulation 59 15. Property-Liability Insurance Accounting, p. 1-7; Laws of New Hampshire 1851, Ch. 1, 111, Sec. 3. 16. Acts and Resolves of Vermont, 1852, nos. 45, 46, and 47. 17. Property-Liability Insurance Accounting, p. 1-7; Acts and Resolves of Massachusetts 1855, ch. 124; Acts and Resolves of Massachusetts 1858, ch. 177; Acts and Resolves of Massachusetts 1866, ch. 255. 18. Lilly, p. 101. 19. Lilly, p. 102. 20. Proceedings of the National Insurance Convention (1871), p. x. 21. Proceedings of the National Insurance Convention (1871), p. x. 22. Proceedings of the National Insurance Convention (1871), pp. xxiv, xxv, and end of the Proceedings. 23. Lilly, p. 102. 24. Lilly, p. 104. 25. Lilly, p. 104. 26. Lilly, p. 105. 27. Proceedings of the National Convention of Insurance Commissioners (1921), p. 18; Proceedings of the National Convention of Insurance Commissioners (1923), p. 33; Proceedings of the National Convention of Insurance Commissioners (1933), p. 116. 28. Proceedings of the National Convention of Insurance Commissioners (1922), pp. 2021. 29. Banks McDowell. Deregulation and Competition in the Insurance Industry (New York, NY: Quorum Books, 1989), p. 14. 30. McDowell, p. 14; Harry Chase Brearley, Fifty Years of a Civilizing Force (New York, NY: Frederick A. Stokes Company, 1916), pp. 12, 13; Edward R. Hardy, The Making of Fire Insurance Rates (New York, NY: Spectator Company, 1926), pp. 93-94. 31. Hardy, p. 94; Proceedings of the National Board of Fire Underwriters and of the Executive Committee (New York, NY: New York Economical Printing Company, 1876), pp. 1-30. 32. J. A. Fowler, “The Executive Committee of the National Board of Fire Underwriters,” American Exchange and Review (June 1869), p. 274. 33. Lilly, p. 103. 34. United States v. South-Eastern Underwriters Association, et al., paragraph 555. 35. Lilly, p. 103. 36. McDowell, p. 17. 37. Hartford Fire Insurance Company v. Raymond, 70 Michigan 485 (1888), 38 N.W. 474 (1888). 38. McDowell, pp. 14-15. 39. German Alliance Insurance Company v. Hale, 219 U.S. 307, 316 (1911).

60 The Regulation of Insurance 40. Lilly, p. 103; Proceedings of the National Convention of Insurance Commissioners (1923), p. 165. 41. United States v. South-Eastern Underwriters Association, et al., paragraph 533. 42. United States v. South-Eastern Underwriters Association, et al., paragraphs 535-536; Lilly, pp. 106-107. 43. United States v. South-Eastern Underwriters Association, et al., paragraph 539. 44. United States v. South-Eastern Underwriters Association, et al., paragraph 539. 45. United States v. South-Eastern Underwriters Association, et al., paragraphs 540 through 547. 46. United States v. South-Eastern Underwriters Association, et al., paragraph 553. 47. Proceedings of the National Association of Insurance Commissioners (1945), pp. 2829. 48. Proceedings of the National Association of Insurance Commissioners (1945), pp. 28, 29. 49. Daniel F. Spulber, Regulation and Markets (Cambridge, MA: The MIT Press, 1989), pp. 464-468. 50. Proceedings of the National Association of Insurance Commissioners (1945), pp. 28, 29. 51. McDowell, p. 19. 52. Lilly, p. 108. 53. Proceedings of the National Association of Insurance Commissioners (1947), p. 392. 54. National Association of Insurance Commissioners, “Unfair Trade Practices Act,” Model Laws, Regulations and Guidelines, vol. IV (April 1994), pp. 880-15 to 880-18. 55. National Association of Insurance Commissioners (NAIC), “Post-Assessment Property and Liability Guarantee Association Model Act,” Model Laws, Regulations and Guidelines, vol. III (October 1993), pp. 540-21 to 540-29. 56. “Post-Assessment Property and Liability Guaranty Association Model Act,” p. 540-25; Lilly, p. 111. 57. Property-Liability Insurance Accounting, p. 1-13. 58. National Association of Insurance Commissioners (NAIC), “NAIC Policy Statement on Financial Regulatory Standards,” Model Laws, Regulations and Guidelines, vol. IV (April 1993), pp. 690-1 to 690-9. 59. S. S. Huebner, Kenneth Black, Jr., and Robert S. Cline, Property and Liability Insurance, 3d ed. (Englewood Cliffs, NJ: Prentice-Hall Inc., 1982), p. 537. 60. Huebner, Black, and Cline, p. 122. 61. Property and Liability Insurance Fact Book of 1981-1982, pp. 8-9; Property and Liability Insurance Fact Book of 1987-1988, p. 10; Model Laws, Regulations and Guidelines (January 1992), p. 705-29. 62. National Association of Insurance Commissioners (NAIC), “Property Insurance Declination, Termination and Disclosure Model Act,” Model Laws, Regulations and Guidelines, vol. IV (July 1992), pp. 720-11, 725-11.

Chapter 2 / The Evolution of Insurance Regulation 61 63. National Association of Insurance Commissioners (NAIC), “Collision Damage Waiver Model Act,” Model Laws, Regulations and Guidelines, vol. IV, April 1993, p. 728-9. 64. Property-Liability Insurance Fact Book, 1990, p. 7; Joanne Wojcik, “Proposition 103 Upheld,” Business Insurance (August 22, 1994), pp. 2, 31. 65. Property-Liability Insurance Fact Book, 1988-1989, pp. 7-8. 66. Judy Greenwald, “Antitrust Settlement to Alter ISO, Industry,” Business Insurance, October 10, 1994, pp. 1, 37. 67. Property-Liability Insurance Accounting, p. 1-7. 68. “Compromise on McCarran,” Business Insurance, March 7, 1994, p. 8.

Chapter 3

An Overview of State Insurance Departments Insurance, like banking and other financial service businesses, is regulated. The reason for regulation is that insurance, being a transfer of risk, is a financial promise: under specified conditions stated in a contract, the insurance company promises to put the insured back into the same financial position that existed before a loss occurred. Regulation is intended to assure that the future performance promise, to pay a claim, will be fulfilled as needed. As a result, insurance companies have a fiduciary responsibility to policyholders, claimants, stockholders, and the general public. Regulation protects the public interest. Additionally, because the McCarran-Ferguson Act in 1945 stipulated that regulation of insurance is the domain of the state governments in the absence of regulation by the federal government, the states have regulated it. Each state (as well as the federal government) has three separate and equal branches of government: legislative, judicial, and executive. The legislative branch makes the laws, the judicial branch interprets the laws, and the executive branch implements the laws. The day-to-day regulation of the insurance industry is done by the executive branch of each state government. Within that branch, the work of state insurance regulation is done either by a separate department or division of the executive branch or by a unit that (1) is a part of a larger group within the branch and (2) is responsible for more than just the administration of a particular state’s insurance laws. All states have one or the other arrangement within their executive branches. 63

64

The Regulation of Insurance

The Insurance Commissioner Every state has a person within the executive branch who is in charge of the insurance department or division (hereafter referred to as the insurance department). That individual might also be responsible for other matters, to be explained later in the chapter. However, this discussion is limited to insurance. The top administrator in most of the states is referred to as the insurance commissioner, but for about 20 percent of the states, the job title for the person in charge of the state’s insurance department is superintendent of insurance or director of insurance. The difference is in name only. One reason for the title difference is tied to the organization of the particular state’s executive branch. In some states, the head of the insurance department is a cabinet level position; other states designate the post as one that reports to an executive branch official other than to the governor. Another reason is that in some states, the legislature specifies in its laws the job title for the individual in charge of the insurance department. (The legislature might also specify the job titles for other state departments.) In this book, the designation insurance commissioner will be used.

Elected Versus Appointed Commissioners Insurance commissioners are either elected or appointed. No common demographic, geographic, or political characteristics explain why the commissioners are elected rather than appointed or vice versa. Twelve states elect an insurance commissioner: California, Delaware, Florida, Georgia, Kansas, Louisiana, Mississippi, Montana, North Carolina, North Dakota, Oklahoma, and Washington. Periodically, efforts are made in some states to change the status of the office from appointive to elective and, from time to time, either (1) legislation is introduced or (2) a petition is circulated to have the change in status put on the ballot. In thirty-two of the thirty-eight states that have appointed insurance commissioners, the governor makes the appointment. In the other six states (Alaska, Hawaii, New Mexico, Rhode Island, South Dakota, and Virginia), a group or an executive branch official (such as the Secretary of Commerce and Regulation1) makes the appointment, although in one of these states (South Dakota) the governor must approve the official’s choice of an insurance commissioner. Not uncommon is the state law that connects the appointed insurance commissioner’s term to that of the governor’s. Missouri law, as an example, says, “. . .shall hold. . .office concurrently with that of the governor. . . .” 2

Chapter 3 / An Overview of State Insurance Departments

65

The Elected Versus Appointed Arguments Some disagreement still exists regarding whether an elected or an appointed commissioner best serves the public interest. Proponents of an elective system cite the following arguments to support their position: •

•

•

•

An appointed insurance commissioner is subject to dismissal for cause,3 which could make the term of office uncertain. An elected commissioner is generally in office for a full term. An appointed insurance commissioner might continue regulating in the same manner as his or her predecessor when a different approach to regulation is required. An elected commissioner would likely change the insurance department’s stance. An appointed insurance commissioner might or might not be as aware of the public’s concerns. The elected commissioner is keenly aware of what insurance issues are important to the public. An appointed insurance commissioner might feel inclined to yield to the interests of those responsible for the appointment. The elected commissioner is not obligated to any particular group or special interest.

Proponents of an appointive system cite the following arguments to support their position: •

•

•

•

An appointed insurance commissioner has no need to campaign and therefore, no need to be involved in raising campaign funds and unduly influenced by a particular segment of the constituency, as might occur for an elected commissioner. An experienced and knowledgeable person can be designated as the insurance commissioner. Some states (such as Indiana) require that an insurance expert be appointed. An elected official might not be knowledgeable about insurance. An appointed insurance commissioner is less likely to be swayed by public opinion than an elected one would be. An elected insurance commissioner might be overly influenced by public opinion, which could have an adverse effect on insurance regulation. An appointed insurance commissioner is more likely than an elected commissioner to be perceived as a career state government employee interested in insurance regulation. An elected insurance commissioner might be perceived as a politician interested in political advancement.

Less than half of the states have legislative involvement with the selection of an insurance commissioner. These states have laws that use such phrases

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The Regulation of Insurance as “. . .with the advice and consent of the Senate. . .,”4 “. . .subject. . .to confirmation by the Legislature,”5 and other similar wording to explain the role of a state’s legislature in the appointment process.

Commissioners’ Previous Experience The backgrounds of regulators chosen have been diverse. Although many insurance commissioners have had an insurance oriented background such as serving as a deputy insurance commissioner, being an insurance agent, company official, or risk manager, many other regulators come to the office with a wide variety of work experience. Accountants, bankers, bureaucrats, business owners, college professors, lawyers, legislators, and members of the medical profession have also become insurance commissioners in various states. Qualifications for the position of insurance commissioner vary as does the annual salary (from less than $20,000 to more than $100,000). Approximately half of the states have eligibility requirements specified in their insurance codes. Half of those say that the person must be a registered voter or a resident for a specified period of time. Few jurisdictions require insurance experience for eligibility, and only three states cite a minimum age. Common among the state laws that have eligibility standards is a stipulation that the commissioner of insurance not have any ties to the insurance industry other than as a policyholder. Some states actually mandate that the regulator give full time to the duties involved. Many appointive states’ laws give the governor (or designated person(s)) a great deal of latitude in choosing the insurance commissioner.

Duties of the Insurance Commissioner A review of the insurance laws in all jurisdictions shows that state insurance commissioners have several duties in common. A typical law states the following: The [commissioner] shall: A. organize and manage the insurance department and direct and supervise all its activities; B. execute the duties imposed upon him by the Insurance Code; C. enforce those provisions of the Insurance Code which are administered by him; D. have the powers expressly conferred by or reasonably implied from the provisions of the Insurance Code; E. conduct such examinations and investigations of insurance matters, in addition to those expressly authorized, as he may deem proper upon reasonable and probable cause to determine whether any

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person has violated any provision of the Insurance Code or to secure information useful in the lawful enforcement or administration of any such provision; and have such additional powers and duties as may be provided by other laws of this state.6

In contrast, another law simply says that “[t]here is hereby established a department to be known as the Insurance Department which is charged with the execution of the laws of this Commonwealth in relation to insurance.”7 Such differences in insurance commissioners’ charges do not mean that one state regulates insurance more or less than another state. Differences that do exist in the amount of insurance regulation within states are due to differences in the extent of insurance laws among the states. Laws are broad in their application. Such latitude is necessary to deal effectively with the increasing complexity and variety of insurance issues. Also, by making laws broad, state legislatures avoid having to repeatedly revise them when new or different insurance issues occur that would merit the attention of the regulators. Regardless of the wording of such laws, typical duties of state insurance commissioners include the following: • • • • • • • • •

Overseeing the operation of the state insurance department Promulgating orders, rules, and regulations necessary for administration of insurance laws Determining whether to issue business licenses to new insurance companies, agents and brokers, and other insurance entities Reviewing insurance pricing and coverage Handling financial and market conduct examinations of insurers Holding hearings on insurance issues Taking action when violations of insurance laws occur Issuing an annual report on the status of the state’s insurance industry and insurance department Maintaining records of insurance department activities

These duties are further discussed later in this chapter.

Delegation of the Insurance Commissioner’s Duties Insurance commissioners usually delegate authority and responsibility for most of their tasks to others in their insurance departments. Deputy commissioners and assistant commissioners are generally the first in line to receive

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delegated tasks. All states except Oregon (which has an administrator in place of a deputy insurance commissioner or an assistant insurance commissioner) have a deputy insurance commissioner. A review of the National Association of Insurance Commissioners’ (NAIC) Insurance Department Directory and also of the Insurance Almanac published by the National Conference of Insurance Legislators shows that less than half of the states also have an assistant commissioner of insurance. Deputy insurance commissioners are not necessarily subordinate to assistant commissioners. For example, the organizational chart of the North Carolina Department of Insurance (dated September 1993), illustrated in Exhibit 3-1, shows that the chief deputy commissioner and the assistant commissioner both report directly to the insurance commissioner and are responsible for different areas of North Carolina’s Department of Insurance.

Multiple Roles of Insurance Commissioners In some states—Florida, Minnesota, Montana, Oregon, Rhode Island, Tennessee, and Vermont—the insurance commissioner is responsible for more than just insurance regulation. Statutory requirements8 in Florida, for example, divide that state’s insurance department into different operating divisions, among them the division of state fire marshal and the division of treasury. Florida’s insurance commissioner is also the state’s fire marshal and the state’s treasurer. Thus, in addition to the responsibilities as insurance commissioner, the individual must also, as state treasurer, keep track of all the jurisdiction’s finances, and, as state fire marshal, oversee fire safety and education activities. Minnesota’s commissioner of commerce is in charge of the state’s commerce department, which has an insurance division. By law, Minnesota gives the commissioner of commerce the powers and duties of an insurance commissioner among other commerce activities. Tennessee’s commissioner of insurance is also the state’s commissioner of commerce. The insurance commissioner in Montana is also the state auditor and commissioner of securities. Montana law, however, requires the insurance commissioner to “. . .appoint a chief deputy insurance commissioner who is in charge of the insurance department under the direction and control of the commissioner.”9 Oregon’s legislature in 1993 abolished the Department of Insurance and Finance; in its place, it created the Department of Consumer and Business Services consisting of the following areas:

Fire and Rescue Safety Grants

Market Conduct

Seniors Health Program Managed Care and Health Benefits

Agent Services

Financial Evaluation

Actuarial Services

Regulatory Actions, Estate Operations

Regulatory Actions, Admin. Supervision

Budget

Life and Health

State Property Fire Fund

Manufactured Housing

Engineering

Personnel

Property and Casualty

Consumer

Information Systems

Safety Services Group

Medical Database Commission

Technical Services Group

Company Services Group Public Services Group

Executive Assistant

Special Assistant to Chief Deputy

Executive Secretary

Chief Deputy Commissioner

Commissioner of Insurance

Governor

Exhibit 3-1 North Carolina Department of Insurance: Senior Deputies and Division Heads

Administrative Officer

Western Regional Office

Special Services

Investigations

Regulatory Services Group

Clerk Typist

Eastern Regional Office

Public Information

Chief Legislative Counsel

Assistant Commissioner

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• • • • • • • •

Division of Insurance and Finance Building Codes Agency Oregon Medical Insurance Pool Board State Plumbing Board Board of Boiler Rules Manufactured Structures and Parks Advisory Board Appraiser Certification and Licensure Board Office for Minority, Women, and Emerging Small Business

The director of the Department of Consumer and Business Services also has the designations of insurance commissioner and superintendent of banks. An administrator appointed by the director supervises the staff of the insurance division and oversees the daily regulation of the state’s multibillion dollar insurance industry. Rhode Island’s director of business regulation is also the banking commissioner and insurance commissioner. The director designates a person as superintendent of insurance. Day-to-day operation of the state government’s insurance division is also handled by the superintendent. Vermont’s insurance commissioner has the additional titles of commissioner of banking and commissioner of securities. What is noteworthy about the insurance commissioners of the seven states noted above is that even though they all wear multiple hats, they represent jurisdictions having little else in common with respect to size, population, location, and whether the insurance commissioner is appointed or elected. Common to all of them, though, is the point that the multiple responsibilities are related—commerce, finance, and insurance. The insurance industry is a business that affects consumers and involves the exchange of money and the making of investments. Also, insurance is a product that (1) is priced not completely knowing its cost (frequency and severity of losses), (2) is subject to price control (insurance regulation), and (3) has part of its profit set aside (claim reserves). Because of this unique business situation, some states combine the regulatory functions of finance and commerce with insurance.

Regulatory Philosophy and Style Whether state laws give explicit or implicit authority, insurance regulators operate with a philosophy and style that varies from state to state and sometimes from a predecessor to successor within the same jurisdiction. The latter situation occurs usually in states that elect an insurance commissioner or

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in states in which the governor appoints the regulator and the governorship changes from one political party to another. Benefits and costs are associated with whatever regulatory philosophy and style is used. A benefit in refusing to approve insurance pricing increases is that doing so keeps prices down. A cost associated with that particular regulatory philosophical approach is that it can reduce the number of insurers in the marketplace and abdicates the state’s responsibility of solvency regulation. An effective philosophy and style of insurance regulation is one of balance, rather than a zero-sum game in which one side wins and the other side loses. Many insurance commissioners are effective administrators and communicators and are interested in regulating insurance in the most efficient way.

Regulatory Philosophy Regulatory philosophy can be defined as a theory consisting of a set of beliefs, concepts, and attitudes concerning the relationship of the state government to the regulation of insurance. It is an atmosphere in the state insurance department created by the insurance commissioner that permeates the regulation of insurance in that state. The law can be the basis for an insurance commissioner’s regulatory philosophy. Wisconsin’s insurance law defines the purpose of regulation to include the following: • • • • •

Ensuring the solidity of insurers Ensuring the fair and equitable treatment of insureds and insurers Ensuring an adequate and healthy insurance market in the state Encouraging loss prevention Informing the public on insurance matters10

Nebraska’s insurance law enables that state’s insurance commissioner to develop rules and regulations “for the purpose of carrying out the true spirit and meaning. . .” of the laws relating to insurance.11 Other factors contributing to a commissioner’s philosophy about insurance include whether the commissioner is appointed or elected, the pattern of insurance regulation in the state, the state’s business climate, the experience and employment background of the insurance commissioner, and the relationship of the insurance commissioner with the state’s governor and legislature and with the public. An elected insurance commissioner can make consumerism a campaign pledge, and might tilt the scales of insurance regulation. However, some

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insurance industry participants believe that most insurance commissioners are consumer advocates already, because “[w]ithout making headlines, they serve consumers’ best interests by ensuring stable markets and fair rates.”12 The history of a state’s insurance regulation can affect the insurance commissioner’s philosophy by influencing how departmental resources are allocated and what issues are to be emphasized. A state’s business climate affects the philosophy of regulation. Some states seek out insurance companies to locate their offices within those states, while working to maintain a balanced approach in dealing with insurance carriers. An insurance commissioner’s regulatory philosophy is also affected by his or her previous experiences and his or her relationship with other elected officials, the insurance industry, and the general public. As mentioned earlier, insurance commissioners come from a variety of backgrounds. Therefore, either from knowledge, experience, or bias (or a combination), each insurance commissioner has formulated a particular philosophy.

Regulatory Style The governor, the state legislature, and the state’s voters might support or oppose an insurance commissioner’s regulatory philosophy. As a result of this interaction, the insurance commissioner develops a style. Regulatory style can be defined as the way in which the insurance commissioner regulates. The insurance commissioner can issue a few or many orders, hold many or no press conferences, frequently or rarely meet with state and federal legislators, lobby behind the scenes or often attend public forums, promote various insurance issues, and decide how that state’s insurance department is to regulate. Philosophy is the attitude; style is the approach. The stance of insurance commissioners can affect the functioning of an insurance department. Politically oriented regulators operate differently from bureaucratically inclined ones. Of course, insurance commissioners can use a variety or combination of styles. No single style is necessarily the best or the worst for regulation.

Political Environment Because a state’s insurance department is part of the executive branch of government headed by an elected official (the governor), insurance regulators operate in a political environment. (It is even more the case when the insurance commissioner is also elected.) Laws have been enacted for insurance departments to enforce that have more

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to do with politics than with insurance. Reporting of (1) business written by ZIP Code, (2) amount of money spent on advertising, (3) numbers of agents by specified characteristics, and (4) other social and economic factors is required of insurers. Other examples of politically inspired insurance laws are requirements in some states that automobile insurance rates maintain a set relationship by territory, that homeowners insurance pricing not have a minimum standard for the amount of coverage purchased, and that certain driver characteristics not be considered when determining the rate for car insurance. These laws might be considered politically motivated because they do not uphold the premise of insurance that the price should be matched to the risk. Take note that these kinds of laws and regulations are not the exclusive domain of states with elected insurance commissioners or of a particular geographic area; rather, they are the result of insurance being regulated in the public interest. An astute insurance commissioner is always balancing competing interests when regulating. Regulators know that they operate in an open environment. Theory and reality of insurance regulation are such that even though, for example, a typical rate regulatory law in the states says that rates shall not be excessive, inadequate, or unfairly discriminatory, the reality is that insurance rates might not meet those theoretical standards due to the political environment. For example, people have campaigned for the office of commissioner with promises to stop or reduce price increases even though such changes might be warranted under the law.

Commissioner’s Influence Due to the political environment in which insurance regulation occurs, personalities of insurance commissioners affect the operation of state insurance departments with respect to budgets, resources, staff, regulatory stance, and other concerns. Whether the regulator is appointed or elected, insurance commissioners still have a constituency in the states’ executive and legislative branches. How insurance commissioners deal with this constituency can affect how states’ insurance departments operate. Insurance departments (unless self-funded, as discussed later), must often compete with other state regulatory agencies for a share of a limited state budget. A review of the NAIC’s Insurance Department Resources Report shows that sometimes the budgets for insurance departments from year to year stay at the same dollar amount (which is really a decrease after the effects of inflation on purchasing power are considered) or decrease. Despite the insurance commissioner’s best efforts in conveying the financial needs of the insurance department’s budget to others, more money might not be available. However, the insurance commissioner who addresses the needs, interests, and attitudes

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of those people involved in a state’s budget might benefit from a bigger budget or from other forms of resources. For example, computers might be installed in the insurance department ahead of other executive branch departments that have requested them. The insurance commissioner’s rapport with the state legislature can influence the regulation of insurance in that state. Having rapport with a state’s legislature in order to have insurance issues addressed is not an exclusive domain of either an elected or appointed regulator. When dealing (directly or indirectly) with the legislature, a former legislator who has been either appointed or elected as insurance commissioner can benefit or suffer from having served as a state legislator. More important as a determining factor in the relationship between the insurance commissioner and the legislature are the personalities of the people involved. A good relationship with the legislature can result in insurance issues being addressed on a regular basis and in a beneficial manner. The opposite might be true when friction exists between the insurance commissioner and the state legislature. Future plans of an insurance commissioner can affect the operation of a state’s insurance department if the job is viewed by the commissioner as a stepping stone to employment in industry or politics. For example, when a commissioner enters office with a predetermined decision to deny all insurance price increases to achieve public support for political advancement, the necessary balancing act of an insurance department’s operation is tilted. In a similar vein, a commissioner who enters office with the goal of meeting the demands of insurance companies for rate and form approvals to gain the support of the insurance industry for future employment opportunities is also going to tilt the operation of the insurance department. However, a slant in favor of the insurance industry is curtailed by some state legislatures when laws were passed to prohibit or restrict former insurance regulators from lobbying on behalf of the insurance industry or to require a period of one to two years out of office before former regulators can be employed by the insurance industry.

Regulatory Departments and Functions As indicated by the organizational chart in Exhibit 3-1, a state insurance department can have a large number of areas and personnel. The North Carolina Department is among the largest of the state insurance departments. Wyoming, on the other hand, is the smallest. Its organizational chart is shown in Exhibit 3-2. However, although the size of the staff differs greatly, these

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Exhibit 3-2 Wyoming Insurance Department’s Organizational Chart Governor

Commissioner of Insurance Clerical Support

Finance Accounting

Deputy Commissioner Industry Compliance

Staff Attorney Consumer Protection

Consumer Affairs

Policy Review

Financial Services

Education and Licensing

insurance departments (as well as the other state insurance departments) have common areas and personnel and perform similar regulatory functions. The remainder of this section describes the various areas and functions of, and personnel within, state insurance departments.

Licensing All state insurance departments deal with the licensing of insurance companies and agents who do business in their states. In some states, claims adjusters must also be licensed. Regulators are concerned with standards being met and maintained and insist that insurance companies meet financial and legal requirements that vary by state. In addition, insurers must pay fees, which also vary by state, in order to be licensed. Insurance agents and claims adjusters must also meet certain requirements (discussed later in this chapter) and pay fees that vary by state. Regulators have the authority by law to set standards that are in the public interest.

Coverage and Pricing Regulation All of the state insurance departments regulate, to a greater or lesser degree, what prices are charged for the purchase of insurance and what types of coverage are offered to the public. For example, a typical law states that rates shall not be inadequate, excessive, or unfairly discriminatory. Every state defines the types of insurance that are regulated by law, and most states’ laws specify which pricing and coverage changes are to be submitted to

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regulators. However, in some states, specific laws about the regulation of insurance pricing or coverage do not exist; in these states, insurance commissioners have considerable authority by law and can regulate these affairs under the “powers and duties” provision of the state’s insurance statutes. Some choose to do so by use of regulation, administrative order, or other means. For example, Illinois regulations set filing requirements for insurers to follow for certain personal lines of insurance and liquor liability, although the Illinois rating law expired in 1971.13 The information filed is used for market conduct studies. Some states have specific exemptions from regulation for specified areas of insurance such as aircraft, ocean marine, and inland marine insurance. Each state insurance department has staff devoted to regulating the insurers’ filings of new or revised prices and coverages. Some insurance departments separate the task of filing review for pricing from the job of coverage filing review; some regulators divide the task by type or line of insurance. The number of filing analysts varies widely by state. A review of the NAIC’s Insurance Department Resources Report shows a staffing range for property/ casualty rate and form analysts from as few as zero in some states to a hundred and over in others. Exhibit 3-3 shows the 1992 rate and form analysts numbers for each state. There are four basic types of filing laws for property and casualty lines: prior approval, file and use, use and file, and no file. Prior approval means that the regulator must authorize the rate or coverage filing before it can be used by the insurer. File and use means that the filer must submit the rate or coverage to the state insurance department before it can be used, but the insurance company does not have to wait for approval. Use and file means that the insurance company can go ahead and use the rate or coverage, provided that it is sent to the regulator within a short time (ten to twenty days, depending upon the state) for information. No file means just that; insurers are not required to make a filing. However, even in those jurisdictions that have other than prior approval filing laws, the insurance regulators still have legal authority to disapprove a rate or coverage and to require withdrawal of the rate or coverage being used. The most common reasons for disapproval are that the regulator deems the rate or coverage to be (1) not in the public interest, (2) illegal, or (3) unfairly discriminatory. Regulators can also disapprove rates and coverages for other legally relevant reasons, such as being excessive or inadequate or not meeting minimum standards. Because individual state filing laws within a state can vary for pricing and coverage and by line of insurance, only a general statement can be made regarding their use. The majority of states have a prior approval law applying

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Exhibit 3-3 Full-Time Equivalent State Insurance Rate and Form Analysts for 1992 Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky

3.0 6.2 10.5 5.0 100.0 4.0 5.0 0.5 16.0 7.0 5.0 1.0 6.0 3.0 1.0 14.0 4.0

Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota

30.0 4.0 6.0 1.0 6.0 5.0 2.0 6.0 0.0 3.0 1.0 3.0 16.0 3.0 95.0 10.0 2.0

Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming

6.0 12.0 2.0 4.0 3.0 5.0 2.0 0.0 165.0 1.0 2.5 15.0 4.0 2.0 0.0 2.0

to most coverage filings. About 10 percent of the states have a file and use or use and file law for most coverage filings. A few states have no filing requirements for some lines of insurance coverage, and almost all of the states do not require certain inland marine exposures to be filed for coverage approval. For pricing review, many of the state regulators take a different view, believing that competition in the marketplace will work to keep insurance pricing fair. As a consequence, only about half of the states have a prior approval law, with the remaining jurisdictions (except Illinois, which has no filing law) split between file and use and use and file. Certain inland marine pricing exposures are treated the same under the law as are coverage submissions.

Examinations Individual state laws give insurance regulators the authority and duty to examine insurers periodically regarding their finances and market conduct. A quotation from Minnesota insurance law illustrates this point: At any time and for any reason related to the enforcement of the insurance laws, or to ensure that companies are being operated in a safe and sound manner and to protect the public interest, the commissioner may examine the affairs and conditions of any. . .company. . .or any other person or organization. . .doing. . .any insurance business in this state. . . .14

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All states perform the examination function. Because an insurer’s financial condition and market conduct problems are frequently related, both kinds of examinations can be done simultaneously. The examined insurers pay the costs for both financial and market conduct examinations. This discussion will cover both financial examinations and market conduct examinations.

Financial Examinations From a state insurance regulator’s viewpoint, monitoring the financial status of an insurer goes hand in hand with helping insureds. Financial examinations are the primary tool used to regulate an insurer’s financial condition. A typical authorization for the financial examination of insurers can be found in Arizona insurance law, which says, in part, that the insurance commissioner “. . .shall examine the affairs, transactions, accounts, records and assets of each authorized insurer as often as. . .deems advisable [and]. . .shall in like manner examine each insurer applying for an initial certificate of authority to do business in this state.”15 All the insurance companies operating in a state, whether they are domestic (domiciled in that state), foreign (domiciled in another state) or alien (domiciled outside of the United States) are subject to financial regulation. The regulators are concerned with life and health insurance companies as well as property and casualty insurers. Financial regulation can also include annual audits by independent certified public accountants (CPAs) and actuarial opinions on an insurer’s loss reserves. The number of people involved with financial regulation at a state insurance department depends on the size of the regulatory staff, the available budget, the number of insurance companies licensed in the state, the timing requirements set by statute for examinations (for example, annually, triennially, etc.), and other factors. Most states have a chief examiner (or one chief examiner in charge of life insurance and another in charge of property insurance), while a few state insurance departments place the job of financial examinations within another related area, such as Annual Statement filings or receiverships and liquidations. According to the Insurance Department Resources Report published by the NAIC, seventeen states hire financial examiners from outside the state government. In a few of these states, the examiners under contract are the only financial examiners that the insurance regulators have. For the other jurisdictions, the examiners under contract augment the staff of those state insurance departments. Sometimes these contract examiners are former regulators who have retired from a state insurance department and have expertise in insurance financial affairs. An insurer’s Annual Statement can serve as the basis for a state insurance department’s financial examination of that insurer. About 80 percent of the

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state insurance departments have a separate area in which to handle the Annual Statements from insurance companies on their financial condition. The remaining 20 percent of the regulators make this task part of another area’s responsibility within the department, for example, market conduct or financial regulation. All states require the same information to be filed in the Annual Statement per company for all insurance companies. The Annual Statement is usually required to be submitted to a state insurance department by March 15 and pertains to the prior calendar year’s business. The statement gives detailed information about the insurer’s financial condition and includes an analysis of an insurer’s assets, capital, expenses, investments, losses, premiums, reinsurance, and surplus. Most states assess fees for late Annual Statements. The Fire and Casualty Annual Statement is approximately 100 pages in length. The NAIC publishes the Financial Condition Examiners Handbook, which is used by all states. This publication promotes uniform financial exams across all states (which makes sense, considering that about 70 percent of insurers are licensed in more than one state16). According to the Handbook, the basic purposes of a financial examination are “(1) to detect as early as possible those insurers in financial trouble and/or engaging in unlawful and improper activities and (2) to develop the information needed for timely, appropriate regulatory action.”17 Financial examinations are usually conducted once every few years, can be done by a few or many examiners, and can take from a few weeks to several months, depending on the financial status of the insurer and the extent of the exam. For example, an insurer in poor financial condition will most likely receive an extensive financial examination that takes a few months, while a financially strong insurer might receive a brief financial exam that takes a couple of weeks. The financial exam process is a review of an insurer’s statistical statements, accounting procedures, financial statements, financial controls, management practices, and investment procedures. The NAIC developed the Insurance Regulatory Information System (IRIS) for regulators to use as a guide to help highlight insurers needing financial scrutiny. IRIS is a group of financial ratios applied to a company’s financial situation. The NAIC also uses other financial tools to track an insurer’s financial performance and the need for a financial examination of the insurer.

Market Conduct Examinations All the states conduct market reviews of the ways in which insurers do business: advertising, soliciting, policy issuing, claims handling, and other

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aspects of dealing with the public. The staffing of the state insurance departments to handle this task varies widely. About 20 percent of the state insurance departments have a separate group to review insurance companies’ marketing practices. The remaining states incorporate the function as part of their departments’ examination division. Just as is done for financial examinations, the NAIC produces material to assist state insurance regulators in handling market conduct examinations. Its Market Conduct Examiners Handbook, which is used in all states (at least to some extent), is a model guide for examiners to review four key areas of an insurer’s dealings with insureds and claimants: sales and advertising, underwriting, pricing, and claims. Not only is a state insurance department concerned with whether an insurance company is meeting legal and regulatory stipulations; it is also interested in having a fair marketplace in existence for the insurance trade. The Handbook states that “[t]he examination can be most effective if it focuses on general business patterns or practices of an insurer rather than merely cataloging individual file errors. While not ignoring random errors, the market conduct examinations should concentrate on an insurer’s general practices.” 18 Market conduct exams, as with financial exams, can vary in length and subject matter. The following are summaries of three different market conduct exams conducted by the Missouri Department of Insurance in 1992: •

Company X was examined for a total of 1,322 hours in the areas of claims, complaints, policy form filing, regulatory history, and underwriting.

•

For Company XX, the market conduct examiners spent 519 hours on cancellations and nonrenewals, claims, complaints, licensing, policy form filings, regulatory history, and underwriting.

•

With Company XXX, 200 hours were expended on examination of cancellations, claims, complaints, licensing, and underwriting.

Agents and Brokers Just as state insurance departments have the legal authority to regulate insurance companies and related entities, the laws also give them authority over insurance agents, brokers, and solicitors. A variety of laws are used, which (1) can require that prospective agents and brokers pass examinations and pay fees to obtain licenses to operate as agents and brokers and (2) can require that licensed agents and brokers meet continuing education requirements and conflict of interest standards, among other things, to maintain their licenses.

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Claims Adjusters Since insurance is essentially a transfer of risk with a future promise to pay contingent on the occurrence of covered losses, state insurance regulators are keenly interested in how insurance companies settle claims. Market conduct exams are sometimes performed to examine an insurer’s claims handling practices. Another way to review the work of claims adjusters is to have a law, such as Alaska’s, which says that the insurance commissioner can examine or require a written report based on the accounts or records pertaining to the affairs of an independent adjuster.19 A third approach is to require claims adjusters to (1) be licensed by passing a test and paying a fee and (2) maintain their licenses through proof of continuing education.

Fraud Surprisingly, only fifteen states have fraud bureaus, half of which are underfunded.20 Only twenty-eight states have some type of antifraud program, ranging from one-person offices to 116 full-time investigators in New Jersey.21 There are various reasons why every state insurance department does not have a fraud bureau. The two main reasons are restraints on budgets and a lack of insurance fraud laws. Many states have limited financial resources and do not have specific laws that make insurance fraud illegal. A general fraud law often is inappropriate for insurance fraud prosecution. State insurance regulators do the best they can with limited financial and legal resources. However, there is a trend in state governments to give increased resources to deal with fraud. The 1994 omnibus crime bill that became federal law contained provisions addressing insurance fraud. For example, the law made it illegal to defraud, loot, or plunder an insurer. The law also instituted a multi-state application of antifraud activities that solves the problem of individual states’ antifraud statutes not applying beyond their own state’s borders.

Insurer Receivership In this category of regulatory responsibility are the functions of receivership, rehabilitation, and liquidation. Less than half of the state insurance departments put these tasks into a separate and distinct area within the department; most treat the matter as another part of their financial services area. State laws require insurance regulators to be concerned with the financial condition of insurance companies. State laws also recognize the need for insurance departments to have the authority to supervise, rehabilitate, reorganize, conserve, or liquidate impaired insurers. Grounds for rehabilitation of an insurance company include the following:

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• • •

An insurer’s liabilities exceed its assets An insurance company “[h]as refused to submit any of its books, records, accounts or affairs to reasonable examination by the commissioner” An insurer “[h]as willfully violated its charter or articles of incorporation or any law of this state”22

In any of these cases (as well as in other situations), the insurance commissioner can request permission from a court to become receiver of an insurer. Such actions, from the time an insurance company is first taken over to the point of its rehabilitation or liquidation, can take from several months to several years.

Consumer Services Of major interest to insurance regulators is the protection and education of the public about matters of insurance. To work towards such a goal, 90 percent of the state insurance departments have a separate person or area designated to handle consumer services. The remaining 10 percent of the states assign the function to a related area within the insurance department, such as market conduct, or to an employee who has other related duties, such as insurance contract review. Virginia goes a step further by dividing its consumer services group into two areas: property and casualty insurance and life and health insurance. Insurance regulators in each state strive to do the following for their constituents: • • •

Help with claims, complaints, and inquiries from the general public Offer educational programs to inform policyholders about insurance and loss prevention and reduction Publish information about guides for the purchase of insurance

Several states have a separate complaint unit, and some states have established toll-free telephone numbers for information. Regulators can hold informal hearings for policyholders to present grievances. Some state insurance departments have representation at state fairs and county agricultural shows. Insurance commissioners and their deputies frequently give speeches to the public and hold public hearings to discuss insurance concerns. Regulators also participate in public anticrime and fraud organizations. Some states require by law that their insurance departments provide certain information to consumers. For example, Alaska insurance law includes the following provision:

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The director shall regularly inform the public of matters concerning the purchase, price, coverage, benefits, and rights of insurance marketed in this state and make available information on availability of the services of the division of insurance. The director shall prepare, publish, and revise as it becomes useful or necessary to do so, an information pamphlet on insurance and the rights of a consumer of insurance and on how to take advantage of the services of the division of insurance.23

Alaska has fulfilled this requirement by periodically including a consumer guide supplement in its state’s newspapers. This supplement provides information on property, liability, and auto insurance for individuals, families, and small businesses. Another way in which state legislatures support the efforts of insurance regulators dealing with consumer issues is to allow regulators to set standards. For example, the following excerpt is from Nevada insurance law: Consumer Protection Standards 1. The Commissioner may: (a) Take measures to enhance the public understanding of insurance coverages purchased by consumers and encourage price competition among insurers and a public understanding of the standards promulgated under paragraph (b). (b) Develop, promulgate and revise as he deems appropriate, standards in each of the several areas of insurance appropriate to be applied to policies sold in the State of Nevada. The standards shall seek to ensure that policies shall not be unjust, unfair, inequitable, unfairly discriminatory, misleading, misunderstanding of the contract. 2. Nothing in this section shall prohibit an insurer from offering policies encompassing standards more favorable than those promulgated under this section.24

Under this law, Nevada has appointed a consumer advocate for car insurance in the state’s most populous city. Some state insurance departments are permitted specifically by statute to create a special fund for consumer services. In North Carolina, a “Consumer Protection Fund” has money annually appropriated to it by the state’s general assembly. (However, the law says that “[i]n the event the amount in the Fund exceeds one million dollars at the end of any fiscal year, such excess shall revert to the General Fund.”25) This law limits use of the fund to pay only certain expenses, such as “. . .retaining outside actuarial and economic consultants. . .in the review and analysis of rate filings. . ., [i]n connection with any delinquency proceeding. . ., and [i]n connection with any civil litiga-

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The Regulation of Insurance tion. . . .”26 Note that all of these costs are related to protecting the interests of the insurance-buying public. Another way for insurance regulators to deal with consumer services is to have a consumer’s advisory panel. Kentucky, as an example, has a Consumer’s Advisory Council to “. . .advise the commissioner of insurance on matters of concern to the consumers of insurance and problems relating to the availability and affordability of insurance.” Members of the council are appointed by the governor. In the law establishing this group is a geographic and occupational range of requirements for the members, which is an attempt to have a diversity of viewpoints represented.27 The nine members represent insurance agents, insurance companies, consumers, labor unions, lawyers, self-insureds, business, and health care. Regardless of the specific state laws involved, or the manner in which the regulators operate, the consumer services work of a state insurance department is a vital part of insurance regulation.

Sale of Insurance Securities Insurance securities consist of such items as stocks and bonds, real estate, mortgage loans, and other types of loans. State insurance regulators oversee the sale of insurance securities to ensure that the insurers do not impair their overall financial condition. If insurers do not make investments prudently, insurers might not have enough assets to continue operations. More than half of the states have a distinct group within their insurance departments to deal with the sale of insurer securities. Other states review insurers’ securities sales as part of the financial work of the insurance departments.

Senior Citizens State insurance departments deal with issues concerning the country’s aging population. About half of the states have a designated person or group to deal specifically with insurance issues that affect our aging population. The other state insurance departments handle the matter as part of their consumer services. About 15 percent of the states have a Seniors Health Insurance Information Program, which has received a grant from the federal government to fund staff positions. This work will become more important as the percentage of our older population increases.

General Counsel Every state insurance department has a need for legal services, just as other departments of a state government do. The lawyers employed by the state

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insurance departments usually hold the title of general counsel. The functions performed by the general counsel include the following: • • • •

Give legal opinions on proposed, pending, or enacted legislation Assist in drafting administrative rules and regulations Represent the insurance regulators in noncriminal (civil and administrative) proceedings28 Offer legal advice on insurance issues

In a few state insurance departments, these attorneys are also responsible for other affairs, such as the receivership of insurers or being liaison to the legislature. Most state insurance departments employ a single general counsel. However, about a dozen states use the services of the office of the attorney general, a part of the executive branch. Some of these states have an assistant attorney general assigned to the insurance department. Just as every state insurance department has an insurance commissioner, every such department also has at least one legal advisor.

Public Communication Sixty percent of the state insurance departments have a designated official as the spokesperson for the department. This person represents the state’s insurance regulators in encounters with the news media, the public, and the insurance industry. The remaining 40 percent of the state insurance departments use a variety of ways to communicate with the public. The insurance commissioner might be the contact person—or individual division heads might speak, depending on the subject. An influencing factor can be whether the position of insurance commissioner is elected or appointed, because a commissioner who is elected might need to communicate with constituents in order to build voter identification and support.

Legislative Relations Another common position in a state insurance department is that of liaison to the state legislature. About 30 percent of the departments have someone specifically assigned to this task. In the other states, the work of this position is done by a variety of people. In some states, the insurance commissioner is the primary contact person with the state legislature. In other states, the liaison is the general counsel or the division head within the department who is most appropriate to deal with a particular issue being considered by the legislature, such as fraud, fire safety, licensing, or pricing.

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Relations with state legislatures can be affected by the fact that some states’ insurance commissioners are former state legislators. Relations can also be affected by how the office of insurance commissioner is filled—whether by election or by appointment. (This was discussed earlier in this chapter.) Because it affects everyone, insurance is a political as well as an economic issue. Therefore, the position of legislative liaison is crucial in a state insurance department. Testimony needs to be given, misconceptions addressed, supporting data offered, questions answered, and advice given to assist the state’s legislature in their dealings with insurance codes and related laws.

Miscellaneous Insurance regulators perform functions in addition to those listed above. In a few state insurance departments, these duties are handled separately rather than being combined with the responsibilities of other divisions or sections of the insurance departments. In a few states, the duties are unique to those states, being the result of legislation enacted. For example, the Idaho Department of Insurance is involved with the certification of underground storage tank technicians.29 Following are some examples of other areas that state insurance departments handle: • • • • • • • • •

Building codes Computer services (to handle the submission of information from insurers) Engineering (to review construction plans) Investigations (for arson and fraud) Liquefied petroleum gas regulation (to make safety inspections, investigate accidents, and administer licensing) Manufactured housing regulation Research (to study insurance availability and affordability) Safety (to study and promote, for example, fire and earthquake loss prevention and reduction) Risk management (to administer a state’s self-insurance programs for fire, workers compensation, and other coverages)

Regulatory Communications State insurance regulators use a variety of ways to communicate with their audience, whether it is the general public, the insurance industry, business

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trade groups, state legislatures, the federal government, or even people outside the United States. Regulators can communicate to their various audiences directly through the use of state governments or indirectly through the use of the NAIC News, which is the official newsletter of the National Association of Insurance Commissioners. This newsletter is published for insurance regulators, insurance professionals, and consumers. (More will be said about NAIC communications in Chapter 5.) Insurance regulators regularly communicate with the insurance industry. For such communication, insurance regulators usually use (1) written material such as informational newsletters and bulletins, (2) surveys of insurance companies, and (3) advisory groups. An insurance commissioner can also convene a meeting of the news media and make an announcement. Regulators also notify insurance professionals through the use of insurance departments’ annual reports, regularly issued general newsletters, and periodic specific topic circulars. Newsletters issued by different state insurance departments show a wide variety of style, size, and content. Some of these items are produced monthly; others are released quarterly. Most are free, since one of the functions of a state insurance department is to disseminate insurance information to as broad an audience as possible. Following are two examples of typical insurance department publications: •

The Idaho Insurance News is produced by the Idaho Department of Insurance. It might include a discussion of current popular topics; a summarization of the amount of money recovered for policyholders because of insurer errors; excerpts from speeches given by the state regulators; the continuing education meeting schedule for insurance agents; and the disciplinary actions taken against various insurance companies and agents.

•

The Bulletin is published by the Wisconsin Office of the Commissioner of Insurance. It might contain a reminder about agent licensing renewal; a summary of recent pertinent court cases and administrative rules about insurance; a listing of new brochures available (for example, “Resolving an Insurance Complaint”), and a statement of administrative actions taken against insurance companies and agents for violations of insurance laws.

Regulators also mail notices (usually a page or two in length) about a wide range of topics to different sectors of the insurance industry whenever such notification is needed—such as to announce new laws, court rulings, changes in regulations, new guidelines, and recent reports. These notices go to which-

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ever group is affected by the information contained in the bulletins, and might include all licensed insurers or just insurance agents or company statisticians. Notices from state insurance departments can also take the form of administrative orders, rules, and regulations. These notifications carry the same weight as state laws. Insurance regulators can receive authority for making such pronouncements under the broad authority of law, which is cited in the order, rule, or regulation issued, or the state legislature can enact a law that specifically directs the insurance commissioner to promulgate rules and regulations as necessary to implement the law. Such notices might be reviewed by state administrative law offices or judges before they are made public. Issuance of administrative orders, rules, and regulations by state insurance departments is an efficient and effective way to deal with topical insurance issues that might not be addressed by legislation. Surveys are used in insurance regulatory work. Such documents can be useful and might become the basis for more discussions within the insurance industry and between the industry and its regulators. However, because they can be costly and time consuming, surveys are not as common as newsletters and circulars. The industry might also view these inquiries as a public relations gambit by the insurance commissioner and therefore not worth the effort to respond to. Advisory groups are an additional communication method used by state insurance regulators to confer with the insurance business community. They can be formal or informal, established by either law or custom, and meet frequently or occasionally. Usually the insurance commissioner or a senior insurance regulator meets periodically with a small group of representatives from the state’s insurance industry. The group might include insurance company people, insurance agents, consumers, and others as members who talk about insurance issues and exchange ideas. Sometimes the gatherings of advisory groups are for a specific purpose, such as when a state insurance commissioner asks the insurance industry to form a working group or a task force to deal with a current issue, be it statistics, health care, or homeowners insurance. The commissioner might be reacting to legislative action or might be trying to forestall such activity, believing that the executive branch of government (through the insurance department) can better deal with the issue than the legislative branch can. A Colorado insurance law created an advisory board to deal with the state’s Uniform Billing and Electronic Data Exchange Act. In part, the law said: The Commissioner shall appoint the. . .advisory board. . .to encourage the development and implementation of a comprehensive, uniform electronic

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system for billing and paying claims and exchanging related information. . . . (b). . .the membership of [this group]. . .shall be broadly based. . . .”30

Another example of an advisory group occurred in Texas. The insurance regulators had appointed an advisory committee that included members from the insurance industry and also consumer representatives. The committee’s task was to review the contamination exclusion in various property insurance policies for residential use. This group concluded its study and issued a report with recommendations, among them: • • • • •

Institute a state program addressing the risk of hazardous substances such as pesticides to residence dwellers Institute a state program to speed up payments for wrongdoing to injured parties Emphasize loss prevention efforts regarding the use of common household chemicals Provide aid to victims of contamination losses Define the standard used to decide whether a contamination loss is due to a peril insured against in a policy

An area of disagreement in the committee concerned the extent of the applicability of the homeowners policy contamination exclusion and whether to change it.

Regulatory Funding The poet Ogden Nash wrote that “[c]ertainly there are lots of things in life that money won’t buy, but it’s very funny—Have you ever tried to buy them without money?”31 State insurance departments, like the industry that they regulate, need money to operate. And, also like business, regulators charge for their services. Revenue for the state insurance departments can come from a variety of sources, including the following: • • • • •

Premium taxes Fees and assessments An appropriation from the state treasury Fines and penalties A combination of the above funding methods

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The following state law references show the variety of insurance regulatory funding sources: •

•

•

•

In Oregon, the state legislature passed a law that amended the method of funding insurance regulation. The law said in part that the department of insurance operations is to be “financed by the fees, assessments and charges established and collected in connection with” the duties and functions the department performs.32 Maine law requires that assessments be made annually against all insurers licensed to do business in the state in proportion to their respective direct gross premium. The assessments must cover the expenses of the Bureau of Insurance for each year.33 Nevada insurance law provides for legislative appropriation from the general fund to cover the state insurance department’s costs of regulating the insurance industry.34 Iowa law specifies that “[f ]orty percent of the nonexamination revenues payable to the division of insurance. . .in connection with the regulation of insurance companies. . .shall be subject to annual appropriation to the division for its operations. . . .”35

State insurance department regulators charge a variety of types and amounts of fees for their services. Some states have laws that specify the types and amounts of the fees; other states’ laws allow the insurance commissioner to set the fees, and some states have laws that implicitly give the regulator such power, without expressly delineating it. When the fees are not set by law, the regulators issue rules and regulations promulgating them with an effective date for their use. Sometimes a fee is even charged to receive a copy of the list of fees! The variety in the kinds and amounts of fees is due to a state’s regulatory philosophy, financial condition, business climate, and other factors. Following is a list of various services for which state insurance departments charge fees: • • • • • • • •

Certificate of authority to do business Certified copies of materials Continuing education registration Copies of rules, regulations, and orders Examination for license (public adjuster, insurance agent, broker) Insurer annual financial statement filing License examination sample test questions and answers License application

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• • • • • • • • •

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License License renewal Listing of licensed insurance agents Listing of licensed insurance companies Mailing list for proposed regulations Photocopies of regulatory filings Product pricing and coverage filings Publications on various insurance issues Service of legal process

The dollar amounts of the fees range from one dollar per page photocopied to a few thousand dollars for a certificate of authority. Most state laws give the state insurance departments latitude in the setting and collecting of fees. Therefore, some charge fees for the transactions of professional bail bond companies, for the operation of continuing care facilities, and for the issuance of operator permits pertaining to amusement rides or attractions, to cite just a few examples. Remember that states use fees for the dual purpose of regulation and revenue. According to the NAIC’s Insurance Department Resources Report, less than half of state insurance departments have dedicated funding, which means that the state legislature puts set amounts into an insurance department fund and only insurance regulators can use that specifically appropriated money.

Regulatory Budgeting A review of all the states’ budgets for insurance departments shows a great disparity in the total amounts. For fiscal year 1994, California had the largest budget, over $79 million, and Wyoming had the smallest budget, about $1.25 million. An average for the fifty states was approximately $11 million.36 Many reasons exist for the differences in budgets among the states: •

• •

Size of insurance department. In 1992, California had a total full-time staff of over a thousand people in its insurance department; Wyoming had two dozen. Size of domestic market. While Wyoming had five domestic insurers, California had over two hundred. State population. The population of California numbers in the millions of people, whereas Wyoming has a few hundred thousand residents.

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•

Other reasons. Other reasons for budget differences among states include tax revenue, business climate, regulatory philosophy, and the relationship of the insurance department to the rest of the state’s executive branch and to the state’s legislative branch of government.

State insurance departments are just like the businesses they regulate in that the amount of their expenditures is related to the amount of their revenue. A state insurance department with an adequate budget can do a much more effective job of regulating than one in which funding is reduced and resources are consequently constrained. A regulator who alone has to review insurance pricing and coverage filings, agency licensing matters, and consumer complaints daily has difficulty giving complete attention to any of these important items.

Regulatory Hiring Employment practices can vary from state to state, but generally three types of hiring are done by state insurance departments: contract, appointment, and career. Contractual agreements with people are usually made because specific technical expertise (actuarial, financial) is needed on an irregular basis (either part time or for occasional specific projects such as a rate filing review or an examination of an insurer), and the insurance departments cannot afford to hire full-time people for these tasks. Appointments of insurance department personnel typically involve senior-level staff members such as deputy commissioners, who would then be employed at the discretion of the insurance commissioner who appointed them. Power to appoint people is a necessary function of the office of the insurance commissioner. Career insurance department employees can be the backbone of the state insurance departments. Elected and appointed insurance commissioners come and go as do the contractual and appointed members of the departments; the career employees remain at the department over a long period of time and serve under the direction of more than one insurance commissioner. Hiring can affect regulation. Civil service employees can view their jobs with a long-term perspective, since they do not have political influence or contract considerations affecting their work. Of course, employing specialists on a temporary basis and hiring assistants might still be needed due to special regulatory situations, the insurance department’s budget, or changing regulatory needs. Sometimes a special project, such as dealing with the aftermath of a natural catastrophe, requires additional and specially trained staff. For example, during the aftermath of Hurricane Andrew in 1992, the Florida Insurance Department asked other states’ insurance regulators for assistance.

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Budgets of state insurance departments limit staff size and type (professional, technical, and others). Needs of regulators vary over time because of changes in the economy, insurance marketplace, and other factors. Having the ability to hire people under different conditions and by different methods is vital. Competing interests vie for a regulator’s attention, and the insurance commissioner’s hiring decisions (sometimes made at the deputy commissioner level) can affect regulation. Regulation is affected, for example, by an insurance commissioner’s decision to hire more financial examiners than filing analysts, to contract with consulting actuaries to review all rate change submissions, or to appoint many assistants concerned with consumer affairs. Such decisions mean that one area of a state insurance department might have adequate staff and equipment, another section might not; the work of regulation is consequently affected. Like other state agencies, insurance departments have limited resources. Also, the need to balance competing interests means that regulators choose how to allocate resources, which in turn has an impact on insurance regulation.

Regulatory Commissions Two states have laws establishing governmental groups charged with the regulation of insuring pricing: Louisiana has the Louisiana Insurance Rating Commission and Oklahoma has the State Board for Property and Casualty Rates. The Louisiana and Oklahoma entities are in addition to the respective states’ insurance departments. An important point is that both the Louisiana and Oklahoma entities work with their respective state’s insurance department.

Louisiana The Louisiana Insurance Code37 established the Louisiana Insurance Rating Commission and its powers and duties. There are seven members: the state’s elected insurance commissioner (who is also the chairperson of the group) and six members appointed by the state’s governor and confirmed by the state’s Senate. Every two years, the members have to be reconfirmed. According to the law, the only requirements for membership are Louisiana residency and voter qualification. Its members are paid for attending meetings, although the law specifies that the commission should not meet for more than twenty days in any month. Under state law, the commission has all the powers, duties, and functions related to the control of insurance pricing. Usually, the commission meets

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once a month to review submissions of rating changes by insurers. The Louisiana Insurance Rating Commission can approve an entire filing, part of it, or none of it. The following material is excerpted from an actual agenda of the Louisiana Insurance Rating Commission. After a reading was done of the previous meeting’s minutes, the commission (in an open meeting) considered over a hundred rate changes outlined in a seventy-three page document. Some of the lines of insurance represented in the agenda were automobile (personal and commercial), commercial multi-peril, fidelity, homeowners, inland marine, general liability (various sublines) and workers compensation. In addition to the introduction of insurers’ programs, the agenda listed rate increases, rate decreases, deviations, and program withdrawals for consideration and approval. The commission also considered the topic of companies ignoring the its request for additional information. Exhibit 3-4 shows some other examples.

Oklahoma Oklahoma insurance law38 created the State Board for Property and Casualty Rates with five members. As in Louisiana, one of the members is the state’s elected insurance commissioner who serves as the board chair. Also like Louisiana, Oklahoma’s governor appoints the other Board members, with the state Senate’s consent, for a set term of four years. Board members are required by law to be at least age twenty-seven and a three-year resident of the state. Interestingly, the law that established the board states, “any person who has been appointed to the Board shall not file as a candidate for any public office while serving on the Board or within two (2) years from the time his term of service with the Board has ended.” In Oklahoma, the State Board for Property and Casualty Rates has the authority to examine any filings for pricing revisions, just as is done in Louisiana. The following information comes from an actual agenda of the State Board for Property and Casualty Rates. Old business included the reading of minutes from an earlier meeting. In an open meeting, the Board then considered for action sixty-three different rate filings summarized on twenty-two legal-size pages. Each agenda item is listed in a brief paragraph with the name of the insurance company making the filing, the line of insurance or type of coverage (mechanical breakdown for example) involved, an explanation of the change proposed, and the overall effect of the submission in terms of income to the carrier. As required by law, there is also a statement that the filing is in compliance with the state’s laws, rules, and regulations. (Otherwise, the Board could not consider it for action.) Additionally, there is a comment as to whether certification is or is not required, which depends upon the type of

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Exhibit 3-4 Example of Louisiana Insurance Rating Commission Agenda 78.

TRANSAMERICA INSURANCE COMPANY GENERAL LIABILITY RATE/RULE FILING MARDI GRAS PROGRAM NAIC NO.: 185-25534 PROPOSED EFFECTIVE DATE: 11-17-93

This company submits rates and rules for its Mardi Gras Program. The Company states the intent of this program is to provide liability coverage for Louisiana Carnival Club and subsequently the Mardi Gras events. 79.

ST. PAUL FIRE AND MARINE INSURANCE COMPANY ST. PAUL MERCURY INSURANCE COMPANY ST. PAUL GUARDIAN INSURANCE COMPANY THE ST. PAUL INSURANCE COMPANY NON-PROFIT ORGANIZATION DIRECTORS AND OFFICERS LIABILITY PROTECTION - CLAIMS MADE RATE SUBMISSION REQUESTED EFFECTIVE DATE: 11-23-93

These Companies submit their Non-Profit Organization Directors and Officers Liability Guide “A” Rates. The Companies state Non-Profit Organization Directors and Officers Liability coverage is written to protect against error or omission claims which result from the conduct of duties performed for a non-profit organization and this coverage will always be written in conjunction with their current Commercial General Liability Protection policy. 80.

PLANET INSURANCE COMPANY POLLUTION AND REMEDIATION LEGAL LIABILITY POLICY PROGRAM PROPOSED EFFECTIVE DATE: 11-17-93

This company states the Pollution and Remediation Legal Liability Policy Program is very similar to the previously filed pollution Legal Liability Insurance Program. However, the difference is that the Pollution and Remediation Legal Liability policy provides coverage that would respond to both onsite clean up requirements, as well as the offsite third party pollution legal liability exposures. The details of the expansion of coverage (first party coverage) are found in the Insuring Agreement, Exclusions and Definitions section. This program offers coverage on a claims-made basis. Defense costs are included in both the single and annual aggregate liability limits are applied against the self-insured retention. Basic coverage is offered on a combined single limit basis with an annual aggregate limit of liability. In the event of cancellation or nonrenewal of the policy by either the Company or the Named Insured, the Named Insured is entitled to purchase 12 month Extended Reporting Period Coverage. Source: Louisiana Insurance Rating Commission Agenda, November 17, 1993, p. 48.

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Exhibit 3-5 Example of Oklahoma Commission Agenda ITEMS FOR FINAL CONSIDERATION - NOVEMBER 4, 1993 PAGE 6 15. FIDELITY AND GUARANTY INSURANCE UNDERWRITERS, INC. Re: INDEPENDENT FILING - COMMERCIAL MULTI PERIL Company is filing revised package modification factors which is a credit applied to policies containing property and liability coverage for Division Nine - Commercial Multiple Lines of the Commercial Lines Manual to replace those approved in Oklahoma File #90-5779C. This revision results in a +2% and + $3,044.00 total overall effect. This filing was revised to leave the package modification factors for Industrial and Processing Class as previously approved. This filing is in compliance with Oklahoma Statutes, Rules and Regulations. Overall effect + $3,044.00 + 2% FILING HAS BEEN CERTIFIED. Received: March 10, 1993 Filing: 93-0493C Motion made: ________________________________________ ________________________________________ Motion made by: _____________ Yea

16.

Nay

Yea

Nay

Yea

Weatherford

Marshall

Stein

Kilpatrick

Livingston

Gomez

Nay

FRONTIER INSURANCE COMPANY Re: INDEPENDENT FILING - DIRECTORS & OFFICIAL LIABILITY Company is filing rate and rules for use with the Non-Profit Organization Directors and Officers Liability Policy Program. Certification is not required. Received: August 27, 1993 Filing: 93-2879C Motion made: ________________________________________ ________________________________________ Motion made by: _____________ Yea

17.

Second: ___________

Nay

Second: ___________ Yea

Nay

Yea Nay

Weatherford

Marshall

Stein

Kilpatrick

Livingston

Gomez

GREAT CENTRAL INSURANCE COMPANY Re: INDEPENDENT FILING - COMMERCIAL MULTI PERIL Company is filing to convert from Insurance Services Office

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Non-Simplified to Insurance Services Office Simplified Program along with some company exceptions for Division Nine - Commercial Multiple Lines. This filing contains company exception pages for their Liquor Store Program. This filing results in a –46.9% rate level effect but there are no current policyholders in Oklahoma. This rate level effect is a result of adoption of Loss Costs as well as modifications to the Package Modification Factors. This filing is in compliance with Oklahoma Statutes, Rules and Regulations. Overall effect –46.9% with zero dollar effect. FILING HAS BEEN CERTIFIED Received: March 6, 1993 Filing 93-0436C Motion made: ________________________________________ ________________________________________ Motion made by: _____________ Yea

Nay

Second: ___________ Yea

Nay

Yea Nay

Weatherford

Marshall

Stein

Kilpatrick

Livingston

Gomez

Source: Oklahoma State Board for Property and Casualty Rates Agenda, November 4, 1993, p. 6.

filing involved. Like the previously noted Louisiana agenda, this agenda involved many of the same or similar lines of insurance and kinds of pricing changes. Exhibit 3-5 shows part of the agenda; note the format differences from Exhibit 3-4.

Summary Insurance commissioners (or directors or superintendents) are responsible for regulating the insurance industry in their respective states in accordance with the insurance laws of their states. Most insurance commissioners are appointed by state governors. However, in twelve states, insurance commissioners are elected and, in six states, insurance commissioners are appointed by a state official or a group of state officials, subject to approval by the governors. Insurance commissioners often have some insurance industry experience. Because insurance commissioners serve as the heads of their insurance departments, which are part of state executive branches, their insurance regulatory activities are influenced by political pressures. The insurance departments’

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activities also reflect the regulatory philosophies and regulatory styles of their commissioners. Often the success of insurance departments’ regulatory activities depend on the ability of the commissioners to motivate state legislators to support insurance regulation through appropriation of budgets and passage of insurance laws. Insurance commissioners are charged with the following regulatory duties, among others: • • • • •

Promulgating regulations and rules necessary to enforce insurance laws. Licensing insurance companies and insurance producers. Reviewing insurers’ rates and forms Examining the financial practices and market conduct of insurers. Taking appropriate action against insurers and producers and others found in violation of insurance laws, regulations, or rules.

Insurance commissioners often delegate their responsibilities to others in their insurance departments. State insurance regulators communicate with the insurance industry, the public, and other interested parties in a variety of ways. For example, periodicals and newsletters can be used to inform insurers about new state developments of importance to insurers. Advisory groups can be formed to provide guidance and industry input to insurance regulators. Surveys can be used to generate information regarding specific regulatory concerns. Insurance departments are a part of state executive branches. Often, the budgets are allocated to the insurance departments by state legislatures. However, some state insurance departments are financed by dedicated funding. The amount of funding state insurance departments receive in part determines the extent to which they can regulate. The number and type of insurance regulatory staff hired by insurance departments also influences the departments’ regulatory activities. Staff can be hired as needed on a contractual basis, can be appointed, or can be full-time career insurance department personnel (who can serve as the backbone of the insurance departments). In two states, Louisiana and Oklahoma, insurance regulatory commissions exist to regulate rates. In these states, the commissions work with the insurance departments, despite the fact that they are separate entities.

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Chapter Notes 1. 1980 S.D. Laws § 58-2-2.1. 2. 1949 Mo. Laws § 374.020.1. 3. Dismissal for cause means that for the person to be dismissed, there has to be malfeasance in office, such as conviction of certain crimes, failure to perform duties of the job, or some other violation of an objective standard as defined by law, rather than a subjective standard such as belonging to a different political party. 4. 1993 Utah Laws § 31A-2-102(1). 5. 1987 Me. Laws 24-A § 201.(2). 6. NM Stat. Ann. § 59A-2-8. 7. 1921 Pa. Laws 40 P.S. § 41a. 8. Fla. Admin. Code Ann. § 4-121.003. 9. 1993 Mont. Laws § 33-1-303.(1) . 10. Wis. Stat. § 601.01. 11. 1989 Neb. Laws § 44-101.01. 12. Dave Lenckus, “A New Breed of Regulator?,” Business Insurance, July 5, 1993, p. 94. 13. Illinois Insurance Regulations § 754.10 and 754.20. 14. 1992 Minn. Laws § 60A.03 subd.1. 15. 1993 Ariz. Sess. Laws § 20-156. 16. 1993 Best’s Key Rating Guide—Property and Casualty, Oldwick, NJ, A.M. Best Company, 1993. 17. 1993 Best’s Key Rating Guide—Property and Casualty, p. I-1. 18. 1993 Best’s Key Rating Guide—Property and Casualty, p. I-1. 19. Alaska Stat. Subchapter § 21.06.130 1992. 20. Rick Pullen, “Group Offers Blueprint for Making Insurers a Smaller Target for Fraud,” Best Week, January 17, 1994, p. 16. 21. David Wichner, “Arizona May Create an Anti-Fraud Unit,” Journal of Commerce, February 25, 1994. 22. 1971 Ala. Acts § 27-32-6. 23. Alaska Stat. § 21.06.115. 24. 1971 Nev. Stat. § 679B.150. 25. N.C. Gen. Stat., § 58.2.215 (1989). 26. N.C. Gen. Stat., § 58.2.215 (1989). 27. 1988 Ky. Rev. Stat. & R. Sov. § 304.2-155 (Baldwin). 28. Representation for insurance regulators regarding criminal matters such as prosecution for insurance fraud is generally handled by another part of state government.

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The Regulation of Insurance 29. “Underground Storage Tank Technician Certification Act,” Idaho Code § 41276 (1990). 30. Colo. Rev. Stat. § 10-1-131.(4)(a) (1993). 31. Ogden Nash, “The Terrible Place,” Happy Days, (New York, NY: Simon & Schuster, 1933). 32. Oregon Senate Bill 167. 33. 1993 Me. Laws 24-A § 237. 34. 1971 Nev. Stat. § 679B.380. 35. Iowa Code § 505.7.3 (1991). 36. National Association of Insurance Commissioners (NAIC), Insurance Department Resources Report (Kansas City, MO: 1993). 37. La. Rev. Stat. Ann. § 22:1401 (West 1988). 38. Okla. Stat. § 331 (1987).

Chapter 4

The Influence of State Legislatures and the NAIC As indicated in Chapter 1, state insurance departments do not operate in a regulatory vacuum. Their actions are influenced by others, including the state legislatures and the National Association of Insurance Commissioners (NAIC). This chapter will examine their effect on the regulation of insurance. The enactment of laws, deliberations about laws, hearings, investigations, and reports are all ways through which state legislatures can affect insurance regulation. And even though the NAIC is a voluntary organization, every state’s insurance commissioner is a member, and the organization is influential. Model acts developed by the NAIC can become laws in the states when passed by legislatures and approved by governors.

State Legislatures as Insurance Regulators State legislatures are involved in the regulation of insurance. State legislatures often directly control the budgets within which state insurance departments must operate. State legislatures also pass the insurance laws that insurance commissioners are charged to enforce. In addition to those activities, state legislatures have other means of influencing state insurance regulation.

101

102 The Regulation of Insurance Only a few states do not have any legislators who list insurance as their occupation, according to data reported to the National Conference of State Legislatures. Slightly more than three percent of the nation’s state legislators list insurance as their occupation. An almost identical percentage (3.9) of the members of the U.S. Congress list insurance as their occupation, according to Congressional Quarterly. Hopefully, the presence of legislators who have insurance work experience or are employed in the insurance industry is beneficial during insurance discussions in the legislatures. However, competing interests are often involved in legislative issues; political considerations are present; economic influences cannot be ignored; and the numbers of legislators who are knowledgeable about insurance issues are scarce.

Direct Legislative Oversight Insurance commissioners are charged with the duty of regulating the insurance industry for the states. However, state legislatures retain some direct control over how insurance commissioners perform their duties. Since state legislatures control the purse strings and the legal foundation of state insurance departments and might confirm the insurance commissioner, legislators expect regulators to periodically submit to the scrutiny of the legislature. Such investigations take different forms, including requiring annual reports, completing performance reviews, and conducting audits of state insurance departments.

Annual Reports Most states have a law that requires an insurance commissioner to submit a report annually to his or her state legislature (sometimes to the governor or another official, or to a variety of state officials), which summarizes the activities of the insurance department and the status of the insurance industry in the state. A few states (such as Iowa) stipulate that the report be done semiannually or biennially (such as North Dakota); some jurisdictions require additional reports on insurance matters (such as California). These reports are often available to the public for a small fee, usually the publication cost. A review of the laws requiring annual reports shows what is required to be included in many states: • •

Statement of income and expenses of the insurance department Exhibit summarizing the financial status and business transactions of licensed insurers in the state, as disclosed by their filed financial statements

Chapter 4 / The Influence of State Legislatures and the NAIC 103

• • • •

Listing of insurers closed for that business year Names of insurance companies in receivership or other official financial difficulty with a brief explanation of their status Recommendations by the insurance commissioner about insurance laws and the department’s operation Other insurance matters of general interest to be determined by the insurance commissioner

Although this list is short, state annual reports often include information on specific state programs. The length of the report varies by state as well because of the scope of the state’s insurance regulation operations and the number of insurers subject to that regulation. For example, New Mexico’s 1993 report consisted of 25 pages, while Texas’s 1993 report contained more than 150 pages. Material included in the annual report covers the time period from the issuance of the prior report; the information is neither cumulative nor repetitive. The topics covered in the 1993 New Mexico report are listed in Exhibit 4-1, and the organization of the 1993 Texas report is shown in Exhibit 4-2. Exhibit 4-1 Topics Covered by the 1993 New Mexico Insurance Commissioner’s Report to the New Mexico State Legislature • Staff Directory • Operating Budget • Program Activities (Administration, Examinations, Taxes and Fees, Statistical Division, Licensing Division, Policy Rates and Form Division, Consumer Affairs Division, Investigations Division, and Workers Compensation Assigned Risk Pool) • New Mexico Title Insurance Law • Title Insurance Division • Revenue Report • Allocation of Funds • Fire Protection Fund • General Insurance Receipts Fund • Carrie Tingley Fund (hospital for crippled children) • Subsequent Injury Fund

• • • • • • • • • • • • •

Medical Malpractice Act Company Licensing Division Surplus Lines Brokers Active Agent Appointment Totals Inactive Agent Appointment Totals Complaints and Investigation Totals Policy, Rates, and Form Totals New Mexico FAIR Plan Examinations (Financial Audit) Domestic Companies Summary of Accident and Health Business Summary of Property and Casualty Business Summary of Life Insurance Business

104 The Regulation of Insurance

Exhibit 4-2 Organization of the 1993 Texas Insurance Commissioner’s Report to the Texas State Legislature Part I - Reports of Program Activity • Organizational Chart • Mission, Philosophy, and Goal Statements • Preface • Commissioner’s Office • Policy, Planning, and Research • Early Warning • Planning • Management Services • Conservation • Legal and Compliance • Financial • Regulated Lines

• Consumer Services • Financial Management and Administrative Services • Information Services • Human Resources Part I - Table of Figures and Graphs* Part II - Reports on Certificates of Authority Part III - Liquidator’s and Conservator’s Report Part IV - Summary of Information from Annual Statements Part V - Financial Report

*Following is an example of one of the charts: Amusement Ride Safety and Insurance Act Policies Approved 181 Inspection Certificates Approved 2,094 Injury/Accident Reports 15 Number of Injuries 60

Some states also require other types of reports. Two examples follow: 1. In Arizona the insurance commissioner must report each year to the governor and state legislature about the profitability of motor vehicle liability insurance in the state. As part of this report, the insurance commissioner must include the following information: • An analysis of the level of competition in auto liability insurance • The steps needed to promote a reasonable degree of competition • The steps required to inform the public about auto liability insurance rates and rate filings • Recommendations about how to improve the availability of public information and how to increase public awareness on rates so that competition is enhanced • Recommendations about other auto liability insurance market problems

Chapter 4 / The Influence of State Legislatures and the NAIC 105 Once the report is put together, the commissioner must hold public hearings and take public testimony on it in at least five geographical areas in Arizona.1 2. California law requires its insurance commissioner to make a host of reports: • An annual report analyzing specific types of tort cases. This report must include analysis on eight types of tort action—such as medical malpractice claims and product and design liability actions.2 • An annual report to the legislature. This report must include data on the quantity of insurers reporting business written by category; loss ratios; analysis of changes in loss reserves; and analysis of the state’s program to reduce the number of uninsured motorists and its affect on auto insurance rates.3 • An insurer’s annual report of public liability experience.4 • An annual report of fraudulent claims.5

Performance Reviews State legislatures use performance reviews to evaluate state insurance departments’ operations. Performance reviews can affect the budget and operations of the state insurance department. For example, California’s Legislative Analyst Office Report examines the operation of many facets of state government, including the Department of Insurance. Included in one of the reports was a review of certain aspects of the state insurance department’s work. The discussion focused on four areas of concern: the budget of the conservation and liquidation division, the lack of workload measures and standards, the lack of justification for new positions in the fraud division, and the proposal for an enforced conservation unit. The highlights of the report are noted in Exhibit 4-3.6

Audits In their oversight of the state insurance departments, legislatures deal with other governmental authorities such as state auditors who periodically issue reports on various state agencies, including the insurance departments. For example, the Massachusetts Auditor released a report in 1993 entitled “State Auditor’s Report on the Oversight and Controls Exercised by the Division of Insurance Over the Insurance Industry.” Its twenty-seven pages concerned an audit that “. . .focused on the effectiveness of the policies, procedures, and practices used by the division to determine the financial condition, solvency, and adequacy of reserves of all licensed insurance companies operating within the Commonwealth.”

106 The Regulation of Insurance

Exhibit 4-3 Highlights of California’s Legislative Analyst Office Report on the California Insurance Department • The budget of the Conservation and Liquidation Division. The analysts recommended that the budget not be approved, because the restructuring of the division was not complete. Numerous reasons were cited to support this recommendation, including the following: • No meaningful budget because the division spends on an “as-needed”

basis rather than from a set budget • No management plan for oversight of the assets of the insolvent insurers

being conserved • No policy procedure for establishing non-civil service positions • Uncontrolled hiring and salary setting • Benefits more costly for non-civil service employees • Division chief replaced by highly paid consultant • Over $3 billion in assets not managed by the division but by commis-

sioner-appointed on-site managers. The report noted that the state insurance department was making a plan of reorganization for the division to deal with these and other issues; therefore, the analysts recommended that the legislature defer approval of the division’s budget. • The lack of workload measures and standards . The department had not reported workload measures and standards to the legislature as required. The analysts suggested deferring decisions on the department’s budget until the required report was submitted. • The lack of justification for new positions in the fraud division. The 100 new permanent positions proposed for the workers compensation fraud program and the automobile insurance fraud program were not justified, according to the report, because problems existed with how the department’s resources were allocated by office location in relation to the fraudulent activity and because the insurance department had not developed workload measures that would allow the added value of the new positions to be quantified. • The proposal for an enforced conservation unit. The analysts recommended that the proposed unit not receive funding because the need for such a unit had not been established and the justification for more employees to staff the unit had not been provided. Existing law allows the insurance commissioner, with the court’s authority, to seize and conserve the assets of impaired insurance companies, but the proposed unit would take a further step. No objection was stated in the report to the idea of such action; rather, the objection was that additional staff was needed, without detailed justification having been given. Source: “Department of Insurance,” California Legislative Analyst Office Report to the California State Legislature 1994, pp. G-42 to G-49.

Chapter 4 / The Influence of State Legislatures and the NAIC 107 Auditors in state government have a wide range of authority and responsibility and can sometimes choose what is to be examined. Such examinations are also subject to legal requirements, depending on the state, because legal stipulations require certain state functions, often involving money, to be examined.

Legislative Influence Through Noninsurance Laws The insurance environment is affected by the passage by a state legislature of many different types of laws other than for insurance. Banking, contracts, fraud, and investments are some of the areas of commerce that have statutes affecting insurance. Imagine a wheel of commerce with spokes for banking, contracts, securities, and insurance connected to a hub that is financial issues. The rationale used by lawmakers in relating insurance to other types of financial commerce, when enacting legislation, is understandable because insurance is a financial arrangement, just as are banking and investing.

Banking Current federal banking laws and rules have a provision allowing federally chartered financial institutions to sell insurance in certain circumstances. This provision, known to insurance agents as the “town of 5,000 loophole,” allows a national bank in a small town to sell insurance.7 The sale of insurance by banks is affected by other federal laws, such as the Truth in Lending Act. In the early 1990s, the United States Treasury Department proposed (1) to allow banks and insurance companies to become affiliated and (2) to permit banking regulators to examine insurance company affiliates. These proposals have not been enacted as of this writing. Delaware law allows state-chartered banks to engage in both insurance sales and underwriting, provided that the underwriting be done in a location physically separated (by use of a wall, for example) from the bank.

Contracts An insurance policy is a contract: in exchange for consideration (the premium) by one party (the insured), the other party (the insurer) agrees to a performance (loss payment or claim adjustment) under mutually agreeable conditions. Because so many different types of contracts exist, legislators make laws that apply to the whole range of contracts, not just those involving insurance. For example, Florida law among other things requires that “[a]ctions other than for recovery of real property” be made within five years and be founded for legal purposes on a written contract.8 That means, for example, that the time period of the Standard Fire Policy allowing suit against

108 The Regulation of Insurance the insurer would be changed in Florida to five years to comply with that state’s contractual law.

Premiums Premium financing is another area of commerce that is controlled by legislation due to the potential for abuse. Financing of premiums occurs either when the policy premium charge is large or when the insured does not want to pay the entire cost immediately. The policyholder can pay the premium by installment and have other uses (investment, for example) for the money that would have been used to pay the entire premium all at once. (Interest from the investments might even be enough to pay part of the premium.) Laws about financial services such as insurance premium financing are necessary to ensure that the transaction is fair and equitable. For example, suppose Company A2Z has 600 locations in fourteen states, covered for commercial property insurance with the Excellent Insurance Company, which has a premium finance corporate subsidiary, the MUN-NEE Company. When A2Z decides to finance its commercial property insurance premium of $15 million with MUN-NEE, state laws require that the finance agreement specify the length of the transaction (twelve months, for example), how much money is to be paid and when it is to be paid (such as monthly payments of an equal amount), and what happens if the payments are not made.

Fraud Fraud is another subject that affects insurance and also one that has laws dealing with it. Although not every state has specific insurance fraud statutes, fraud is against the law in all jurisdictions. Even though a state law does not deal specifically with insurance fraud, this does not mean that a general fraud law cannot be used. Increasingly, state insurance departments are establishing fraud units to deal with the different kinds of insurance fraud, such as claims fraud, director and officer fraud, and agency fraud.

Investments Investments are yet another area of commerce for which state legislatures pass laws, and which involve insurance companies. Because of the large amounts of funds that insurers are required by law to have as reserves for claims and to meet solvency standards, insurance companies buy and sell stocks and bonds and engage in other kinds of investment activity (for example, acquiring or selling real estate) in order to achieve their financial goals. Insurers give a great deal of attention to investments, since profit from investments can be used to help offset unexpected underwriting losses.

Chapter 4 / The Influence of State Legislatures and the NAIC 109

Lobbying Over the years, some state legislatures have become concerned with what they view as the “revolving employment door” of regulators being hired by the industries they used to regulate and then returning to government service at a later date. Concerns have been raised about whether improper influence is involved when people accept offers of employment from businesses formerly regulated by them, and whether former regulators or private industry personnel should become employed in the public sector to regulate the line of work of their former employer. One of the ways that state governments deal with potential conflicts of interest and undue influence is to enact laws dealing with lobbying. The following examples show how some states deal with the issue of lobbying. New Mexico’s Lobbyist Regulation Act was enacted in 1978 and amended in 1993. The law controls the actions of lobbying state agencies and related groups such as boards and commissions that are involved in the process of making rules and policies. The purpose of this law is to reduce the opportunities for undue influence by people employed by or representing the state government.9 The New Mexico law defines lobbying as an attempt “. . .to influence any decision related to any matter to be considered or being considered. . .” and a lobbyist as a person who is compensated for lobbying. A few exceptions to the definition of a lobbyist exist, such as for an elected person performing in an official capacity. Lobbyists must register each year with the secretary of state of New Mexico. The lobbyist’s registration includes, among other information, a brief description of the interests the lobbyist will be representing and the name of the individual or entity that maintains the information required by the law. The lobbyist must also file a sworn statement of lobbying expenditures at least once a year, including entertainment, food and drink, advertising, and political contributions. Each individual expense over $50 made to or for the benefit of a state employee or legislator must be recorded with the date, amount, and name of the recipient. Each lobbyist’s registration and expense records become public record. Engaging in acts deemed to be a violation of the New Mexico law and being found guilty in court is considered to be a misdemeanor with a fine of not more than a thousand dollars. The lobbyist’s registration might also be suspended for up to three years. Missouri Senate Bill 262 became law in 1992 and deals with ethical standards and campaign finances. The law defines lobbying as attempts to influence governmental actions, and requires lobbyists to register. Penalties are assessed

110 The Regulation of Insurance for law violation. This Missouri law deals with the “revolving door” issue by putting restrictions on lobbying by former state officials and employees. Furthermore, lobbyists cannot serve on state commissions while acting as lobbyists.

NAIC The National Association of Insurance Commissioners (NAIC) is a voluntary organization formed in 1871 to coordinate the regulation of insurers operating in multiple jurisdictions. The insurance commissioners of each of the fifty states, the District of Columbia, American Samoa, Guam, Puerto Rico, and the Virgin Islands are members. This group gives regulators a way to deal with common interests and to work cooperatively on interstate and intrastate insurance matters. Uniform financial reporting from insurance companies was one of the first significant steps by the NAIC to create effective regulation that would help to maintain the insurance industry’s financial stability. Today, the NAIC continues to assist state insurance regulators in their work of financial and market conduct regulation of insurance. A profile of the NAIC is given in its Annual Report: The objective of the NAIC is to serve the public interest by assisting state insurance supervisory officials, individually and collectively, in achieving the following fundamental insurance regulatory objectives: 1. Promotion of the public interest through the regulation of insurance and the fair, just and equitable treatment of insurance consumers and customers; 2. Reliability of the insurance institution as to solvency, financial solidity and guaranty against loss; and 3. Maintenance and improvement of state regulation of insurance in a responsive and efficient manner.10

Achieving these objectives is accomplished by regularly scheduled meetings of all the members to discuss important insurance issues and to develop NAIC policy. Functions performed and services provided by approximately 300 support staff members in the following three locations also help the NAIC to meet its objectives: • •

The NAIC Support Services Office (SSO) in Kansas City, Missouri The NAIC Securities Valuation Office (SVO) in New York, New York

Chapter 4 / The Influence of State Legislatures and the NAIC 111 •

The NAIC Financial Analysis and Government Relations Office in Washington, D.C.

Together, the NAIC employees in these locations assist state insurance regulatory officials in many ways, including the following: • • • • • •

• • • • •

Supporting the NAIC’s committees, subcommittees, and task forces Maintaining computerized databases to help regulators keep track of the financial adequacy of insurers Scrutinizing alien surplus or excess lines insurers seeking to do business in the United States Supporting individual state insurance regulators in court cases by issuing “friend of the court” briefs Valuing insurers’ securities Keeping track of insurance issues at the federal level while working on behalf of state insurance regulators to express their concerns and interests to the federal government Helping state insurance officials with information about pricing and coverage regulatory submissions Assisting the states in responding to federal reporting requirements Producing various publications about insurance issues for use by the states Developing statistical reports dealing with a variety of financial and market matters and interpreting them for state insurance regulators Giving expert advice about financial regulation, market conduct regulation, and computer usage to state insurance officials

In addition to involvement in state and federal insurance regulatory issues, the NAIC is also involved internationally. The NAIC has helped to develop the International Association of Insurance Supervisors (IAIS) and hosts meetings for insurance regulators from other countries. NAIC members annually elect a president, vice president, and a recording secretary to serve one-year terms. The members choose these officers from their midst, and the insurance commissioners who are elected to be the NAIC officers continue to be the insurance commissioners in their respective states. NAIC insurance regulatory policy is adopted only by a vote of all of the members (each member has one vote) who have already reviewed and considered the policy. Before the entire membership votes on an issue at the plenary session, the issue will have been discussed by a committee, subcommittee, or task force of the NAIC and reports and recommendations will have been made. Exhibit 4-4 illustrates the NAIC’s committee structure, which is not

112 The Regulation of Insurance

Exhibit 4-4 NAIC Committee Structure Executive (EX) Committee (EX) Special Committee on Antifraud (EX) Committee on Credit Insurance (EX) Special Committee on Health Care Reform (EX) Special Committee on Information Systems (EX) Special Committee on Interstate Compact (EX) Special Committee on Regulatory Efficiency (EX) Special Committee on Statistical Information (EX) Statistical Task Force

Internal Administration (EX1) Subcommittee Zone Coordination (EX2) Subcommittee Market Conduct & Consumer Affairs (EX3) Subcommittee Insurance Availability & Affordability Task Force Market Conduct Examination Oversight Task Force

Financial Condition (EX4) Subcommittee Accounting Practices & Procedures Task Force Blanks Task Force Examination Oversight Task Force RIsk-Based Capital Task Force Valuation of Securities Task Force

Life Insurance (A) Committee Accident & Health Insurance (B) Committee Regulatory Framework Senior Issues Task Force State & Federal Health Insurance Legislative Policy Task Force

Personal Lines P&C Insurance (C) Committee Commercial Lines P&C (D) Committee Workers’ Compensation Task Force

Special Insurance Issues (E) Committee International Insurance Relations Task Force Surplus Lines Task Force

Insolvency (EX5) Subcommittee Financial Regulation Standards & Accreditation (EX6) Subcommittee Technical Task Forces Casualty Actuarial Life & Health Actuarial

Notes: AAA = ASB = IAIABC = NCOIL = JIR =

Joint Committees and Boards NAIC/AAA/ASB NAIC/IAIABC NAIC/NCOIL NAIC/JIR Board Consumer Participation Board of Trustees

American Academy of Actuaries Accounting Standards Board International Association of Industrial Accident Boards and Commissions National Conference of Insurance Legislators Journal of Insurance Regulation

Source: NAIC Program for the Spring National Meeting, March 1995.

Chapter 4 / The Influence of State Legislatures and the NAIC 113 static. Over the years, committees, subcommittees, and task forces have been formed and disbanded or merged as the need arose, depending on the insurance issues involved. The staff structure of the NAIC is shown in Exhibit 4-5. This structure is designed to give the utmost service to state insurance regulators. Included in this exhibit are the operations from all three NAIC offices. Some of the staff have previously worked in various positions within state insurance departments or within insurance companies. Unlike the NAIC’s president, vice president, and recording secretary, the executive vice president of the NAIC is not a state insurance regulator and is not elected annually by the membership. The effect of the NAIC on insurance regulation can be examined by looking at three NAIC activities: model laws, accreditation, and research. Involvement in each of these activities by the NAIC puts it in the forefront of insurance regulation. The services provided by the NAIC are essential to the operation of efficient and effective state insurance regulation. Other services and the NAIC’s budget are also important to insurance regulation and are discussed at the end of this chapter.

Model Laws The genesis of an NAIC model law occurs at an NAIC national meeting. During and before such a meeting, a committee of NAIC members or their delegates studies a specific insurance regulatory matter, deliberates, and has hearings to gather oral and written testimony from others—consumer representatives and insurance industry personnel, for example. The committee then takes a position on the issue. That committee action can lead to the creation of a new model law, regulation, or guideline. If the entire NAIC membership votes to adopt the committee’s recommendation, the recommendation is then an actual NAIC position on insurance regulatory practice. Such a policy recommendation can lead to proposed model legislation. Model legislation created by the NAIC is derived from efforts by members, staff, and outside interests such as other government personnel, consumers, and industry. Ideally, people knowledgeable about insurance work with those experienced in legal matters to make a useful and acceptable model law, regulation, or guideline for use in state supervision of insurance. Over the decades, the NAIC has formally recommended insurance regulation in the form of hundreds of model laws, regulations, and guidelines. Model Laws, Regulations and Guidelines is a four-volume set of the NAIC’s model legislation, which includes a record of whether each member’s state govern-

114 The Regulation of Insurance

Exhibit 4-5 NAIC Support Staff Structure

Executive Vice President Commissioner Services Meetings Department NAIC Education & Research Foundation

General Counsel Legal Division Health Analysis Market Affairs Insolvency Securities Valuation Counseling Special Services

Director of Information Systems

Director of Financial Services Accreditation Financial Services Member & Examination Services NAIIO Reinsurance

Executive Director Securities Valuation Office

Director of Operations Accounting Consumer Services Education & Training Human Resources Office Services Publications

Director of Research Actuarial Analysis Data Quality

Data Services

Administrative

Market Analysis

Operations

Office Management

Research Library

Special Projects

Securities Analysis

Research Studies

Systems Development Applications

Washington Counsel Director of Government Relations Government & Media Relations

Statistical Reports

Director of Financial Analysis Life & Health Property & Casualty

Legislative Counsel

Source: NAIC 1993 Annual Report.

Chapter 4 / The Influence of State Legislatures and the NAIC 115 ment has taken action and a historical summary of the NAIC’s work in creating the model. One example of an NAIC model law is entitled Managing General Agents Act, excerpts of which are shown in Exhibit 4-6. Originally adopted at a special plenary session of the NAIC in 1989, it is now a law or regulation in every state, with most jurisdictions having adopted all of the model. That Act contains nine sections: • • • • • • • • •

The title Definitions Licensing Required contract provisions between the managing general agent (MGA) and the insurer The duties of the insurance company Examination authority by insurance regulators Penalties and liabilities Rules and regulations The effective date of the law

Throughout the Act, the authors inserted drafting notes that help to interpret the intent of the text and offer guidance to states on how to make the model compatible with existing laws in the state. (The drafting notes vary with each model law.) For example, the model Managing General Agents Act includes a drafting note that suggests that a state’s law “[i]nsert the proper title for the chief insurance regulatory official wherever the term ‘Commissioner’ appears.”11 The model Managing General Agents Act is a typical NAIC model law dealing with one of dozens of subjects of insurance regulation on which the NAIC has taken a position. While some model laws are adopted in their entirety by state legislatures, not all of the NAIC models become laws in the states. Some model laws are adopted as regulations by some departments of insurance. Other model laws are not adopted in some states. The reasons that some model laws are changed by legislatures, some take years to become laws, and some are never adopted by state legislatures or state departments of insurance include the following: •

Individual state legislatures might view a particular model law as inappropriate or unnecessary because the subject matter is already sufficiently covered by other state laws.

116 The Regulation of Insurance

Exhibit 4-6 Excerpts from the NAIC’s Model Managing General Agents Act Table of Contents Section 1. Section 2. Section 3. Section 4. Section 5. Section 6. Section 7. Section 8. Section 9. ... Section 2.

Short Title Definitions Licensure Required Contract Provisions Duties of Insurers Examination Authority Penalties and Liabilities Rules and Regulations Effective Date Definitions

As used in this Act: ... C. “Managing General Agent” (MGA) means any person, firm, association or corporation who (1) Manages all or part of the insurance business of an insurer (including the management of a separate division, department or underwriting office); and (2) Acts as an agent for such insurer whether known as a Managing General Agent, manager or other similar term, who, with or without the authority, either separately or together with affiliates, produces, directly or indirectly, and underwrites an amount of gross direct written premium equal to or more than five percent (5%) of the policyholder surplus as reported in the last annual statement of the insurer in any one quarter or year together with one or more of the following activities related to the business produced: (a) Adjusts or pays claims in excess of an amount determined by the Commissioner; or (b) Negotiates reinsurance on behalf of the insurer. Note: Insert the proper title for the chief insurance regulatory official wherever the term “Commissioner” appears. Managing General Agents Act (3)

Notwithstanding the above, the following persons shall not be considered MGAs for the purposes of this Act: (a) An employee of the insurer; (b) A U.S. Manager of the United States branch of an alien insurer; (c) An underwriting manager which, pursuant to contract, manages all or part of the insurance operations of the insurer, is under common control with the insurer, subject to the holding company regulatory act, and whose compensation is not based on the volume of premiums written; (d) The attorney-in-fact authorized by and acting for the subscribers of a reciprocal insurer or inter-insurance exchange under powers of attorney.

Chapter 4 / The Influence of State Legislatures and the NAIC 117 ... Section 3.

Licensure

A. No person, firm, association or corporation shall act in the capacity of an MGA with respect to risks located in this state for an insurer licensed in this state unless such person is a licensed producer in this state. ... Section 4. Required Contract Provisions No person, firm, association or corporation acting in the capacity of an MGA shall place business with an insurer unless there is in force a written contract between the parties which sets forth responsibilities of each party and where both parties share responsibility for a particular function, specifies the division of such responsibilities, and which contains the following minimum provisions: A. The insurer may terminate the contract for cause upon written notice to the MGA. The insurer may suspend the underwriting authority of the MGA during the pendency of any dispute regarding the cause for termination Drafting Note: Nothing in the above subsection is intended to relieve the MGA or insurer of any other contractual obligation. ... Section 5. Duties of Insurers A. The insurer shall have on file an independent financial examination, in a form acceptable to the Commissioner, of each MGA with which it has done business. B. If an MGA establishes loss reserves, the insurer shall annually obtain the opinion of an actuary attesting to the adequacy of loss reserves established for losses incurred and outstanding on business produced by the MGA. This is in addition to any other required loss reserve certification. ... Section 6. Examination Authority The acts of the MGA are considered to be the acts of the insurer on whose behalf it is acting. An MGA may be examined as if it were the insurer. Section 7. Penalties and Liabilities A. If the Commissioner determines that the MGA or any other person has not materially complied with the Act, or any regulation or Order promulgated thereunder, after notice and opportunity to be heard, the Commissioner may order: (1) For each separate violation, a penalty in an amount not exceeding [insert amount]; (2) Revocation or suspension of the producer’s license; and (3) If it was found that because of such material non-compliance that the insurer has suffered any loss or damage, the Commissioner may maintain a civil action brought by or on behalf of the insurer and its policyholders and creditors for recovery of compensatory damages for the benefit of the insurer and its policyholders and creditors or other appropriate relief. ... Section 8. Rules and Regulations The Commissioner of Insurance may adopt reasonable rules and regulations for the implementation and administration of the provisions of this Chapter. Section 9. Effective Date This Act shall take effect on [insert date]. No insurer may continue to utilize the services of an MGA on or after [insert date] unless such utilization is in compliance with this Act.

Adapted with permission from NAIC Model Laws, Regulations and Guidelines (NAIC, October 1993), pp. 225-1 to 225-6.

118 The Regulation of Insurance • • •

Legislators might decide to modify a model law to meet their states’ particular needs or to better coalesce with other laws. A state’s legislature might not meet in session every year, or an annual session might be brief (forty working days in some states). With so many matters for a state legislature to consider, legislators might view an NAIC model law as just another agenda item that competes for their attention.

Although insurance is a national business, it is regulated on an individualstate basis and states recognize the need to have some general agreement about control of insurance. Model legislation developed by the NAIC is helpful in guiding states in adopting the same or similar insurance laws, regulations, and guidelines. Also, with models available, state government officials do not have to spend time writing legislation in each state: research and development have already been done, and states can adopt or modify proposed model laws, regulations, and guidelines. The states benefit each other by having the same or similar laws. Insurance companies can benefit from legal uniformity among the states on a variety of matters such as agency and claims adjuster licensing standards, and pricing, coverage, and statistical filing requirements because an economy of scale is involved. Since insurers can be licensed for business in more than one state, it is cheaper for them to have to comply with one or a few sets of standards than with many different standards. For example, suppose an insurance company were licensed in thirty states for a particular line of insurance and decided to file a new product for approval. Now, imagine two scenarios: (1) twenty-seven of the thirty states accept a standardized regulatory filing form, or (2) only ten accept it, with the remaining twenty states all having different filing requirements. The former situation is much more economical for an insurer. NAIC model laws, regulations, and guidelines help the states and the insurance industry to operate more efficiently.

Accreditation Program In 1988, the NAIC decided to create basic standards to improve the quality of insurance company solvency regulation by the individual states. These financial regulation standards were adopted by NAIC members in June 1989 at a plenary session. “To provide guidance to the states regarding the minimum standards and an incentive to put them in place, the NAIC adopted in June 1990 a formal certification program.”12

Chapter 4 / The Influence of State Legislatures and the NAIC 119

General Nature of Accreditation The accreditation program works through a series of steps, of which the major ones are as follows: 1. The state insurance commissioner submits a request for a review to the NAIC head office. 2. An NAIC Review Team consisting of from three to six people and “. . .comprised of experts in insurance regulation with no present ties to either the industry or an insurance department”13 is chosen by the Financial Regulation Standards Accreditation Committee (FRSAC) of the NAIC. The number of people on the team is determined by the size of the state involved. A minimum of one impartial former senior level insurance regulator must be on the team. The NAIC pays for the Review Team’s state visit. These visits are scheduled for a specific time and usually last a few days. 3. The review involves the following activities: a. Interviewing department personnel b. Reviewing laws and regulations c. Reviewing prior examination reports and supporting work papers and analytical reviews d. Inspecting regulatory files for selected companies e. Reviewing organizational and personnel policies f. Walking through the department to gain an understanding of document and communication flows g. Discussing comments and findings from the review h. Conducting a closing conference with the state to discuss findings and prepare a report14 4. After a meeting between FRSAC and the Review Team, the state becomes accredited or must make the required changes and go through the review again.

Standards of Financial Regulation States must meet three criteria to satisfy the NAIC’s Financial Regulation Standards and to be accredited: 1. The laws and regulations used by the state must meet certain basic standards of NAIC models. 2. The regulatory methods of the state must be acceptable. 3. Department practices must be adequate.

120 The Regulation of Insurance

Changes in Financial Regulation Standards Because the insurance industry changes, the NAIC’s standards of financial regulation can change. Therein lies the potential for conflict, since many of the NAIC legal and budgetary standards for insurance departments are out of the departments’ control. Legislatures and governors make the laws and set the budgets. In dealing with the NAIC’s Financial Regulation Standards, state governments have practical and philosophical constraints. Most state insurance departments are not self-funded; they depend on a budget that might not have sufficient funds to implement spending for organizational and personnel practices as stipulated by the NAIC. Furthermore, not every state legislature meets annually and some meet only for a brief period. Insurance-related legislation such as NAIC model laws might not be a part of a legislative agenda because of competing interests, other issues, or philosophical objections. Although most state legislatures agree with the concept of the NAIC’s accreditation program, many have two concerns: the pace and the philosophy of the program. With the adoption by the NAIC of additional and revised model law requirements for accreditation, a continual need for new legislation is created. Even the chairman of the NAIC Financial Standards and Accreditation Committee has said “. . .‘it was a mistake’ for the NAIC not to have stopped introducing new accreditation standards ‘a couple of years ago’ to allow regulators and legislators to ‘catch our breath.’ ”15 The National Conference of Insurance Legislators (NCOIL) has advised that the NAIC accreditation requirements for the states could create a situation that “. . .legislatures would resent and eventually resist because of the view that the NAIC was dictating law to them and was usurping their constitutional authority.”16 Indeed, a prominent member of the New York state legislature expressed his discontent with the accreditation program in saying “[t]he NAIC is not an elected body. They have no authority to legislate, yet they continue to act as a surrogate legislature.”17 A Texas legislator agreed that legislators are going to take issue with the NAIC requirements.18 The NAIC has heard these concerns and plans to address them as the accreditation process continues to evolve.19

Success of Accreditation The program has been a success. “Since the program’s beginning, all 50 states and the District of Columbia have enacted laws and regulations designed to bring them closer to compliance with the standards.”20 Insurers licensed in the accredited states represent over 97 percent of all the insurance premiums (life, property, and casualty) nationwide.21 As of the end of 1994, forty-four state insurance departments were certified under the NAIC’s Financial Regulation

Chapter 4 / The Influence of State Legislatures and the NAIC 121 Standards and Accreditation Program. Because this program is ongoing, other state insurance departments are likely also to become accredited. More state legislatures and governors will enact laws that encourage the insurance regulators to seek NAIC accreditation by enabling them to have the needed legal and other authority, resources, and work practices to effectively regulate the solvency of insurance companies. Critics of the financial regulation standards and accreditation program have charged that this activity is a belated response to criticism of the system of insurance regulation by the states and a call for a federal regulatory oversight system. Regardless, the NAIC action has been the impetus for many states to enact legislation improving the quality and quantity of insurer solvency regulation. The basic premise of the program, to have uniform solvency regulatory standards, is still laudable.

Research and Development The Support and Services Office of the NAIC includes a research division whose staff helps support the work of insurance regulators on different subjects such as rate regulation, market conduct, and financial review. Six main activities are performed by the research division: • • • • • •

Giving information to state insurance departments Helping the staffs of insurance departments with technical and regulatory questions Giving information to federal and state government agencies and others Helping to develop the NAIC financial and statistical databases Providing pertinent statistical material and research studies Giving other NAIC departments support through research22

Experienced regulatory specialists, economists, and research actuaries in the division make use of a 10,000 volume library of insurance information and computerized databases containing millions of records. Three areas of activity undertaken by the research division are of primary importance: statistics, insurance issues, and advice on pricing and coverage regulation.

Statistics Four aspects of statistical work will be covered here: quality monitoring, routine reporting, special reporting, and model plans. A group within the

122 The Regulation of Insurance research division of the NAIC checks the completeness and correctness of financial data, including annual statements and real estate surveys, of insurance companies. These quality assurance efforts include testing the appropriateness of the database. This group also works with individual state insurance departments regarding the monitoring of insurer filings and data quality. Help is given for changing the reporting requirements for insurer annual and quarterly statement blanks, when the issue is studied by an NAIC task force. Research is done about how to develop a variety of tools to collect and review data of insurance companies’ finances. This quality checking group also prepares some NAIC publications, among them the Contact Person Report, which lists what is occurring with insurers that are licensed in more than one state and are under insurance department supervision, conservatorship, rehabilitation, or liquidation. Routine statistical reports are produced by the NAIC’s research division when requested by state insurance regulators. These standard reports are done on the following subjects: • • • • • • • •

Premiums and losses Loss ratios Assets Surplus Profits Real estate holdings Average premiums Insolvencies

Some routine reports are also available to the public. These reports deal with a variety of topics such as the following: • • • • •

Investment holdings of insurance companies A breakdown of profitability by jurisdiction and by kind of insurance Details of staff and budget of state insurance departments Loss ratios by line of insurance Average expenses and premiums by state for auto insurance

Special statistical reports are generated by the research division in response to nonroutine requests from state insurance regulators, federal agencies such as the General Accounting Office and the Securities and Exchange Commission, and committees of the U.S. Congress. The following are examples of topics included in these made-to-order reports:

Chapter 4 / The Influence of State Legislatures and the NAIC 123 • • • • • •

Extraordinary dividends Market share reports by state Guaranty fund assessments Products liability Market entries and exits Title insurance loss ratios

Such reports respond to interest expressed for more insurance information by regulators and legislators. Model statistical reporting plans for the major insurance lines were created by the NAIC’s Statistical Task Force with help from the research division of the NAIC staff. Use of improved and consistent statistical reporting methods by insurers will improve the precision of ratemaking and help track insurance markets on a multistate basis.

Insurance Issues While regulating the insurance marketplace, state insurance departments can be confronted with economic, political, and social implications of insurance issues. Insurance regulators must consider the effect of their actions on insurance market affordability and availability, insurer solvency, service quantity and quality, and loss adjustment expenses. The NAIC research division assists state insurance departments by studying and preparing reports on special subjects that insurance regulators are asked about for comment. These reports aid insurance commissioners in reviewing important issues and giving presentations at public gatherings and before legislatures. Among the subjects of these studies are insurance redlining; personal automobile insurance competition; risk-based capital; credit insurance regulation; the underwriting cycle; and market and claims studies for various lines of insurance. The research division of the NAIC gives insurance regulators current information about many topics to help them in their decision making.

Regulatory Advice The last area of research division activity concerns pricing and coverage regulation and also life and health actuarial services. State insurance department staff contact the division’s staff for information and advice. The research division acts as a clearinghouse and repository for information on the regulatory activities of all the states. Solutions to regulatory problems and concepts of regulation are discussed, with individual NAIC members benefiting from the research division’s staff experience and knowledge of multiple states’

124 The Regulation of Insurance regulatory affairs. The types of advice given by the research division is varied: it could concern the regulation by other states of difficult to place insurance coverages or the way other state insurance departments dealt with sensitive issues being considered by legislatures.

Other Services The other services provided by the NAIC are many and varied. The three offices of the NAIC each provide different services to NAIC members and others involved in insurance regulation. The services provided by each NAIC office are discussed below.

Support and Services Office The Support and Services Office (SSO) located in Kansas City, Missouri, is the location of most of the services the NAIC staff provides to state insurance regulators. Among the many activities carried out by NAIC staff at the SSO are database development and maintenance, education and training, financial services, consumer information, electronic communications, publications, and legal assistance (the research and development activities of the SSO were discussed earlier in this chapter). In addition, the International Insurers Department operates out of the SSO.

Databases Information about the insurance industry’s behavior in the marketplace is an NAIC service. Three electronic systems exist: the Regulatory Information Retrieval System (RIRS), the Special Activities Database (SAD), and the Complaints Database System (CDS). These databases have information concerning the areas of claims handling, advertising and marketing, agent and insurer licensing, and business management. By checking the computer database, an insurance regulator can help avoid the situation in which violators identified in one state get a license to do business in another state. Those conducting market investigations of insurers also use these sources. RIRS has the names of people and companies that have had regulatory or disciplinary action taken against them. When regulators use RIRS, they lessen the opportunity for disciplined companies to move from state to state to avoid disciplinary or regulatory action. SAD has the names of insurance companies and people of concern to insurance regulators, including entities that have had charges brought against them, have been specially investigated by the government (for insurance related or other affairs), or that might have been involved in fraudulent, unlicensed, or other unauthorized events. CDS contains information about complaints made against people and companies in the insurance business on a state or national basis. All three systems quickly and easily allow

Chapter 4 / The Influence of State Legislatures and the NAIC 125 on-line access to market information, which is routinely updated. Insurance companies and the public are able to see the RIRS information. Such information is helpful as a pre-employment check. However, only insurance regulators can use the SAD and CDS systems. Another significant NAIC database service compiles United States domiciled insurers’ annual and quarterly financial statements and all special exhibits filed throughout the year. That compilation is the basis for the necessary solvency checks and controls by insurance regulators of the insurance industry. Insurance companies need money to pay claims and stay in business. All states require their respective insurance commissioners to monitor the financial status of insurers operating in their jurisdictions.

Education and Training Education and training about insurance are offered by the NAIC through programs and seminars primarily for regulators but also for the public in some instances. Regulator-exclusive programs include a commissioners’ education program and an insurance department staff program, both designed to acquaint insurance commissioners and their staff with the area of insurance and regulation. These regulator-exclusive programs include the following: • • • •

•

A financial examiners program to help new examiners learn more about financial regulation. The “Regulating for Solvency” program for experienced financial regulators to study various insurance company financial issues in depth. The “Regulating the Marketplace” program developed to further the education of experienced regulators involved in market conduct work. An investment seminar designed by a bank as a “. . .non-technical derivatives program. . .to develop an understanding of derivative products, their uses and abuses.” The seminar explains ideas and basic concepts involved with derivatives.23 A forum for market conduct chief examiners to explore topics of mutual interest about examinations of insurers.

Public seminars and workshops include a solvency regulation symposium, a reinsurance seminar, an insolvency workshop, a workshop about annual statement reporting changes, and a continuing legal education seminar on a particular issue. For example, in one year’s seminar, the subject was securities law; in another year, regulating unauthorized insurers was the topic. Also, seminars and workshops are held on subjects that periodically need to be addressed; some topics are for regulators, and others are for the public. Additionally, NAIC staff do consulting and program development for indi-

126 The Regulation of Insurance vidual or groups of state insurance departments interested in continuing insurance education or research training. Because the insurance environment is evolving, regulatory continuing education and training are crucial to effective regulation.

Financial Services The financial services division of the SSO gives expert advice to insurance regulators about accounting, reinsurance, and financial reporting to help them effectively and efficiently examine the financial condition of insurers. This division also reviews the financial filings of alien insurers. Consumer Information The NAIC’s constitution mentions consumer protection as one of the organization’s primary functions. Consumer services of the NAIC include the publishing of consumer guides about various types of insurance, producing movies on insurance topics, and creating senior citizen insurance counseling programs. The NAIC membership has also allocated money to help pay the cost of qualified representatives of consumer organizations to attend NAIC national meetings. These representatives help keep the NAIC informed on issues of importance to consumers and help shape model legislation to better protect consumers. International Insurers Department The International Insurers Department has data on alien insurance companies that desire to do business in this country as excess or surplus lines writers. If such an insurer were placed on the acceptable list by that office, about 40 percent of the states automatically approve that insurer to write excess or surplus lines. Other states also review the periodic listing and consider it to be important when evaluating the acceptability of an insurer. The International Insurers Department is the international representative of the NAIC. Publications Paper and electronic publications are another service offered by the NAIC. Over five dozen different titles are available to regulators; the NAIC also has publications available to noninsurance regulators and the public. Categories of NAIC publications include the following: • • • •

Accounting and annual statement reporting Alien insurers Consumer information Financial analysis

Chapter 4 / The Influence of State Legislatures and the NAIC 127 • • • •

Model laws and other legal matters The NAIC in general Research projects Statistics

Some of the publications are available in an electronic format. Altogether, over a hundred different products are available when the various statistical compilations are counted along with the publications.

Electronic Communications Tying all NAIC services together is the electronic communications network that links each state insurance department with the NAIC headquarters in Kansas City. An electronic news service, E-Mail, gives insurance departments across the nation access to current, significant news each week about forthcoming gatherings, pertinent federal government activities, NAIC decisions on various matters, and news about the insurance industry and individual states. Also, insurance departments can send messages to each other through the computer network, and they can access the NAIC databases for information quickly and easily regarding insurance companies’ financial and market information. Computerized access to data simplifies the job of regulators. Efforts at automation are continuing by the NAIC to attain the goal of improved service using leading edge technology.

Financial Analysis and Government Relations Office The Financial Analysis and Government Relations Office located in Washington, D.C., handles certain financial analysis and government relations activities for the NAIC.

Government Relations Federal action regarding insurance regulation is not ignored by the NAIC; the NAIC’s Financial Analysis and Government Relations Office is located in the nation’s capital so that close contact can be made with Congress, members of the federal executive branch, and the national news media. Staff of the NAIC in the District of Columbia present oral and written testimony, conduct research, and assist state insurance officials who appear as witnesses in federal government proceedings. NAIC’s counsel in Washington also follows pertinent legislation and notifies members by a newsletter. The office of the NAIC counsel is the principal contact for its members with the federal government. The NAIC’s Financial Analysis and Government Relations Office also “. . .staffs the NAIC’s International Insurance Relations Task Force, whose members assist U.S. trade negotiators in connection with the North American

128 The Regulation of Insurance Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT) and their effects on state insurance regulation.”24 Staff members have participated in U.S.-Japanese trade discussions and frequently offer advice to the U.S. Department of Commerce officials. Media relations tasks are also part of the Washington, D.C., office operation. Those tasks include disseminating information about state insurance regulation, describing the NAIC and its work, training insurance commissioners in public speaking, and developing speeches and editorials.

Financial Analysis Regarding financial analysis, the NAIC’s Financial Analysis and Government Relations Office personnel monitor the financial condition of “nationally significant” insurers and provide professional assistance in the areas of financial regulation and solvency tracking for insurance regulators. Staff members work with state regulators in an active “peer review” process of early identification and treatment of failing insurers.

Securities Valuation Office In New York, the Securities Valuation Office (SVO) monitors the quality and value of the investments of insurance companies. The SVO “. . .determines uniform accounting values of securities investments for all jurisdictions. The [securities] database consists of securities investments owned by all U.S. insurers and includes government, municipal and corporate bonds, and common and preferred stocks.”25 Besides insurance regulators, bankers and insurers have access to the database of all this securities analysis. Proper valuation of securities is crucial to an insurer’s assets.

Potential for Liability The services that the NAIC provides to its members and others are enhanced by the work done by state insurance department personnel. They serve on task forces, study groups, and other NAIC bodies in order to lend their expertise to the scrutiny of whatever insurance issues are being examined by the NAIC, in addition to doing their work in their respective insurance departments. (Insurance industry people, consumer organization representatives, and others also become involved in working with the NAIC on various issues.) Because of the implications of these efforts, some states address the potential for liability. Alaska insurance law says the following: The director, employees or agents of the division, and the National Association of Insurance Commissioners and its employees are not liable for civil damages for an act or omission in the execution of their authorized

Chapter 4 / The Influence of State Legislatures and the NAIC 129

activities or duties under this title, or for the publication or dissemination of a report or bulletin related to their authorized activities or duties.26

Other references to the NAIC appear in the insurance statutes of some states, usually under the heading of interstate cooperation, interstate exchange of information, and the like, with some states saying that the insurance commissioner can be a member of the NAIC,27 and some states stipulating in their laws that the insurance commissioner and staff must participate in the activities and affairs of the NAIC.28 Reciprocal services exist between the states and the NAIC; each helps the other and receives service in return.

Budget Money to pay for the NAIC services comes from a variety of sources: state assessments, database fees, publications and subscriptions, services and meeting registration fees, interest income, education and training, and “other.” Over half of the almost $32 million in income in 1993 was raised through database fees, while state assessments accounted for only slightly more than a million dollars.29 Although revenue from state assessments is but a small percentage of the total NAIC income, its political effect can be significant because of two factors: how the assessment is calculated and the involvement of state legislatures. Assessments are not uniform for all jurisdictions and are based on the size of the state. This means that the charge is based on the premium volume in the state as reported by insurers to the NAIC. Therefore, a large state with a greater reported premium volume than a small state would be assessed more money than would a small state. Where that money comes from can be an issue in state legislatures—whether dedicated funding or general funding is involved. While the laws in some states (those that require participation in the NAIC by insurance regulators) allow payment of NAIC-related expenses incurred by state regulators, most state laws do not address NAIC-related expenses and assessments. For those states having a dedicated funding method for operating their insurance departments, the regulator can use some of that funding to pay the NAIC assessment. However, in states in which the insurance departments receive their operating costs from a general fund or other means, legislators sometimes object to the concept of paying an assessment to an organization such as the NAIC. The legislatures have no control over the NAIC, and the NAIC does not seem to directly benefit the state in an immediate and obvious way, as would, for example, a grant to a community organization or the construction of a new highway. In 1994, the chairman of the Senate Insurance Committee of New York complained about the amount of money that the state insurance depart-

130 The Regulation of Insurance ment paid to the NAIC. (Premium taxes paid by insurers doing business in that state are used to fund the state insurance department, although New York’s governor determines the amount of the state insurance department budget.) Responding to the complaint, the NAIC president said that the “[s]tates receive benefits from the NAIC many times over the amount they pay the association. In New York’s case, the insurance department paid $117,000 to the NAIC in 1993; in return, we estimate that it received approximately $1.2 million in services.”30 The NAIC is also funded by insurance companies, which must pay fees for the filing of financial statements with IRIS and for securities valuation, among other fees. The fees paid for the filing of financial statements are referred to as database fees because they are used to collect, analyze, and maintain the solvency database. The securities valuation fees are used to help rate securities held by insurers. In 1994, approximately two-thirds of the NAIC’s SSO revenues were raised through database fees and securities valuation fees. In addition, insurance companies must pay the costs of each examiner team that examines insurers. In recent years, insurance companies have faced significant increases in the fees paid to the NAIC. As a result, insurance company representatives and insurance industry trade associations have requested that the NAIC open its budget meetings to the public and make audited financial reports available to the public. The NAIC is working with the insurance industry to make the NAIC’s budgeting process more open.31

Summary Although state insurance departments have primary control of insurance regulation, state legislatures and the National Association of Insurance Commissioners (NAIC) affect that state insurance regulation. State legislatures oversee state insurance department activities as part of the legislature’s oversight of state executive branch activities. As such, state insurance departments must file annual reports and submit to performance reviews and audits. State legislatures also indirectly affect the insurance industry through legislation passed in other areas. State laws that apply to banking, contracts, premium financing, fraud, investments, and lobbying affect certain insurance industry activities and concerns. As businesses that operate in states, insurance companies, agents, and brokers, among other industry organizations, can be subjected to state laws that do not directly apply to the insurance industry.

Chapter 4 / The Influence of State Legislatures and the NAIC 131 The NAIC is the major forum in which state insurance regulators can interact, discuss regulatory issues, and develop cooperation and uniformity in state insurance regulation. The NAIC develops model laws, regulations, and guidelines that states can adopt, in total or as modified to meet a particular state’s needs. The NAIC has implemented the accreditation program to promote uniformity in solvency regulation and institute uniformity of minimum solvency standards. The NAIC members are supported by NAIC staff at three offices. The Support and Services Office (SSO) provides the bulk of NAIC member support, including databases, education and training, financial services consumer information, publications, and electronic communications. The SSO also serves as the headquarters for the International Insurers Department. International issues, along with other government services and financial analyses, are dealt with by the NAIC’s Financial Analyses and Government Relations Office. The NAIC’s Securities Valuation Office guides insurers on the valuation of their securities for financial reporting requirements. State insurance departments contribute to the NAIC’s budget. Each state pays a fee for membership in the NAIC that is based on the state’s size. The remainder of the NAIC’s budget is funded by fees for various services provided by the NAIC and fees paid by insurance companies when filing various information with the NAIC.

Chapter Notes 1. 2. 3. 4. 5. 6.

Arizona Insurance Law § 20-154.01. California Law Chapter 2, article 3.5 § 12961. California Law Chapter 2, article 3.5 § 12962. California Law Chapter 2, article 3.5 § 12963. California Law Chapter 2, article 3.5 § 12964. “Department of Insurance,” California Legislative Analyst Office Report to the California State Legislature 1994, pp. G-42 to G-49. 7. National Bank Act, Section 92. 8. Florida Law subparag. 95.11.2. 9. Lobbyist Regulation Act 1993 New Mexico Laws, Chapter 2, articles 11-1 to 11-9. 10. NAIC 1993 Annual Report, National Association of Insurance Commissioners (NAIC), Kansas City, MO. 11. National Association of Insurance Commissioners (NAIC), “Managing General Agents Act,” Model Laws, Regulations and Guidelines (NAIC, October 1993), p. 225-1.

132 The Regulation of Insurance 12. Financial Regulations Standards and Accreditation Program, (Kansas City, MO: National Association of Insurance Commissioners, July 14, 1993), p. 1. 13. Financial Regulation Standards and Accreditation Program. 14. Financial Regulation Standards and Accreditation Program. 15. L.H. Otis, “NAIC Eyes Accreditation Standards Moratorium,” National Underwriter, November 22, 1993, p. 1. 16. L.H. Otis, “NAIC Eyes Accreditation Standards Moratorium,” p. 1. 17. “N.Y. Senate Approves Retaliation Measure,” National Underwriter, April 4, 1994, p. 23. 18. “NAIC Issues Texas Dep’t a ‘Stay of Execution,’ ” National Underwriter, March 14, 1994 p. 2. 19. David Foppert, “The Mouse That Roared,” Best’s Review, Property-Casualty, June 1994, p. 116. 20. “Accreditation Goals Achieved,” NAIC News, January 1994, p. 1. 21. “Accreditation Goals Achieved,” NAIC News, January 1994, p. 1. 22. National Association of Insurance Commissioners (NAIC), Research on Insurance Regulation (Kansas City, MO: 1993). 23. National Association of Insurance Commissioners (NAIC), NAIC Education Programs (Kansas City, MO: 1993). 24. National Association of Insurance Commissioners (NAIC), Services to NAIC Members (Kansas City, MO: 1993). 25. National Association of Insurance Commissioners (NAIC), A Tradition of Consumer Protection (Kansas City, MO: 1993). 26. Alaska Insurance Law § 21.06.165. (a). 27. Nevada § 679B.220 and New Mexico § 59A-2-15. 28. New Hampshire § 400-A:28, Utah § 31A.-2-210, and Wisconsin § 601.48. 29. National Association of Insurance Commissioners (NAIC), NAIC 1993 Annual Report, Kansas City, MO, 1993. 30. “N.Y. Senate Approves Retaliation Measure,” National Underwriter, April 4, 1994, p. 23. 31. “NAIC Holds First Open Budget Meeting,” Best Week Special Supplement, December 19, 1994.

Chapter 5

The Federal Government’s Role in Insurance Regulation Regulation of the “business of insurance” has generally been the domain of the states and their agencies. As discussed in Chapter 2, in the United States Supreme Court decision of Paul v. Virginia1 (Paul) in 1868, the Court determined that an insurance policy was not a “transaction of commerce.” That being the case, there was no interstate commerce subject to federal regulation under the commerce clause of the nation’s Constitution. State insurance regulation was largely unchallenged until the appeal in the case of the United States v. South-Eastern Underwriters Association2 (SEUA) to the United States Supreme Court. The Court, speaking more than seventy-five years after its ruling in Paul, took a different direction. It reversed the lower court’s ruling and found that the Sherman Act, among other federal acts, applied to the insurance industry. While the issue in Paul was whether the commerce clause precluded state regulation, the issue in SEUA was whether the federal legislators had the power through Congress to regulate the “business of insurance.” But in 1944, given the economic power held by the insurance industry, it was appropriate for the federal government to regulate the industry.3 The SEUA decision so frightened the insurance regulators and the insurance industry that they turned to Congress with a bill developed by the National Association of Insurance Commissioners (NAIC) that would provide a partial

133

134 The Regulation of Insurance antitrust exemption for the insurance industry. Although some insurers would have preferred an absolute exemption, it was time to compromise.4 Congress in passing this bill, now known as the McCarran-Ferguson Act (McCarran), provided the insurance industry with special treatment.

The Usual Allocation of Powers Between State and Federal Governments For most businesses operating on an interstate basis, federal regulation is primary to state regulation. The U.S. Constitution gives the federal government the specific power to regulate interstate commerce and the general power to enact all laws “necessary and proper” to carry out its specific powers. State governments have broad powers to enact laws and regulations concerning the welfare, health, and safety of their citizens and businesses, within the limits established by the U.S. Constitution. State laws and regulations can be void under the U.S. Constitution under the following circumstances: 1. When a state law contradicts a federal law 2. When the courts determine that a state law interferes with the purpose or results of a federal law although the state law does not expressly contradict the federal law 3. When a state law imposes an improper burden on interstate commerce, even though a federal law does not exist Regarding 2 above, federal law is often comprehensive and cannot continue with differing results under various states’ laws. In these situations, federal law can preempt state law.

The Allocation of Insurance Regulation Between State and Federal Governments When McCarran was enacted by Congress in 1945, states were given primary regulatory control over the “business of insurance” in most areas, with the following exceptions: 1. The Sherman Act prohibits boycott, coercion, and intimidation. 2. Federal antitrust laws apply to the extent that state laws do not regulate such activities. 3. Federal laws enacted specifically to regulate the “business of insurance”

Chapter 5 / The Federal Government’s Role in Insurance Regulation 135 preempt any state laws applying to the same activities addressed by the federal laws. It must be stressed that McCarran did not eliminate federal regulation of insurance. McCarran also did not repeal the federal antitrust laws with respect to the insurance industry. Under McCarran, federal regulation, including the federal antitrust legislation, is inapplicable to the “business of insurance” (1) to the extent that the “business of insurance” is regulated by the states and (2) when there is no boycott, coercion, or intimidation. It must also be stressed that McCarran reverses the usual state-federal allocation of regulatory powers only for the “business of insurance.” The “business of insurance” does not include everything that insurance companies do. For example, as employers, insurance companies are subject to federal employment laws just like any other business. Likewise, as businesses that sell their stock to the public to raise capital, insurance companies are subject to SEC regulations like any other business. Essentially, the federal regulatory role was limited by McCarran to a few areas, should state laws not be in existence.5 The problem, however, was that McCarran did not define what constituted the “business of insurance”6 and, in general, the insurance industry was concerned about federal involvement. The antitrust exemption granted to the insurance industry was, therefore, somewhat unclear.

What Is the “Business of Insurance”? Although Congressional debate concerning the McCarran bill before it was passed focused primarily on the regulation of insurance by the states, there was some discussion about what Congress viewed as the “business of insurance.” First, it is important to note that Congress did not adopt a specific list of activities that would limit its view of the “business of insurance.” For example, a bill proposed by the NAIC enumerated seven specific practices to which federal antitrust acts would not apply, all involving intra-industry concerted or cooperative activities.7 The law ultimately enacted—McCarran—did not, however, include a specific list of activities to define the scope of the “business of insurance.” The committee reports provide little assistance on what was meant by the “business of insurance.”8 The U.S. Supreme Court has been instrumental in determining what constitutes the “business of insurance.” Several U.S. Supreme Court cases have helped bring about an understanding of the term. These cases are highlighted in Exhibit 5-1 and are discussed below. Although many of these cases deal with life and health insurance issues, the determinations resulting from these cases affect all lines of the “business of insurance.”

136 The Regulation of Insurance

Exhibit 5-1 Court Cases Key to the Definition of the “Business of Insurance” Year

Case

Results

1944

United States v. South-Eastern Underwriters Association (322 US 533)

Fixing rates by insurers is part of the “business of insurance.”

1946

Robertson v. California (328 US 440)

1958

FTC v. National Casualty Co. (357 US 560)

The selling and advertising of insurance policies is part of the “business of insurance.”

1959

SEC v. Variable Annuity Life Insurance Co. (359 US 65)

Risk underwriting is the distinctive feature of the activities encompassed by the “business of insurance.”

1969

SEC v. National Securities, Inc. (393 US 453)

The licensing of insurance companies and insurance agents is part of the “business of insurance.”

Company-stockholder relationships are not part of the “business of insurance.” The key features of the “business of insurance” are as follows: • The relationship between the insurer and the insured • The types of policies that can be issued • The reliability, interpretation, and enforcement of policies Activities that affect insurance companies as they would any other business are not part of the “business of insurance.”

1979

Group Life and Health Insurance Co. v. Royal Drug (440 US 205)

The “business of insurance” is characterized by all three of the following: 1. The spreading and underwriting of risk 2. A direct connection to the policy contract 3. The conduct of entities within the insurance industry

1982

Union Labor Life Insurance Co. v. Pireno (458 US 119)

The three criteria from the Royal Drug decision are not determinative in their own right—each case must be independently considered.

Chapter 5 / The Federal Government’s Role in Insurance Regulation 137

The First U.S. Supreme Court Cases The first cases heard by the U.S. Supreme Court dealing with the “business of insurance” resulted in specific insurer activities being identified as part of the “business of insurance.” The Court indicated that the fixing of rates by insurers when making rates was considered part of the “business of insurance” with its decision in the 1944 United States v. South-Eastern Underwriters Association case.9 In 1946, the U.S. Supreme Court also included the licensing of insurance companies and insurance agents within the “business of insurance” with its decision in Robertson v. California.10 The selling and advertising of insurance policies was also considered part of the “business of insurance” with the Court’s 1958 decision in the FTC v. National Casualty Co. case.11

SEC v. Variable Annuity Life Insurance Co. The Court’s decision in the SEC v. Variable Annuity Life Insurance Co.12 case in 1959 began the move away from identifying specific activities as part of the “business of insurance.” The case examined whether the “business of insurance” included the offering of variable annuities that placed the investment risk on the annuitant and not the life insurance company. The Court concluded that such variable annuity products were not part of the “business of insurance” because the “business of insurance” must “involve some investment risk-taking on the part of the company.”13 In other words, the insurer must perform some form of risk underwriting for a product to be considered part of the “business of insurance.” Therefore, variable annuities were not part of the “business of insurance” preserved for state regulation by McCarran.

SEC v. National Securities, Inc. The Supreme Court expanded its discussions of the “business of insurance” in the 1969 SEC v. National Securities, Inc.14 (National Securities) case. This case arose when the Securities and Exchange Commission (SEC) challenged as misleading communications sent by Producers Life Insurance Company to its shareholders about a proposed merger. Although the facts are not important to this discussion, the case raised complex questions about the SEC’s power to regulate insurance companies and persons involved in the insurance business. The Supreme Court first summarized its prior pronouncement of what constituted the “business of insurance”: the fixing of rates,15 the selling and advertising of policies,16 and the licensing of companies and their agents.17 It added further guidance in stating that state statutes aimed at protecting or regulating the relationship between the insurance company and the policyholder would be considered laws regulating the “business of insurance” and would thus be paramount over federal antitrust laws. Indicative of

138 The Regulation of Insurance this interpretation, the Court stated that the “business of insurance” included the following: . . .the relationship between insurer and insured, the type of policy which could be issued, its reliability, interpretation, and enforcement—these were the core of the “business of insurance.”18

Thus, because an insurance company’s relationship with its shareholders did not meet the Court’s perceptions of the “business of insurance,” the SEC was allowed to regulate insurance companies and persons involved in the insurance business regarding company-shareholder relations.

Group Life & Health Insurance Co. v. Royal Drug Co. The first Supreme Court case to analyze the conduct constituting the “business of insurance” in the context of McCarran’s antitrust exemption was Group Life & Health Insurance Co. v. Royal Drug Co.19 (Royal Drug) in 1979. Owners of independent pharmacies in San Antonio, Texas, sued Blue Shield and three other pharmacies also conducting business in San Antonio, alleging that they violated the Sherman Act by entering into pharmacy agreements to fix the retail prices of drugs and pharmaceuticals and by boycotting nonparticipating pharmacies. At issue was a Blue Shield prepaid prescription plan under which insureds purchasing drugs at participating pharmacies paid only a two-dollar service charge for each prescription and Blue Shield paid the balance to the pharmacy directly. This contrasted with purchases at nonparticipating pharmacies for which the insured would pay full price and then seek reimbursement from Blue Shield for 75 percent of the difference between the prescription price and the two-dollar deductible. The district court concluded that the arrangement used by Blue Shield was not a violation of the Sherman Act, but the Fifth Circuit Court of Appeals reversed the lower court’s decision. The Supreme Court examined whether the Court of Appeals was correct in concluding that the pharmacy agreements were not part of the “business of insurance” within the meaning of McCarran. The Court first observed that McCarran exempted the “business of insurance” rather than the “business of insurance companies” from the antitrust laws. Upon reviewing the provider agreements in question, the Court concluded that they did not constitute the “business of insurance.” In so holding, the Supreme Court focused on three elements: 1. The spreading and underwriting of a policyholder’s risk 2. A direct connection with the contractual relationship between the insurer and the insured

Chapter 5 / The Federal Government’s Role in Insurance Regulation 139 3. The conduct of entities within the insurance industry The Court remarked that the pharmacy agreements involved no underwriting or spreading of risk. In following its decision in SEC v. Variable Annuity Life Insurance Co., the Court concluded that “[t]he significance of underwriting or spreading of risk. . .[was] an indispensable characteristic of insurance. . . .”20 The Court typified the pharmacy agreements as arrangements for the purchase of goods and services that enable Blue Shield to minimize costs and maximize profits. The agreements did not meet the requirements for the “business of insurance.”21 An important distinction considered by the Court in arriving at its conclusion on this issue was the difference between risk underwriting and risk reduction. “By reducing the total amount it must pay to policyholders, an insurer reduces its liability and therefore its risk. But unless there is some element of spreading risk more widely, there is no underwriting of risk.”22 (Emphasis added.) This point is an important consideration to recall when analyzing whether an insurance activity constitutes the “business of insurance.” The Supreme Court then turned its analysis to the relationship between the insurer and the insured in the case. Citing SEC v. National Securities, Inc., for support, the Court recognized that another criteria of the “business of insurance” is the contract between the insurer and the insured. Petitioners argued that the pharmacy agreements closely affected the reliability, interpretation, and enforcement of the insurance contract and related so closely to their status as reliable insurers as to be exempt. The Court disagreed, noting that the agreements were not between the insurer and the insured but were, rather, separate contractual arrangements regarding the sale and distribution of goods and services, not insurance.23 Moreover, acceptance of petitioners’ “reliability” argument would mean “almost every business decision of an insurance company could be included in the ‘business of insurance.’ ”24 A final requirement posed by the Supreme Court was that the activity be limited to entities within the insurance industry. The Court referred to the rationale behind Congress’s passage of McCarran and its belief that intraindustry cooperation was necessary to assure accurate and responsible underwriting of risks and to avoid disorder within the insurance industry.25 The agreements between Blue Shield and the participating pharmacies did not comply with this requirement, as they were not intra-industry agreements; instead, they were agreements involving the purchase of goods outside the insurance industry.26 The Court refused to extend the antitrust exemption to these agreements with entities outside the insurance industry, because in doing so all other agreements made by insurers to reduce costs would also be exempt.27

140 The Regulation of Insurance

Union Labor Life Insurance Co. v. Pireno The Supreme Court’s decision in Royal Drug served only to create confusion among the lower courts and the commentators.28 To begin with, some confusion concerned how the court could reconcile its decision in Royal Drug with its earlier National Casualty decision in which it concluded that advertising by insurers was the “business of insurance.” The Supreme Court in Union Labor Life Insurance Co. v. Pireno,29 (Pireno) attempted to resolve some of the sources of confusion. Union Labor Life Insurance Company (ULL), a health insurer, issued health insurance policies that provided reimbursement for reasonable and customary charges for necessary medical care and services. ULL sought advice in connection with claims from a peer review committee of a state chiropractic association. The committee would, in turn, evaluate claims for chiropractic treatments. The plaintiff, a chiropractor, on numerous occasions had his services and fees reviewed by the peer review committee, which sometimes concluded that his treatments were unnecessary or his charges unreasonable. He filed suit against ULL, alleging that the peer review system violated the Sherman Act. The U.S. Supreme Court in Pireno applied the Royal Drug three-prong test in determining whether the peer review practice was part of the “business of insurance” exempted from the antitrust laws by McCarran. With respect to the first criterion that the spreading and underwriting of risk be present, the Court found that ULL’s use of the peer review committee played no part in the spreading and underwriting of a policyholder’s risk. The Court determined that the risk that an insured would require chiropractic treatment was transferred from the insured to the insurer upon the purchase of insurance. The peer review function only determined the measure of the risk that had already been transferred. In so finding, the Court rejected ULL’s contention that risk transfer occurs when an insured’s claim is settled, and not at the time of contracting.30 The Court next examined the function of the peer review committee to determine whether it served an integral part of the insurer-insured policy relationship. Relying upon the same reasons posed in Royal Drug for rejecting the pharmacy agreements, it found that this arrangement between ULL and the peer review committee was not between the insurer and the insured, but rather a separate arrangement used by ULL to aid it in its decision-making process on claims that resulted in cost savings. Moreover, the arrangement did not involve the interpretation and enforcement of the insurance contract because ULL decided solely whether claims would be covered by its policies.31

Chapter 5 / The Federal Government’s Role in Insurance Regulation 141 Finally, the Court found clearly that the peer review practice was not limited to entities within the insurance industry. It urged that Congress intended only to protect intra-industry cooperation and extensions to third parties that could restrain competition in noninsurance markets.32 As such, the majority did not deem it appropriate to extend protection to a system “ancillary to the claims adjustment process.”33 An important point raised in Pireno that was not specifically addressed in Royal Drug was the fact that none of the three criteria posed in Royal Drug was necessarily solely determinative, indicating that the three criteria will be applied to particular facts on a case-by-case basis.34

Current Definition of the “Business of Insurance” Based on the court decisions rendered thus far, the meaning of the “business of insurance” appears to be the three-pronged test applied in the Royal Drug case. Furthermore, all three characteristics need not be met before an activity is deemed to be the “business of insurance.” Thus, the “business of insurance” is defined as any activity that has one or more of the following three characteristics: 1. The risk of the policyholder or insured is shared and underwritten by the insurer. 2. A direct contractual connection exists between the insurer and the insured. 3. The activity is unique to entities within the insurance industry. Activities that are deemed to be part of the “business of insurance” receive the protection from federal intervention as allowed under McCarran. That is, they are primarily subject to state insurance regulation if it exists. If states do not oversee these activities, or if the federal government enacts legislation to deal with the activities, the activities are subject to federal regulation. However, the Sherman Act applies to any activities that involve boycott, coercion, or intimidation. Furthermore, if activities are not considered part of the “business of insurance” although they are performed within the insurance industry or are subject to state regulation, federal regulation applies as it would to other businesses in general.

Federal Intervention in the “Business of Insurance” McCarran allows the federal government to become involved in the regulation of the “business of insurance” if states are not regulating certain areas or if

142 The Regulation of Insurance federal legislation is enacted to specifically apply to insurance. Areas in which the federal government has become involved in regulating the “business of insurance” are discussed below.

The Risk Retention Act In the midst of a market contraction in the 1970s, business owners found that they either could not obtain or could not afford to purchase products liability insurance coverage. In 1976, the U.S. Department of Commerce formed the Interagency Task Force on Product Liability to determine why coverage was unavailable and, if available, why it was so costly. Its investigation revealed that (1) because of premium increases of up to 300 percent or more, some proprietors could not afford this insurance coverage, and (2) that, in some cases, the coverage was unavailable at any price. The task force reported in its briefing report to the House Energy and Commerce Committee that it had identified the following factors as the three principal causes of the crisis:35 • • •

Questionable ratemaking and reserving practices of insurers Unsafe products Uncertainties in the tort and legislation system36

The Product Liability Risk Retention Act of 198137 was enacted to address the ratemaking and reserving practices problems—but not the others. This legislation enabled product manufacturers, wholesalers, distributors, and retailers to form their own risk retention groups to spread and assume all or a portion of their products and completed operations exposures. These groups would be licensed by a single state and permitted to operate in any other jurisdiction upon notifying it of that intention. Congress recognized that intervention in an area typically governed by the states needed strong support. The “House Report” noted: Federal action is necessary because experience has shown that individual state legislation cannot facilitate the formation of self-insurance groups. Individual states can only enact legislation affecting their respective insurance law requirements. The practical effect of these laws is to prevent product sellers located in several states from forming such groups.38

So, the effect was to preempt restrictive or other state laws that prohibited insurers from giving preferential rates, terms, and conditions to groups seeking products and other liability coverages. The federal laws, by requiring only a single-state license to operate in any state, readily permitted risk retention groups to form to address the availability crisis.

Chapter 5 / The Federal Government’s Role in Insurance Regulation 143 By 1985, unavailability and affordability of commercial liability insurance was again a problem. Congress heard testimony from municipalities, day care centers, and small businesses, among others, that were unable to afford or obtain liability insurance. Therefore, in 1986, Congress expanded the law further to permit risk retention groups to insure commercial liability exposures other than products with the passage of the Liability Risk Retention Act of 1986. Thus, for example, when the pollution liability insurance crisis began, risk retention groups formed to fill the market needs for this coverage, which insurers were beginning to stop writing.

The National Flood Insurance Act Periodically Congress enacts legislation that allows the federal government, usually through one of its agencies, to intervene in insurance markets to provide insurance that is not available in the private insurance market or to provide a mechanism that allows private insurers to offer insurance that would otherwise be unavailable. A special case of this included the risk retention acts discussed above. One of the more well-known programs established by the federal government to provide insurance is the National Flood Insurance Program (NFIP). The NFIP was established in 1968 by the National Flood Insurance Act as a federal response to what is considered an uninsurable risk by the private insurance industry—flooding. It was also a reaction to the catastrophic flooding caused by Hurricane Betsy in 1965. The NFIP makes flood insurance available nationally through the joint efforts of the federal government and private insurers. The Federal Insurance Administration (FIA) administers the NFIP under the direction of the Federal Emergency Management Agency (FEMA). Property-casualty insurers are involved through the Write-Your-Own (WYO) flood insurance program. The program’s purpose is to enable private insurers to replace the federal government as the primary delivery system of flood insurance and to allow the federal government to function as a reinsurer in the event of flood loss. Under the WYO flood insurance program, the FIA still determines rates, coverage limits, and eligibility—thus, in essence, taking a role typically overseen by state insurance departments. But private insurers can issue these flood insurance policies (as the FIA does) at identical premiums and retain 30 percent of the premiums for their administrative expenses. The federal government provides financial backing by committing funds for prompt payment in the event of a flood and by committing to pay claims on policies written by private insurers that are insolvent.39

144 The Regulation of Insurance

Federal Regulation of the Insurance Industry McCarran does not exempt from federal regulation activities performed within the insurance industry that are not considered part of the “business of insurance.” For such activities, the usual allocation of state and federal regulatory powers applies. Thus, for activities that are not part of the “business of insurance,” federal regulation applies as it would to any business. In this regard, the insurance industry is subject to federal regulation in many areas— securities, taxation, employee benefits, and so on.

The Regulation of Securities The Securities Exchange Commission (SEC) regulates the securities of all businesses, including insurance companies. As with other businesses, insurance companies that issue securities (evidences of debt or of property ownership, such as bonds and stocks, respectively) must fulfill reporting and disclosure requirements as mandated by the SEC. The SEC was established in 1934, in conjunction with the passage of the Security Exchange Act of 1934, to help regulate the United States’ securities markets.40 The Securities Act of 1933 had already been passed and was designed to implement corrections to a system that resulted in the market crash of 1929: •

Implement a market system so that investors could gain ready access to material information on publicly-traded securities

•

Prevent the abuses of fraud, deceit, and misrepresentation in the sale of those securities41

The Securities Act of 1934 extended market reforms to the secondary markets (the markets in which individual investors can trade securities among themselves, such as the New York Stock Exchange or the National Association of Securities Dealers).42

Obligations Under the Securities Act of 1933 Stock insurers are required, as are other noninsurer stock organizations, to register the securities they plan to offer or sell to the public in most cases. As part of the registration process, insurers must file a registration statement and a prospectus that discloses certain financial and other data.43

Chapter 5 / The Federal Government’s Role in Insurance Regulation 145

Obligations Under the Securities Exchange Act of 1934 Insurers that publicly offer their securities are also required, as are other noninsurer stock organizations, to fulfill certain duties under the Securities Exchange Act of 1934. The SEC, as provided by the 1934 act, has enacted reporting requirements, which mandate that stock insurers and noninsurer stock organizations that publicly sell their securities provide annual reports to their shareholders. These reports must include the following information: • • • •

Financial data, including income and total assets, for the previous five years Management’s discussion and analysis of such items as liquidity and planned uses of capital Industry segment information for the previous three years Income statements and statements of cash flow for three years and balance sheets for two years44

Effects on Insurance Products The Securities Act of 1933 exempts “any insurance policy or endowment policy or annuity contract or optional annuity contract, by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State. . . .”45 However, finding an exemption has become increasingly more difficult for the life insurance industry in recent decades, as it has developed new, hybrid products. The SEC views the following products as follows: •

•

•

Variable annuities. Variable annuities are subject to registration with the SEC. Further, an insurer that distributes variable annuities representing interests in a separate account must register as a broker-dealer.46 Group annuity contracts. Group annuity contracts developed largely in response to the Self-Employed Individuals Tax Retirement Act of 1962,47 more commonly known as the Keogh Act. This act permitted selfemployed persons to take advantage of some tax deferral options available to those persons in qualified plans.48 Through amendments to the 1933 act and the 1934 act, group annuity contracts were generally49 made exempt because they were securities “arising out of a contract issued by an insurance company”50 in connection with certain employee benefit plans as enumerated by specified sections of the Internal Revenue Code. Guaranteed investment contracts. In the 1970s, the SEC turned to examining another group of products, known as guaranteed investment, interest,

146 The Regulation of Insurance or income contracts (GICs); tax deferred annuity (TDA) contracts; and similar products. These contracts primarily took two forms. One group guaranteed a low interest rate but with the possibility of receipt of higher interest dependent upon successful investment returns. The other group guaranteed a higher interest rate over a specified time period, typically varying between five and twelve years. In 1986, the SEC determined that the GICs would be exempted annuity contracts or optional annuity contracts, only if the following characteristics could be satisfied: • The issuing insurance company was subject to state insurance regulation. • The insurance company—not the insured—assumed the investment risk. • The contract was not marketed primarily as an investment.51

The Federal Taxation of Insurance Companies The federal government has the right to tax insurance companies52 and has, in fact, exercised and continues to exercise that power. This power was not foreclosed by McCarran.53 The general corporate tax rules that apply to businesses are applicable to insurers with some exceptions that are written into the Internal Revenue Code and deal specifically with insurance companies. Just like other businesses, however, insurers are subject to such tax rules as tax rates, depreciation, carryovers, qualified pension and profit-sharing plans, and so on. The primary difference between the taxation of insurers and the taxation of noninsurers relates to the timing of recognition of certain types of income— namely, underwriting income—and certain deductions. The differences are based on the Annual Statement insurers must file with state insurance departments and the NAIC. For example, under requirements for the Annual Statement, premium income is accrued while expenses are immediately recognized. Insurers, for federal income tax purposes, are allowed to deduct estimated loss and loss adjustment expenses on losses that have occurred but have not yet been paid and, in effect, reduce their net income and their federal income tax liability. This is contrary to the general federal income tax rule that deductions for future obligations cannot be made until some “economic performance” has occurred.

The Employee Retirement Income Security Act of 1974 The Employee Retirement Income Security Act of 1974, known as ERISA, is major federal legislation enacted to curb abuse in the private pension system

Chapter 5 / The Federal Government’s Role in Insurance Regulation 147 and in employee benefit plans. According to at least one author, this was the most important insurance-related legislation since McCarran. Too often, employers took tax deductions for contributions to pension plans, but employees did not receive the pension benefits they were promised. Before ERISA, the simple test under the Internal Revenue Code was that a plan was “taxqualified” and contributions were deductible, ordinary and necessary business expenses, so long as the contributions were reasonably sized and were intended to provide pensions to at least some employees.54 ERISA, however, was designed to ensure that plan participants become more informed about their benefits and could gain access to that information readily. Further, it set greater standards for qualified plans, determined proper funding levels, and provided protection to plan participants whose plans were terminated or who had satisfied minimum service requirements. The following items are just a couple of examples of how the insurance industry was affected by this landmark legislation overseen by the Departments of Labor and Treasury. •

Fiduciary. An insurer that administers an employee benefit plan covered by ERISA becomes subject to certain responsibilities and liabilities when acting as such because the law imposes these on plan fiduciaries. They must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”55

•

Employee welfare plans. Employee welfare plans that provide participating members with medical, surgical, and hospital benefits in the event of sickness, accident, disability, or death are governed by ERISA unless an exemption is provided in the law. Many employers purchase insurance coverage to provide these benefits to their employees. Therefore, the insurer offering these benefits under a covered employee welfare plan takes the responsibility of verifying that the plan benefits and the plan structure are in compliance with ERISA.

ERISA has created a good amount of confusion for insurers since its passage. One of the key problems arose from the interplay of comprehensive federal legislation on employee benefit plans and how ERISA would interact with state regulations on the same. ERISA purports in one clause to preempt any and all state laws insofar as they might now or hereafter relate to any employee benefit plan. This clause, known as the ERISA savings clause, saves from preemption those state laws that regulate insurance.56 Yet, employee benefit plans are not deemed to be subject to state insurance regulation as the “business of insurance.”57

148 The Regulation of Insurance Gradually, some essential legal interpretation on ERISA preemption has helped insurers know which laws and duties apply to them. In 1985, the United States Supreme Court interpreted the issue of preemption in Metropolitan Life Ins. Co. v. Massachusetts.58 It determined that self-insurance plans would be subject to state regulation, but only if they were deemed to be part of the insurance industry. The court distinguished between insured plans (where state regulation was not preempted by ERISA) and self-funded plans— subject only to ERISA. An important ruling for health insurers came in 1987 in Pilot Life Insurance Co. v. Dedeaux.59 The U.S. Supreme Court decided in this case that legal disputes over employee benefits would be decided in federal courts, and insurers would not be tangling with the ambiguous and confusing state-bystate requirements. It said: “The policy choices reflected in the inclusion of certain remedies and the exclusion of others under the federal scheme would be completely undermined if ERISA plan participants and beneficiaries were free to obtain remedies under state law that Congress rejected in ERISA.”60 One of the major effects of this decision was to insulate health insurers from punitive damages exposure if they improperly denied a claim—since punitive damages is a remedy available only in state actions.61

Other Federal Regulation Affecting the Insurance Industry Federal legislation other than the securities acts, tax laws, and ERISA also affects the insurance industry. Several examples of other federal regulation and its affects on the insurance industry are discussed below.

The Occupational Safety and Health Act The federal government oversees the regulation of employee safety and health under the Occupational Safety and Health Act (OSHAct) of 1970 in all states except those that have implemented their own program for employees safety and health that meets the approval of the OSHAct. The OSHAct requires both employers and employees to comply with safety and health standards regarding conditions and operations in the workplace. Employers are also required under the OSHAct’s general duty clause to maintain a workplace free of recognized hazards that could lead to the death or serious physical harm of employees. Employers can be given citations and can be fined or can be shut down for failure to comply with the OSHAct’s requirements. The OSHAct applies to all persons and organizations involved in commerce and having employees. Thus, insurance companies, insurance agencies, risk management consulting firms, state insurance departments, the NAIC, and

Chapter 5 / The Federal Government’s Role in Insurance Regulation 149 other organizations within the insurance industry and their employees are subject to the requirements of the OSHAct. The OSHAct is administered by the Occupational Safety and Health Administration (OSHA). OSHA establishes, issues, and modifies the occupational safety and health standards to which businesses and their employees must comply under the OSHAct. OSHA also conducts workplace inspections and investigates working conditions, certifies and monitors state occupational safety and health programs, and issues record-keeping regulations employers must maintain regarding workplace illness, injury, and death. The occupational safety and health standards are specific requirements that protect employees from workplace hazards. These standards include items such as the following: •

The mandatory safety devices and equipment employers must install for use by employers and employees

•

The techniques to be used to train, protect, and medically examine employees

•

The measures that must be taken to warn employees of hazards

•

The methods for safety by which employees must perform their jobs

Employers with more than ten employees are required to keep records of each work-related injury, illness, and death. These records must be made available to employees. Employers are also required to report to OSHA within fortyeight hours of an employee’s work-related death or an accident that results in the deaths of at least five employees. In addition, employers must report their job-related injuries, illnesses, and deaths to the Bureau of Labor Statistics. To enforce the OSHAct, OSHA conducts inspections of employers’ workplaces and investigates the employers’ compliance with the safety and health standards. The investigations occur during working hours and without advance warning. Employers found in violation are given citations and are given a reasonable amount of time to correct the problems. The employers might also be subject to civil and criminal penalties. Employers can contest citations and be heard before an administrative law judge.62

Antidiscrimination Laws Insurance companies, insurance agencies, state insurance departments, the NAIC, and other organizations in the insurance industry are subject to federal legislation concerning discrimination in employment relationships. Several federal laws prohibit certain forms of discrimination. These laws include the Civil Rights Acts, the Age Discrimination in Employment Act, the Older

150 The Regulation of Insurance Workers Benefit Protection Act, and the Americans with Disabilities Act. Each of these laws is discussed below.

Civil Rights Acts The oldest legislation that prohibits discrimination in employment relationships is the Civil Rights Act of 1866. It does not allow employers to discriminate against potential employees on the basis of race, color, ancestry, and ethnic characteristics in the making of an employment contract. Although the act is fairly narrow in its application, it has been interpreted broadly in many cases and has been used to prohibit discrimination in all areas of private employment. Under this act, suit can be brought against an employer that has allegedly violated the act’s provisions. If the employer is found in violation, the injured individual can be awarded compensatory and punitive damages.63 Title VII of the Civil Rights Act of 1964 is probably the most well-known piece of antidiscrimination legislation. Title VII is titled Equal Opportunity Employment and prohibits an employer from hiring, discharging, limiting, segregating, classifying, or otherwise discriminating against employees and applicants on the basis of race, color, religion, sex, and national origin. The act applies to all employers with at least fifteen full-time employees involved in an industry characterized by interstate commerce. The act does not apply, however, to the federal government, religious groups including the educational institutions associated with them, or bona fide nonprofit private-membership organizations other than labor unions. Title VII is enforced by the Equal Employment Opportunity Commission (EEOC). Individuals generally must file charges with the EEOC within 180 days of the date of the alleged discrimination. The EEOC serves the charge on the employers within 10 days of the charge being filed. For the 180 days following the filing date, the EEOC has exclusive jurisdiction over the investigation and settlement process. If the EEOC determines there is reasonable cause to believe a charge, the EEOC arranges a fact-finding conference with all the parties involved to try to settle the case. If the case remains unsettled once the 180-day period has expired, the EEOC issues a right-to-sue letter that releases the case from the EEOCs jurisdiction and allows the alleged victim to bring suit against the employer in court within 90 days of receiving the right-to-sue letter. If found guilty, the employer can be assessed compensatory damages. The Civil Rights Act of 1971 added to the prohibitions against discrimination in employment relationships by instituting a general antidiscrimination statute that primarily applies to state and local governments and to governmental agencies. Individuals alleging discrimination can sue for compensatory and

Chapter 5 / The Federal Government’s Role in Insurance Regulation 151 punitive damages. If the employer is found in violation, the employee can also recover attorney’s fees. In 1978, Title VII of the 1964 Civil Rights Act was amended to prohibit certain other forms of discrimination. Specifically, discrimination based on pregnancy, sexual harassment, and comparable worth are prohibited by the amendments. Under the amendments, women who are pregnant, who are recovering from childbirth, or who are experiencing related medical conditions must be treated for employment-related purposes in a manner similar to others affected by disabilities with similar restrictions on their ability to work. Regarding comparable worth, employers are not allowed to pay employees in mostly female job classifications less than that paid to employees in mostly male job classifications if the jobs are of comparable worth to the employers. The 1991 Civil Rights Act made several key revisions to Title VII of the 1964 Civil Rights Act and to the Civil Rights Act of 1866. The scope of the 1866 act was broadened by the 1991 act to include all aspects of the employment relationship, including termination and harassment. This means that individuals alleging intentional discrimination based on race, color, ancestry, or ethnic characteristics can recover potentially unlimited compensatory and punitive damages. The 1991 act modified Title VII to allow recovery of compensatory and punitive damages if intentional discrimination is determined. However, the amount of damages is limited based on the size of the employer, with $300,000 being the maximum recovery. Furthermore, for suits seeking such damages, jury trials are allowed. The 1991 act also allows prevailing parties to recover expert witness fees on the same basis as recovery for attorneys’ fees.64

Age Discrimination in Employment Act The Civil Rights Acts do not address discrimination based on age. This is dealt with by the Age Discrimination in Employment Act (ADEA) of 1987, which prohibits discrimination in employment relationships based on age when employees are forty years old or older. The act also eliminates mandatory retirement age for all but a specific group of employees: • •

Those employees in executive or high policy-making positions with pensions of at least $44,000 per year must retire at age 65. Those employees under contracts of unlimited tenure at colleges and universities must retire at age 70.

ADEA applies to all employers with at least twenty employees and involved in an industry characterized by interstate commerce. It deals with all aspects of employer-employee relationships, including hiring, firing, wages, and so on. However, the act does allow for preference to be given on the basis of

152 The Regulation of Insurance reasonable factors other than age. Bona fide seniority systems are also allowed if not designed to evade the provisions of ADEA. ADEA is enforced by the EEOC. The process for filing a claim and bringing suit is the same as that described under the Civil Rights Act of 1964. However, the only forms of recovery are back pay and reinstatement or front pay. Front pay is used if reinstatement is not feasible and amounts to legal damages equivalent to the value of reinstatement.65

Older Workers Benefit Protection Act The Older Workers Benefit Protection Act of 1990 amended the ADEA to prohibit discrimination against older workers regarding employee benefits decisions except those decisions based on significant cost considerations. Thus the Older Workers Benefit Protection Act does not allow employers to refuse to hire individuals because of the increased cost of employee benefits, does not allow employers to reduce or discontinue contributions to pension plans because employees have reached a certain age, and does not allow employers to obtain waivers to the rights established for older workers by the ADEA and the amendment unless the waiver is understood and voluntarily made by the employees. In addition, employees must be given certain periods of time in which to consider the waivers and to revoke the waivers, once signed.66 Americans with Disabilities Act In 1990, Congress passed the Americans with Disabilities Act (ADA). The act prohibits discrimination based on individuals’ physical or mental disabilities if they are otherwise willing and able to do the job with or without reasonable accommodations. ADA applies to all employers with at least twenty-five employees in an industry characterized by interstate commerce and applies to all aspects of the employment relationship. Individuals who believe they have been discriminated against based on their disabilities can file charges with the EEOC, which administers the act. The process is similar to that explained earlier concerning the Civil Rights Act of 1964. If suit is brought, possible amounts recovered include compensatory damages and punitive damages in cases involving intentional discrimination, attorneys’ fees, and expert witness fees.67

Federal Agencies The states retain the primary role in regulating the “business of insurance.” The federal government tempers this through its agencies in different areas that affect insurance. In other words, although a single federal agency is not directed exclusively to insurance, a number of federal agencies affect the

Chapter 5 / The Federal Government’s Role in Insurance Regulation 153 insurance industry because it is a business subject to regulation under certain federal laws. But some agencies go further and are more directly involved in regulation that affects the insurance business, which is permitted under McCarran. It would be impossible within the scope of this chapter to cover every role of each federal agency that somehow affects insurance. A few examples, however, are warranted and will demonstrate the broad scope involved.

The Federal Bureau of Investigation The Federal Bureau of Investigation (FBI) has been an important force in detecting and prosecuting (through the Justice Department) fraudulent activities that drain insurers’ financial resources. In recent years, the public has probably heard the most about the FBI’s involvement in cracking down on health-care fraud. Former FBI Director William S. Sessions in 1992 cited the economic toll of fraud, using U.S. Chamber of Commerce estimates that 5 to 15 percent of paid health claims were fraudulent.68 Under Sessions’s tutelage in the summer of 1992, the FBI, after studying alleged fraudulent activities over a two-year period, charged and arrested over 200 persons, searched over 100 locations, and seized illegal medications. It took millions of adulterated and illegal medications out of circulation. This undertaking was also supported by the Drug Enforcement Administration, the Department of Health and Human Services, the Postal Inspection Service, and state and local agencies in over fifty cities, whose efforts continue. The FBI has also been involved in crime investigation in the area of auto theft—of great importance to insurers issuing automobile insurance coverages. For example, in one operation, the FBI teamed up with the New York City Police Department, the U.S. Customs Service, and the U.S. Attorneys Office in 1980 to penetrate several car-theft rings with international ties. Eleven persons were convicted, and 125 stolen vehicles were recovered. Although this did not crack the problem of illegal vehicle export trade, much was learned about car-theft techniques. The operation also led the U.S. Customs Service to institute new regulations regarding the shipping of vehicles.69 In 1993, the deputy assistant director of the Criminal Investigation Division of the FBI addressed the International Association of Special Investigation Units and pronounced that the FBI had prioritized its manpower hours to address insurance company insolvencies, health-care fraud, and organized activity related to fraud. He enthusiastically supported the establishment of joint partnerships with state insurance departments and insurers to combat these problems.70

154 The Regulation of Insurance

Environmental Protection Agency Owners and operators of all petroleum underground storage tanks (unless excepted by law) must demonstrate to the Environmental Protection Agency (EPA) the financial responsibility required by federal law to assure that they can meet the responsibilities of and financial consequences related to a cleanup. Although there are several avenues by which to meet the financial responsibility requirements, two affect insurers directly: •

•

Insurance and risk retention group coverage. Although the EPA does not issue coverage to satisfy the obligation, it dictates the exact wording of the insurance policy required.71 Thus, the EPA indirectly regulates the private insurers. If private insurers do not conform with the federally-mandated language, they cannot serve their insureds. Surety bonds. Surety bonds issued by private insurers can satisfy the federal mandates. But, once again, federal regulations dictate the specific language of any acceptable performance bond.72 Further, surety companies (that is, the insurers) must be acceptable to the U.S. Department of the Treasury before they can issue federal bonds and be listed in the latest Circular 570 reflecting their eligibility.73

Interstate Commerce Commission In many ways, the involvement of the Interstate Commerce Commission (ICC) in the insurance arena is similar to the role of the EPA. It does not act as an insurer, but it prescribes requirements on acceptable insurers and the coverages they provide. To illustrate, the ICC requires freight forwarders (those generally providing transportation of property in interstate commerce in the ordinary course of business) to file an appropriate surety bond or certificate of insurance as evidence of their ability to pay for loss or damage to property or liability losses, unless they qualify as a self-insurer or post other acceptable securities and agreements. The ICC dictates the acceptable minimum limits and conditions on acceptable insurers and sureties.74 The ICC’s involvement increases with motor carriers. Policy forms and endorsements must be in a form prescribed and approved by the ICC, and insurance cannot be canceled until thirty days after written notice has been given to the ICC. Failure to convey notice of cancellation to the ICC means that the insurer continues to cover the risk until notice is conveyed correctly.75

Summary The federal government’s role in insurance regulation is generally viewed from the perspective of the McCarran-Ferguson Act (McCarran). The primary

Chapter 5 / The Federal Government’s Role in Insurance Regulation 155

concern to insurance regulators at the state level and to many in the insurance industry is the threat of greater federal intervention through the repeal or partial repeal of McCarran. Many insurers fear that the loss of the limited antitrust exemptions provided under McCarran would be extremely detrimental to the insurance industry. McCarran provides the insurance industry with an exception from federal regulation in areas that constitute the “business of insurance.” Over the years, the U.S. Supreme Court has helped to establish the definition of the “business of insurance” as any activity that meets the following requirements, which have been determined on a case by case basis: 1. The risk of the policyholder or insured is shared and underwritten by the insurer. 2. A direct contractual connection exists between the insurer and the insured. 3. The activity is unique to entities within the insurance industry. However, the federal government is involved in insurance regulation through other means than McCarran. Congress has authority under various acts to oversee particular insurance aspects of the insurance industry, such as through the Risk Retention Acts of 1981 and 1986. Congress and federal agencies also have influence over noninsurance aspects of the insurance industry through such legislation as the Occupational Safety and Health Act and the Americans with Disabilities Act.

Chapter Notes 1. 75 U.S. 168 (1868). 2. 322 U.S. 533 (1944). 3. John A. Tillistrand , “An Analysis of the McCarran-Ferguson Act: Should It Be Repealed?,” CPCU Journal, June 1990, pp. 100-101. 4. See generally Tillistrand, pp. 101-102. 5. Frank P. Darr, “Federal Claims in Insolvencies,” Tort & Insurance Law Journal, Spring 1990, pp. 606-607. 6. A brief discussion below delineates some Supreme Court case guidance on the issue. However, lower court decisions are often confusing and divergent in analysis. 7. 90 Cong. Rec. A 4406 (1944). S. 12, 79th Cong., 1st Sess. (1945) would have specified “any agreement or concerted or cooperative action between two or more insurance companies for making, establishing, or using rates for insurance, rating methods, premiums, insurance policy or bond forms, or underwriting rules.”

156 The Regulation of Insurance 8. See S. Rep. No. 20, 79th Cong., 1st Sess. (1945); H.R. Rep. No. 143, 79th Cong., 1st Sess. (1945). 9. 322 US 533 (1944). 10. 328 US 440 (1946). 11. 357 US 560 (1958). 12. SEC v. Variable Annuity Life Insurance Co., 359 U.S. 65 (1959). 13. SEC v. Variable Annuity Life Insurance Co., 359 U.S. at 71 (1959). 14. SEC v. National Securities, Inc., 393 U.S. 453 (1969). 15. U.S. v. South-Eastern Underwriters Association, supra, 2 and 9. 16. FTC v. National Casualty Co., supra, 11. 17. Robertson v. People of State of California, 328 U.S. 440 (1946). 18. SEC v. National Securities, Inc., 393 U.S. at 460 (1969). 19. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 205 (1979). 20. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 212 (1979). 21. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 214 (1979). 22. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 214 (1979). 23. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 216 (1979). 24. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 217 (1979). 25. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 221 (1979). 26. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 231 (1979). 27. Group Life & Health Insurance Co. v. Royal Drug Co., 440 U.S. at 232-33 (1979). 28. T. Richard Kennedy, “The McCarran Act: A Limited ‘Business of Insurance’ Antitrust Exemption Made Even Narrower—Three Recent Decisions,” The Forum, no. 18 (1983), pp. 528, 533. 29. Union Labor Life Insurance Co. v. Pireno, 458 U.S. 119 (1982). 30. 458 U.S. at 130-31. 31. 458 U.S. at 132. 32. 458 U.S. at 133. 33. 458 U.S. at 134 n.8. 34. 458 U.S. at 129; see also Kennedy, p. 534. 35. Interagency Task Force on Product Liability: Final Report, U.S. Department of Commerce (October 31, 1977) quoted in Interagency Task Force at I-20. 36. Other causes identified included (1) inflation; (2) increased consumer awareness of their right to bring legal action; (3) the increase in the number and complexity of products; and (4) misuse of products. 37. Product Liability Risk Retention Act of 1981, 15 U.S.C. § 3901 et seq. 38. “House Report No. 97-190 of the Energy and Commerce Committee,” p. 6, quoted in U.S. Code and Cong. News, vol. 2, 97th Congr. 1st Sess. (1991), p. 1434.

Chapter 5 / The Federal Government’s Role in Insurance Regulation 157 39. Insurance Research Council, The National Flood Insurance Program: Agency and Insurer Perspectives (Oakbrook, IL: Insurance Research Council, July 1990), pp. 3-5. 40. K. Fred Skousen, An Introduction to the SEC, 5th ed. (Cincinnati, OH: SouthWestern Publishing Co., 1991), p. 1. 41. U.S. Securities and Exchange Commission, The Work of the SEC, (Washington, The Office of Public Affairs, U.S. Securities and Exchange Commission, September, 1988), p. 7. 42. Skousen, p. 27. 43. Philip Schwartz (revised by John Baily), “Other Financial Reporting Requirements,” Property-Liability Insurance Accounting (Durham, NC: Insurance Accounting & Systems Association, Inc., 1991), pp. 15-3 to 15-4. 44. Schwartz (Baily), pp. 15-4 to 15-5. 45. The Securities Act of 1933, Section 3(a)(8). 46. Ex. Act. Rel. 8389 (1968). 47. Publ. Law No. 87-792, 76 Stat. 809 (1962). 48. See generally Louis Loss and Joel Seligman, Securities Regulation, vol. 2, 3d ed. (Boston, MA: Little, Brown and Company, 1989), pp. 1013-1015. 49. There are several exceptions to the general rule, but they are beyond the scope of this chapter. 50. The Securities Act of 1933, Section 3(a)(2); the Securities Exchange Act of 1934, Section 3(a)(12). 51. Sec. Act. Rels. 6645, 35 SEC Dock. 952 (1986). 52. John Alan Appleman and Jean Appleman, Insurance Law and Practice, rev. ed. vol. 19B, §10984 (St. Paul, MN: West Publishing Co., 1982). 53. Industrial Life Ins. Co. v. U.S., 344 F. Supp. 870, 875 (D.S.C. 1972), aff’d 481 F.2d 609 (4th Cir. 1973), cert. denied, 414 U.S. 1143 (1974). 54. See generally Barbara J. Coleman, Primer on Employee Retirement Income Security Act, 4th ed. (Washington, DC: The Bureau of National Affairs, Inc., 1993), pp. 1-3. 55. Cited in Coleman at p. 99. 56. ERISA, Section 514(a) and 514(b)(2)(A). 57. ERISA, Section 514(b)(2)(B). 58. Metropolitan Life Ins. Co. v. Massachusetts, 471, U.S. 724 (1985). 59. Pilot Life Insurance Co. v. Dedeaux, 481 U.S. 41 (1987). 60. 481 U.S. at 54. 61. Coleman at p. 133. 62. James J. Lorimer, Harry F. Perlet, Jr., Frederick G. Kempin, Jr., and Frederick Hodosh, The Legal Environment of Insurance, vol. II, 4th ed. (Malvern, PA: American Institute for CPCU, 1993), pp. 224-228. 63. Compensatory damages reimburse the injured party for losses actually incurred, such as lost wages. Punitive damages are assessed against the guilty party as

158 The Regulation of Insurance

64. 65. 66. 67. 68. 69.

70. 71. 72. 73. 74. 75.

punishment and to serve as a deterrent to keep others from engaging in similar activity. Lorimer, et al., pp. 209-214. Lorimer, et al., pp. 207-208. Lorimer, et al., p. 208. Lorimer, et al., pp. 216-218. Cited in “Director’s Message,” FBI Law Enforcement Bulletin, October, 1992, p. 1. See generally Mary Ellen Beekman and Michael R. Daly, “Motor Vehicle Theft Investigations: Emerging International Trends,” FBI Law Enforcement Bulletin, September 1990, pp. 14-17. “New FBI Investigation Chief Strongly Supports Joint State/Federal/Insurer Cooperative Efforts,” Insurance Advocate, October 30, 1993, p. 17. 40 CFR § 280.97. 40 CFR § 280.98. 40 CFR § 280.93. 49 CFR §§ 1084.1 - 1084.5. See generally 49 CFR §§ 1043.1 - 1043.11.

Chapter 6

The Role of Others in Insurance Regulation In Chapter 1, regulation was discussed as a system of entities that interact to influence and control, to some extent, the activities of other entities. That system is reproduced in Exhibit 6-1. Thus far, the roles of the state insurance departments, the NAIC, the state legislatures, and the federal government in the system of the regulation of insurance have been discussed. While many people view those entities as the system of insurance regulation, the state-federal regulatory system of insurance regulation does not operate in a vacuum. As noted in the exhibit, other entities play a role in shaping insurance regulation: the courts, the insurance industry, consumers, and other interest groups. This chapter discusses how each of these entities influences insurance regulation.

The Influence of the Courts As with any business influenced by laws, regulations, and rules, interpretation of such legislation that applies to the insurance industry by the courts can change the effects of those laws, regulations, and rules on the insurance industry. In other words, when court decisions interpret particular insurance laws, regulations, and rules in ways that differ from the interpretation of state insurance regulators, federal regulators, or state legislatures, and those court decisions are binding on the authority and responsibility of those regulators,

159

160 The Regulation of Insurance

Exhibit 6-1 System of Regulation

Courts

Legislature

Executive/Bureaus Justice/Commerce/Labor Other Regulatory

Regulatory Agency

Firms

Consumers

Other Interest Groups

The Political Economy of Regulation by Barry Mitnick, p. 35. Copyright © 1980 by Columbia University Press. Reprinted with permission of the publisher.

the insurance industry is likely to experience a change in the way it is regulated by those regulators. For example, when the U.S. Supreme Court determined that the insurance industry should be subjected to the federal antitrust laws in the South-Eastern Underwriters Association decision, the insurance regulatory system was changed. Courts can also directly influence the activities of those within the insurance industry. Courts interpret policy language and decide whether claims have been settled appropriately in light of the policy language. The court system has an increasingly profound influence on state insurance law and the regulatory system. The following paragraphs describe some of the influence, including the effect of court decisions on state insurance department activities, policy language, policy coverage, and claims settlement.

Effects on State Insurance Department Functions State insurance departments derive their powers from the laws that created them. In turn, they must uphold and interpret state insurance laws enacted by

Chapter 6 / The Role of Others in Insurance Regulation 161 the legislature and promulgate regulations. The laws that departments uphold must meet constitutional requirements and provide adequate guidance for rules. For example, the Ohio FAIR plan was challenged as unconstitutional because it was alleged to be vague. However, the court found that the plan was not vague—it established conditions that Ohio Insurance Department rules had to meet.1 Insurance laws should also afford due process rights (rights granting individuals or entities affected by such laws the ability to express their views about the laws and to present facts against the laws) to those aggrieved and allow fair access to information. For example, a District of Columbia law instituted a five-year moratorium on the use of AIDS screening tests as a rating factor. The law was challenged on the basis that it violated due process and was, therefore, unconstitutional. However, the court in this case ruled that, because the law was rationally related to the legitimate purpose of ensuring that individuals with AIDS had access to medical care, the law did not violate due process.2 In promulgating rules, sometimes insurance regulators overstep the authority granted to them by law and, when challenged, the rules or regulations which they promulgated are struck down by the courts (or another entity, such as the office of administrative law or an attorney general, depending on state law). For example, the Montana take-all-comers plan for the residual workers compensation market was found unconstitutional because the Montana Insurance Department had implemented the plan without the Montana state legislature having adopted a law regarding such a plan.3

Direct Influence of the Courts Courts directly influence the activities of the insurance industry when they make decisions regarding policy language, policy coverage, or claims settlement. Such court decisions set precedent for future court cases involving similar situations and can cause the insurance industry to change policy language and coverage and claims settlement practices or to seek legislative relief.

Policy Language Courts exercise their powers over insurance policy language, often with dramatic and unexpected results from the perspective of insurers. The courts only review policy language that comes before them in the context of litigation. In that sense, their influence is limited. On the other hand, although the court decision is an interpretation of a provision of a particular policy under applicable state laws, the effect is typically more far-reaching to the insurance industry because of its use to a great degree of standardized policy language.

162 The Regulation of Insurance Thus, the court’s interpretation of a provision for one situation can affect the interpretation of the provision for all insureds. A policy of insurance is a contract and is interpreted by applying the legal principles of contract law. Courts apply additional theories of contract interpretation in the context of insurance because the insured does not negotiate the policy terms. The insured accepts the terms as offered because the policy is a contract of adhesion (a contract drawn up by only one party, the insurer, in the case of insurance, whose terms the other party, the insured, simply adheres or assents to). Under one of the additional theories applied to insurance contracts, known as the doctrine of reasonable expectations, an insured’s reasonable expectations of coverage will be honored even if that involves reading the policy provisions in ways not intended by the insurer. Further, if policy provisions are ambiguous, they will be interpreted in favor of the insured, since the insurer in drafting the policy created the ambiguity. Consider the following case. A school district purchased fire insurance coverage to cover its school buildings on a replacement cost basis. In 1989, a fire destroyed the district’s high school, which had originally been built in 1979. Since that time, new building codes had been implemented and the cost to rebuild the school to code was more than $200,000 greater than the building’s replacement cost. The insurance policies on the school contained a standard definition of replacement cost, which specifically excluded coverage for the increased cost to rebuild caused by “. . .any ordinance or law regulating construction. . . .” The school district argued, however, that it reasonably expected its replacement cost coverage to pay the entire cost of rebuilding the school to code. The court agreed that the school district’s expectations were reasonable and concluded that the increased replacement cost to cover the code requirements was covered by the school district’s insurance policies.4

Policy Coverage The courts’ interpretations of policy language affect the terms and scope of coverage. It is usually to the insurer’s benefit to use court-tested language in an insurance policy, because past interpretations provide a clearer understanding of how the provisions are likely to be interpreted by the courts in the future.

Claims Settlement Although they can be involved in claims settlement in a number of ways, courts can influence future claims settlement procedures with decisions that require those procedures be changed for the cases heard before the courts. For example, a court might find a particular claims settlement procedure to be unfair to the claimant. Such a decision warns those who might be involved in

Chapter 6 / The Role of Others in Insurance Regulation 163 a future claim of a similar nature that the unfair procedure should not be used. If it is, the courts are likely to make the same determination that the procedure is unfair if that future case is heard before the courts.

Influence of the Insurance Industry The insurance industry, as the regulated industry, seeks to influence insurance regulation to meet the industry’s business needs. Such attempts to influence insurance regulation might be made by insurance industry trade associations, advisory organizations, or individual insurance companies.

Insurance Industry Trade Associations Several national property-liability industry trade associations have developed over the years to provide services to their member insurers and agents and brokers. Some of these associations are listed in Exhibit 6-2. Trade associations serve an important function for property-liability insurers and agents and brokers. For a fee, members can have prompt access to legislative developments and can use association personnel as their lobbying forum. They can also participate on committees of the trade association in drafting new legislation or influencing changes to pending legislation. Trade associations also continually watch for new regulations promulgated by state insurance departments in response to new or modified insurance laws being adopted by the states. Participation in one or more major trade associations can make it possible for insurers—large and small—to exercise influence and gain information that each would otherwise obtain by hiring a large staff exclusively dedicated to government and industry affairs. And, even then, it would be difficult to match the scope of coverage and the prompt dissemination of information that the trade associations provide. Trade associations do not operate solely on the national level. Many state and local associations focus only on the issues important to their members in those jurisdictions. For insurers and agents and brokers doing business solely in one or two states, membership in these associations can be vital and more costeffective than membership in a national trade association that provides many services the one- or two-state insurer or agent or broker might not need. More often than not, however, insurers join associations on all levels. Trade associations, at the national, state, and local levels exert influence on the NAIC, state and federal legislators, and state insurance regulators. Each trade association has the collective power of its membership behind it. Although a representative of a trade association meeting with a legislator

164 The Regulation of Insurance

Exhibit 6-2 Insurance Industry Trade Associations Name

Year Founded

Members

Interests

Alliance of American Insurers (Alliance)

1922

175 propertyliability insurers

Promotes regulatory, legislative, and legal interests of members and provides public information

American Insurance Association (AIA)

1964

250 propertyliability and surety insurers

Promotes the economic, legislative, and public standing of members

Independent Insurance Agents of America (IIAA)

1896

34,000 propertyliability, fire, and surety agents and agencies

Promotes education of agents and promotes regulatory and legislative issues of agents

National Association of Insurance Brokers (NAIB)

1934

Property-liability commercial insurance brokers and regional and specialty brokers

Actively takes part in shaping legislative and regulatory environment for the insurance brokerage industry

National Association of Mutual Insurance Companies (NAMIC)

1895

1,240 mutual property-liability insurers

Provides governmental affairs representation; compiles and analyzes pertinent information

National Association of Professional Insurance Agents (NAPIA)

1931

43,000 independent propertyliability insurance agents

Provides educational, representative, and serviceoriented activities

National Association of Professional Surplus Lines Offices (NAPSLO)

1975

800 associate and wholesale brokers and agents

Sets standards for surplus lines industry and provides educational seminars and workshops and internships

Reinsurance Association of America (RAA)

1969

27 propertyliability reinsurers

Promotes the interests of the property-liability reinsurance industry to federal and state legislators, regulators, and the public

Risk and Insurance Management Society (RIMS)

1950

4,500 corporate risk, insurance, and employee benefits managers

Fosters educational and competitive market interests; researches and compiles statistics

Source: Encyclopedia of Associations , 1995, 29th ed., vol. 1, part 2, Carol A. Schwartz and Rebecca L. Turner, eds. (Detroit, MI: Gale Research Inc., 1994).

Chapter 6 / The Role of Others in Insurance Regulation 165 might be only one person, by speaking on behalf of a major segment of insurers affected by a proposed piece of legislation, this representative can have far more influence than the representative of a single insurer voicing the same opinion. The power that trade associations exert in representing their members is not the sole source of their strength. They also rely on the benefit of information they have gleaned from their membership, which they can impress upon regulatory bodies and their representatives. Legislators and state insurance regulators have proposed legislation or promulgated new rules based on incorrect market assumptions and misinformation or in reaction to crises. The trade associations are often able to provide more accurate information and to educate legislators and regulators on critical issues as legislation and new regulations and rules are being developed. In some cases, consensus might be reached that the industry can solve the problem without the proposed legislation. This intervention serves an important function to the association membership and is an example of association influence.

Insurance Advisory Organizations Insurance advisory organizations are not as active as insurance industry trade associations in shaping insurance regulation. However, insurance advisory organizations do play a role in the system of insurance regulation. Insurance advisory organizations are nonprofit companies that work with and on behalf of insurance companies—those that are members of the advisory organizations and those that only purchase or subscribe to certain services provided by the advisory organizations. Advisory organizations primarily deal with the filing of rates or prospective loss costs (that part of the rate equal to loss costs and loss adjustment expenses) and forms. However, insurance advisory organizations often provide other services that are valuable to insurers that are members or that subscribe to or purchase the organizations’ services and to the insurance industry and its regulators: • • • • • •

Develop rating systems Collect and tabulate statistics Research topics important to members and the industry Provide a forum for discussion of issues important to members Educate members, the industry, insurance regulators, and the public about particular issues Monitor regulatory issues of concern to members

Members, subscribers, and purchasers must pay for the services they receive. Members generally pay a higher total amount than subscribers and purchasers,

166 The Regulation of Insurance because members can vote on such items as board members for the advisory organization. Members might also receive all the services provided by the organization while subscribers and purchasers pay only for those services received. Well-known insurance advisory organizations include the Insurance Services Office (ISO), the National Council on Compensation Insurance (NCCI), and the Surety Association of America (SAA). These organizations and others are listed and briefly described in Exhibit 6-3. Exhibit 6-3 Insurance Advisory Organizations Name

Year Founded

Members

Services

American Association of Insurance Services (AAIS)

1946

500 propertyliability insurers

Supplies advisory rates, rules, forms, and statistical services

Insurance Services Office (ISO)

1971

1,400 propertyliability insurers

Performs statistical, actuarial, policy form, and other related services

National Association of Independent Insurers (NAII)

1945

575 independent property-liability insurers

Collects, compiles, files statistics; develops statistical plans; performs advisory services; develops educational programs

National Council on Compensation Insurance (NCCI)

1919

700 insurance companies writing workers compensation insurance

Develops ratemaking, research, and statistical programs

Surety Association of America (SAA)

1908

650 insurance companies underwriting surety, fidelity, and forgery bonds

Classifies risks; prepares forms, provisions, terms, and riders; collects statistical and other data; files upon request of members

Source: Encyclopedia of Associations , 1995, 29th ed., vol. 1, part 2, Carol A. Schwartz and Rebecca L. Turner, eds. (Detroit, MI: Gale Research Inc., 1994).

Insurance Companies Insurance industry trade associations and insurance advisory organizations do not always meet every need of their members. In addition, insurance companies and insurance producers might not join such associations and organizations because the benefits of becoming a member do not justify the costs to

Chapter 6 / The Role of Others in Insurance Regulation 167 join. For these and other reasons, individual insurers and producers become involved in shaping insurance regulation. For example, the NAIC solicits advice from some insurers and producers on technical insurance issues because of their expertise on the subjects. Insurance company representatives might also lobby state legislatures and state insurance departments. Insurance company representatives and producers might also testify before state and federal legislative committees about issues affecting the insurance industry and the public, such as the effects of a particular law or proposed legislation or the need for certain regulatory action.

Consumer Groups Individual policyholders can feel helpless against the insurance regulatory system or, as more frequently happens, their insurance companies. Policyholders, as insurance consumers, have gained increased influence through the development of consumer groups. Some groups focus solely on insurance issues. Others tackle a variety of public interest issues, including insurance. Probably the most well-known consumer group that continually has its eye on the insurance industry is Public Citizen, headquartered in Washington, D.C., with Ralph Nader as its notable chief crusader. Public Citizen has been highly successful in getting substantive reforms in automobile safety and seatbelt laws. It is frequently a high-profile critic of the insurance industry and (from an insurer’s perspective) tends to distrust any actions taken by the insurance industry. Public Citizen has been active in critiquing the major issues of the day, such as no-fault reform in the 1980s and national health-care reform proposals in the early 1990s. Over the past several decades, Public Citizen has wielded substantial power because its representatives frequently testify before Congressional committees on Capitol Hill. Other examples of consumer groups are identified and briefly described in Exhibit 6-4. A former president of the National Insurance Consumer Organization (NICO), stated that the following were the major consumer concerns for the 1990s: • • • •

Consumers believe that automobile rates can be lowered and service improved. Consumers believe that the insurance industry is generally exceptionally inefficient. Consumers believe that state regulators are too weak. Consumers believe that ratemaking has perverse incentives regarding cost cutting and safety.

168 The Regulation of Insurance

Exhibit 6-4 Consumer Organizations Involved in Insurance Regulation Name

Year Founded

Objectives

Consumer Federation of America (CFA)

1967

To gather and disseminate information on consumer issues; advocate proconsumer policies before Congress, regulatory agencies, and courts

Consumers Union of the United States (CU)

1936

To provide consumers with information and advice on consumer goods and services and financial matters; to create, maintain, and enhance the quality of consumers’ lives

National Insurance Consumer Organization (NICO)

1980

To educate consumers on all aspects of buying insurance; to encourage awareness of insurance needs and to purchase insurance only to meet needs; to advocate consumers on public policy matters; to reform unfair industry practices and marketplace abuses

Source: Encyclopedia of Associations , 1995, 29th ed., vol. 1, part 2, Carol A. Schwartz and Rebecca L. Turner, eds. (Detroit, MI: Gale Research Inc., 1994).

•

Consumers believe that who supplies insurance is less important than that insurance be supplied at reasonable cost and with good service. • Consumers believe that structural reform is needed in regulation. • Consumers believe that competition must be increased, particularly in mass-produced personal lines. • Consumers believe that competition and regulation are not mutually exclusive but, properly structured, work together toward an improved system. • Consumers believe that health insurance is the number-one insurance crisis to be addressed in this decade.5 Consumers, through consumer groups, have had a major influence on the operations or stance of state insurance departments, state and federal legislators, the NAIC, and insurance consumers, as those groups work to accomplish goals. Some have adopted more of a watchdog approach, keeping a careful eye on insurers and their actions. Others take a more activist approach to confront issues and work for change.

Influence on State Insurance Departments Consumers are the source of many changes in insurance regulation. A former

Chapter 6 / The Role of Others in Insurance Regulation 169 New York insurance commissioner once remarked that “[t]he public-spirited regulator needs continuous infusions of the public spirit.”6 It is important that consumers advise regulators of issues of interest to them. Complaints made to state insurance departments alert insurance regulators to insurance industry problems and can trigger market conduct examinations, which, in turn, can lead to actions ranging from insurer rebukes to license revocation (for problems associated with a sole insurer). In addition, regulators view too many complaints as a sign of financial trouble, which can trigger financial examinations. Frequently, consumers and their consumer groups can focus on such complaints to influence state insurance commissioners to call for testimony from the industry on problem issues identified by consumers. The results of such hearings can lead regulators to develop legislative proposals. An example of a departmental response to consumer complaints has focused on insurance availability and affordability (referred to as redlining by many insurance consumers and consumer advocates) problems within urban areas. For two days in September 1993, the insurance commissioner of the District of Columbia called for consumer and insurer testimony on alleged redlining practices. Singularly, all insurers who testified, including a major writer, said they were not engaging in illegal redlining practices. Consumer complaints concerning the major writer continued, however, and a group of the major writer’s current and former employees, under the auspices of a local chapter of the National Association for the Advancement of Colored People (NAACP), charged the major writer with using redlining practices. The commissioner attempted to calm consumer reactions and their continued allegations by initiating a market conduct examination of the major writer to explore this and other market conduct issues.7 One theory that draws on the political theory of regulation discussed in Chapter 1 suggests that insurance regulators focus on matters of the greatest appeal to the general public, as they are forced to allocate their limited resources. Matters with immediate consumer effect and that draw media attention are priorities. Included in this theory is a regulatory matrix, shown in Exhibit 6-5, that can purportedly be used to predict the amount of attention that specific issues will be given by state insurance regulators. Along the horizontal axis is a coverage continuum. Those coverages that affect individual consumers demand greater attention than those that affect large institutional consumers, such as corporations. Furthermore, those coverages that have greater ties to public policy are of more interest than those that do not. So, for example, personal auto insurance is of higher interest than homeowners, and commercial auto insurance is of higher interest than commercial multiperil.

170 The Regulation of Insurance Exhibit 6-5 The Regulatory Matrix Low Interest Corporate Organization Licensing Solvency Availability Market Conditions Price High Interest High Interest

Homeowners

Private Passenger Auto

Commercial Auto

Low Interest

Commercial Multiperil

Adapted with permission from Paul Mattera and Peter S. Rice, “Property and Casualty Insurance Regulatory Matrix,” The State of Insurance Regulation, Francine L. Semaya and Vincent J. Vitkowsky, eds. (1991), p. 125.

Along the vertical axis is a regulatory issue continuum. Those issues that have the most immediate effect on consumers are of higher interest than those that do not. Thus, price and market conditions receive greater attention than corporate organization and licensing. Those issues of highest interest on both axes, such as the price of a private passenger auto, will receive the most regulatory attention. Those issues of lowest interest on both axes, such as the licensing of a commercial multiperil insurer, will receive the least regulatory attention. Certain coverage issues— those that affect consumers the most—will demand substantial attention. Certain insurance issues can be scaled on an interest level as well.8 The point at which the issues intersect with the affected coverage will indicate regulatory interest and response.9 For example, the price of private passenger auto insurance is of the highest interest to regulators, according to this theory, while the licensing of commercial auto insurers is of relatively low interest to regulators. Assuming that this theory is accurate in practice, the extent of the consumers’ influence might depend on the issues on which the consumers

Chapter 6 / The Role of Others in Insurance Regulation 171 choose to focus in relation to a certain coverage. So, if consumers groups choose to focus on the price of private passenger auto insurance, they are likely to wield greater influence with regulators than if the consumers groups focus on the licensing of commercial auto insurers. As an increasing number of state insurance commissioner positions become filled through public elections (as opposed to appointment by the governor or other state executive), consumers have the power to choose the candidate they believe is sympathetic to their needs. In turn, this development has forced elected commissioners to become more public-focused and to seek approval of the public should they hope to be re-elected.

Influence on State Legislators State legislators are influenced by the stories they hear from their constituents and from consumer groups, which cause legislators to prioritize their legislative agenda to deal with issues—such as insurance—that affect a great number of the persons they represent. Consumer complaints have led to major legislative initiatives, such as the following: • • • • • • • •

Redlining prohibitions Unfair claims practices laws Unfair trade practices laws Compulsory insurance laws High-risk driver pools FAIR plans Windstorm and other catastrophe pools Tort reform

Common themes of the examples listed above are (1) legislative response to coverage unavailability and unaffordability or (2) perceived insurer abuses in treating policyholders.

Influence on the NAIC Consumers and consumer groups influence the NAIC by contacting and informing members of NAIC task forces, working groups, and committees about perceived problems. Representatives from consumer groups appear before committees, working groups, and task forces to further express their viewpoints. The NAIC can use the information and testimony given by consumer representatives as it develops model laws on issues of importance to consumers.

172 The Regulation of Insurance Emphasis on consumer issues has also led to sponsoring consumer representatives to attend the national NAIC meetings. The Consumer Participation Board was formed in late 1993 and meets during the NAIC national meetings to discuss and coordinate consumer issues and to select the consumer representatives who will receive NAIC financial support to attend the NAIC national meetings.

Influence on the United States Congress United States Representatives and Senators are usually approached by consumer groups as a last resort, when state legislators have either failed to take action or have been limited in what they can do. Examples are the residual market mechanisms for crime and flood insurance that came about because the state insurance regulatory system could not help those who either could not find or could not afford crime and flood insurance coverages. In the early 1990s consumer groups gained the attention of federal legislators as they sought to repeal the McCarran-Ferguson Act (McCarran). Organizations such as NICO believe that McCarran is thwarting competition in the insurance marketplace.

Influence on Insurance Consumers Consumer groups often identify issues and then take action to get the general public motivated to do something, even if the general public does not really understand what the consumer groups are doing. One example of this is the passage of California’s Proposition 103, which sought to regulate auto insurance rates. Although probably few consumers understood the full impact of Proposition 103, most consumers thought that they were spending too much money for automobile insurance and that a referendum forcing a rollback in rates would be an effective and successful means of displaying this consumer dissatisfaction, despite the more complex problem this action brought to the insurance industry at large.

Other Interest Groups The insurance industry and consumers represent special interests regarding insurance regulation. Insurance industry trade associations, insurance advisory organizations, and consumer groups are formed to protect their membership from insurance regulatory responses or to assist in directing the path of regulation in a manner most favorable to their constituencies. Other interest groups also influence insurance regulation. Regulatory professional associa-

Chapter 6 / The Role of Others in Insurance Regulation 173 tions, coalitions, and the media are organizations with interest in insurance regulation.

Regulatory Professional Associations Professional associations for insurance regulators are important to insurance regulation. The Society of Financial Examiners is a trade association for financial regulatory personnel. The Insurance Regulatory Examiners Society is a trade association for market conduct regulatory personnel. Both associations help to improve the professionalism of insurance regulators, which in turn improves state insurance regulation. More professional, better educated insurance regulators benefit insurance regulation by better understanding their roles as regulators and by ensuring regulation is fairly and efficiently enforced.

SOFE The Society of Financial Examiners (SOFE) began in 1973 as a professional association for financial examiners and other financial regulatory personnel of the industries of insurance and banking. Since that time, SOFE has grown to include more than 2,000 regulatory members whose goal is to promote professionalism in the public interest. SOFE is also supported by associate members who are members of the insurance and banking industries that are interested in or deal with the financial aspects of those industries. SOFE provides a forum for insurance and banking financial regulators to meet and discuss the issues that concern them. It encourages regulatory members to earn professional designations—Accredited Financial Examiner (AFE) and Certified Financial Examiner (CFE)—to increase their knowledge and professionalism in performing their regulatory duties. SOFE also conducts regional and national seminars on various regulatory topics and sponsors an annual three-day Career Development Seminar with workshops on various current financial issues. These meetings are attended by both regulatory members and associate members. Such interaction between the members forges communication networks and allows for the exchange of information and ideas that help to improve the cooperation and understanding of all parties involved in financial regulation.10

IRES The Insurance Regulatory Examiners Society (IRES) began as the Society of Market Conduct Examiners, which was endorsed for formation by the NAIC in July 1987. Since that time, IRES has grown to include more than 1,000 regulatory members, including investigators, rate analysts, policy analysts,

174 The Regulation of Insurance financial examiners, and market conduct examiners. IRES is also supported by sustaining members, which are companies and other organizations interested in market conduct regulation. IRES enhances state insurance regulation by promoting professionalism and integrity among its regulator members. IRES is dedicated to competent, fair, and honest regulation. IRES achieves its goal, in part, by encouraging regulator members to earn professional designations—Accredited Insurance Examiner (AIE) or Certified Insurance Examiner (CIE)—and by conducting seminars on various topics. In addition, IRES holds a national career development seminar each year. At this national meeting, workshops on many different topics are offered over a three-day period. Sustaining members attend the career development seminar and interact with the regulator members. The contacts made and communications received by all members foster cooperation among regulators and industry.11

Coalitions Issues that are of significant importance to certain property-liability insurers and that require their specific devoted attention often develop. Since the issues are not of interest to all insurers to the same degree, it is not uncommon to find the interested insurers forming coalitions, such as the following, to address the relevant issues: •

•

The National Disaster Coalition. The National Disaster Coalition is a compendium of insurance trade associations and independent insurers whose goals are to ensure that loss reduction measures are taken to reduce damage in the wake of natural disasters; to make affordable insurance available to homeowners to cover specified natural disasters; and to form a partnership between the federal government and the private insurance market to protect the nation’s economy in the event of catastrophic events. The Insurance Committee for Arson Control. The Insurance Committee for Arson Control is a coalition of insurers combining their efforts to explore arson prevention and related measures. The coalition is based in New York City.

Coalitions, however, are not always composed solely of insurers and their trade associations. Coalitions can be the avenue through which insurers join with consumers and other interested parties to accomplish a goal. A recent example is the Coalition Against Insurance Fraud, created in 1993 as a broad-based effort to fight insurance fraud. Among its members are national consumer organizations, insurers, insurance regulators, law enforcement officials, and

Chapter 6 / The Role of Others in Insurance Regulation 175 policyholders. The coalition supported a measure in the 1994 Omnibus Crime Bill to expand the scope of the federal mail fraud statute to encompass private mailing systems. The coalition has also been a strong supporter of federal and state legislation and regulations aimed at reducing the drain of insurance fraud on the industry and consumers as policyholders.12 Coalitions, such as those mentioned above, can influence insurance activities directly or they can bring about regulatory change.

Influence of the Media The media plays a number of roles in the insurance environment. Regarding insurance regulation and control of insurance activities, the media’s principal role is one of a catalyst for change. In this role the media serves as a watchdog and as an educator. The manner in which the media influences insurance regulation or insurance activities is, in part, based on the source of the media: national, the Insurance Information Institute, and the insurance trade press. These sources are discussed below.

National Media The national news media has the power to influence its readers, listeners, or viewers—whether they be state or federal regulators, insurance industry participants, or the general public. The media’s power lies in its easy access to a large audience. The media can mobilize its audience to action. When it comes to insurance issues, however, it probably has not exercised its influence to the extent that it could. Property-liability insurance issues are not the hot topics that draw an audience for the evening news or a news magazine program. And, when the media does focus on the industry, it tends to report negative news about the industry and focuses especially on consumer complaints. The effect of those few stories negatively influences the public’s perception about the insurance industry in general. That type of media attention has caused insurance regulators and insurance industry participants to improve communications with insurance consumers to try to educate them on the insurance product. Such media attention has also caused insurance regulators and the insurance industry to fix the problems that created the negative news. For example, human crises attract media attention. Media coverage of natural disasters such as earthquakes, floods, and hurricanes typically begins with the human interest stories. After the immediate crisis is ever, coverage turns to the aftermath. The news turns to focusing on issues such as (1) insurers under threats of insolvency because of natural disaster claims; (2) insureds complain-

176 The Regulation of Insurance ing that they have not received prompt payment so that they can begin their recovery; and (3) insurers canceling insurance coverage in disaster-affected areas or requesting substantial new rate increases. As a result of negative publicity following several catastrophes, insurance regulators and the insurance industry have begun to focus on how to prevent the insolvency of insurers caused by catastrophe loss, how to better reach insureds following such catastrophe losses, and how to better prepare for such losses so that insurance availability and affordability is not a significant problem following a catastrophe.

The Insurance Information Institute The insurance industry believes the lack of media coverage or limited positive coverage might be caused by the media’s misunderstanding of or even ignorance of the industry and its related issues and by the insurance industry’s lack of communication with the media and insurance consumers. A key resource in changing attitudes is the Insurance Information Institute (I.I.I.) based in New York City. For more than thirty years, the I.I.I. has been providing credible information to the public and to the media to fulfill its mission of improving the public’s understanding of insurance. The I.I.I., supported by its member companies, has proved to be an important resource and contact point for the media. At the same time, the I.I.I. disseminates insurance-related news to the press and is available for additional information and public comment. The I.I.I., for example, provides these and other important resources to the national and local media: • •

• •

•

A twenty-four-hour special press phone number to answer media questions The Handbook for Reporters, which is a valuable reference guide on insurance-related topics and which is available at no charge for media representatives Insurance Issues Update, a monthly review on developments in twentyeight insurance-related subject areas Access to the I.I.I.’s Communication Divisions to respond to information requests and to act as industry spokespersons for news pieces, in coordination with senior company executives Video news releases produced by I.I.I. on insurance topics such as airbags, drunk driving, and selecting insurance

Recently, the I.I.I. has changed its focus from a centralized flow of information to a local dissemination of information. The I.I.I. has found that local news is

Chapter 6 / The Role of Others in Insurance Regulation 177 ahead of national network news in reporting on insurance issues, so the I.I.I. supports information flow to local sources.13

Insurance Trade Press The insurance trade press is an important resource to state insurance regulators, insurers, agents, brokers, and others inside and outside the insurance industry for information on news in the industry, legislative proposals, and market developments. What news is reported and how it is reported can influence regulatory changes or general regulatory response. Further, what is reported as “big news” can influence the priorities of state insurance regulators and state and federal legislators. Although the insurance trade associations (and the publications they issue, which are too numerous to mention), are a key source of information to their members, the following are examples of the general insurance trade press resources available by subscription to any interested party: • •

•

Business Insurance, a weekly publication reporting issues of interest to corporate risk, employee benefit, and financial executives The National Underwriter, Property & Casualty/Risk & Benefits Management Edition, a weekly publication that focuses on issues relevant to the property/casualty industry I.I.I. Insurance Daily, a business daily summary of articles on insurancerelated news reported in the national and local press, with a brief synopsis for those who want a quick look at the issues of the day

Summary The system of insurance regulation is broad. Not only are federal and state governments involved, but, as discussed in this chapter, courts, the insurance industry, consumers, and other interest groups such as regulatory professional associations and the media also influence, directly or indirectly, insurance regulation. The influence might result in new and improved laws or better communication of existing laws and regulations. The influence might improve public perception and increase the general understanding of insurance and insurance regulation. Regardless of the type of influence, insurance regulation, although primarily the responsibility of state insurance departments, is not limited to such departments. The courts influence insurance regulation by the decisions made about insurance department activities, policy language, policy coverage, and claims

178 The Regulation of Insurance settlement. The insurance industry seeks to shape insurance regulation to meet its needs. Insurance trade associations focus on issues important to their members. Consumer groups want to make the insurance market a more equitable environment for the general public. Coalitions focus on issues that are important to the entire insurance industry and society. Regulatory professional associations improve insurance regulation. The media also plays a role in insurance regulation. The general public depends on the media to get information about the insurance industry, among other information. The way in which insurance issues are portrayed greatly influences public perception, and, thereby, public demands on the insurance regulators and the insurance industry. The Insurance Information Institute is designed to address negative perceptions by providing accurate information and by offering educational materials. The insurance trade press also helps to keep the insurance industry informed about daily transactions that could influence insurance regulation and its continuing development.

Chapter Notes 1. Ohio FAIR Plan Underwriting Association v. Reese, 477 N.E.2d 1199 (Ohio App. 1984). 2. American Council of Life Insurance, et al. v. District of Columbia, et al., 645 F.Supp 84 (D.D.C. 1986). 3. “MO Supreme Court Upholds Challenge to Take-All-Comers Plan; Insurance Dept. Awards Residual Market Contract to Travelers,” Hotline: An AIA Government Affairs News Bulletin (February 21, 1995). 4. Bering Strait School District v. RLI Insurance Company and Lexington Insurance Company, 873 P.2d 1291; 1994 Alas. LEXIS 46. 5. J. Robert Hunter, “The 1990’s—Where We Are Headed,” Insurance Competition and Pricing in the 1990’s (June 2-3, 1990, proceedings of The National Institute), p. 1. 6. Remarks of Richard E. Stewart at the Joint Convention of the National Association of Casualty and Surety Agents and the National Association of Casualty and Surety Executives, October 7, 1968, “Ritual and Reality in Insurance Regulation,” Reason & Regulation: Selected Speeches of Richard E. Stewart (1971), p. 11. Mr. Stewart was the New York Superintendent of Insurance from 1967 to 1970. 7. Albert B. Crenshaw, “D.C. Insurance Office to Launch Probe of GEICO; NAACP Alleges That Insurer Discriminated Against Blacks,” Washington Post, April 5, 1994, p. D1. 8. Paul Mattera and Peter S. Rice, “Property and Casualty Insurance Regulatory Matrix,” The State of Insurance Regulation, Francine L. Semaya and Vincent J. Vitkowsky, eds., Chicago, IL: 1991, pp. 117-126. 9. The writers note that not all insurance departments will act so predictably, and the matrix is only a guide to presumed regulatory attention and response.

Chapter 6 / The Role of Others in Insurance Regulation 179 10. Society of Financial Examiners, “The Associate Member Program for Society of Financial Examiners” pamphlet; Society of Financial Examiners, “The Credit Union, Financial Institution and Insurance Financial Examiner” pamphlet. 11. “Insurance Regulatory Examiners Society,” Insurance Regulatory Examiners Society pamphlet. 12. “Coalition Endorses Expansion of Crime Bill to Include Private Mail Fraud Statute,” Insurance Advocate, October 30, 1993, pp. 5, 32. 13. Mark A. Hofmann, “I.I.I. Chief Says Information Is Key to Industry Image,” Business Insurance, July 11, 1994, pp. 3, 10.

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181

182 Bibliography Hofmann, Mark A. “IIA Chief Says Information Is Key to Industry Image.” Business Insurance, July 11, 1994, pp. 3, 10. “House Report No. 97-190 of the Energy and Commerce Committee,” p. 6. In U.S. Code and Cong. News, vol. 2, 97th Congr. 1st Sess., 1991, p. 1434. Huebner, S.S., Kenneth Black, Jr., and Robert S. Kline. Property and Liability Insurance, 3d ed. Englewood Cliffs, NJ: Prentice-Hall, Inc., 1982. Hunter, Robert. “The 1990s—Where Are We Headed.” Insurance Competition and Pricing in the 1990s (June 2-3, 1990, proceedings of The National Institute), p. 1. Insurance Accounting and Systems Association, Inc. (IASA). Property-Liability Insurance Accounting. 5th ed. Durham, NC: IASA, July 1991. Insurance Department Resources Report. National Association of Insurance Commissioners (NAIC), Kansas City, MO: 1993. Insurance Facts, 1981-82 Edition. New York, NY: Insurance Information Institute, 1981. Insurance Research Council. The National Flood Insurance Program: Agency and Insurer Perspectives. Oak Brook, IL: July 1990. Interagency Task Force on Product Liability: Final Report. Washington, DC: U.S. Department of Commerce, October 31, 1977. Joskow, Paul L. “Cartels, Competition and Regulation in the Property-Liability Insurance Industry.” The Bell Journal of Economics and Management Science, vol. 4, Autumn 1973, pp. 390-391. ———. “Inflation and Environmental Concern: Structural Change on the Process of Public Utility Price Regulation.” The Journal of Law and Economics, vol. 17, October 1974, pp. 297. Kahn, A.E. “The Reform of Government Regulation: Recent Progress in the United States.” Vereniging voor Economie, Notulen Vijftiende Vlaams Wetenschappelijk Economisch Congres, 1981. In Lutgart Van den Berghe. “(De)Regulation of Insurance Markets.” Risk, Information and Insurance, ed. Henri Loubergé. Boston, MA: Kluwer Academic Publishers, 1990, p. 210. Kennedy, T. Richard. “The McCarran Act: A Limited ‘Business of Insurance’ Antitrust Exemption Made Even Narrower—Three Recent Decisions.” The Forum, no. 18, 1983, pp. 528, 533. Lenckus, Dave. “A New Breed of Regulator?” Business Insurance, July 5, 1993. Lilly, Claude C. “A History of Insurance Regulation in the United States.” CPCU Annals, June 1976. Lorimer, James J., et al. The Legal Environment of Insurance. Vol. 2, 4th ed. Malvern, PA: American Institute for CPCU, 1993. Loss, Louis, and Joel Seligman. Securities Regulation. Vol. 2, 3d ed. Boston, MA: Little, Brown and Company, 1989. Mattera, Paul, and Peter S. Rice. “Property and Casualty Insurance Regulatory Matrix.” The State of Insurance Regulation. Francine L. Semaya and Vincent J. Vitkowsky, eds., Chicago, IL: American Bar Association, 1991.

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184 Bibliography 1990 Property/Casualty Insurance Facts. New York, NY: Insurance Information Institute, 1990. 1993 Best’s Rating Guide—Property and Casualty. Oldwick, NJ: A.M. Best Company, 1993. “N.Y. Senate Approves Retaliation Measure,” National Underwriter, April 4, 1994, p. 23. Otis, L.H. “NAIC Eyes Accreditation Standards Moratorium,” National Underwriter, November 22, 1993, p. 1. Patterson, Edwin Wilhite. The Insurance Commissioner in the United States. New York, NY: Johnson Reprint Corporation, 1968. Peltzman, Sam. “The Economic Theory of Regulation After a Decade of Deregulation.” Brookings Papers on Economic Activity: Microeconomics, 1989, p. 9. ———. “Toward a More General Theory of Regulation.” The Journal of Law and Economics, vol. 19, August 1976, p. 231. Posner, Richard A. “Taxation by Regulation.” The Bell Journal of Economics and Management Science, vol. 2, Spring 1971, pp. 27-28. Pullen, Rick. “Group Offers Blueprint for Making Insurers a Smaller Target for Fraud.” Best Week, January 17, 1994, p. 6. Scoles, Kenneth N., Jr. An Empirical Study of the Effects of State Regulation on Price for Market Segments of the U.S. Property and Liability Insurance Market. Atlanta, GA: Georgia State University, 1993. Schwartz, Philip. (Revised by John Baily.) “Other Financial Reporting Requirements.” Property-Liability Insurance Accounting. Durham, NC: Insurance Accounting & Systems Association, 1991. Skousen, K. Fred. An Introduction to the SEC. 5th ed., Cincinnati, OH: Southwestern Publishing Co., 1991. Spulber, Daniel F. Regulation and Markets. Cambridge, MA: The MIT Press, 1989. Stewart, Richard E. “Ritual and Reality in Insurance Regulation.” Reason & Regulation: Selected Speeches of Richard E. Stewart, 1971, p. 11. Stigler, George J. “The Theory of Economic Regulation.” The Bell Journal of Economics and Management Science, vol. 2, Spring 1971, pp. 4-6. Tillistrand, John A. “An Analysis of the McCarran-Ferguson Act: Should It Be Repealed?” CPCU Journal, June 1990, pp. 100-101. U.S. Securities and Exchange Commission. The Work of the SEC. Washington, DC: The Office of Public Affairs, U.S. Securities and Exchange Commission, September 1988. Wichner, David. “Arizona May Create an Anti-Fraud Unit.” Journal of Commerce, February 25, 1994. Wojcik, Joanne. “Proposition 103 Upheld.” Business Insurance, August 22, 1994, pp. 2, 31. Zartman, Lester W., ed. Yale Readings in Insurance, Property Insurance, Marine and Fire. New Haven, CT: Yale University Press, 1926.

Index A

B

Accreditation, general nature of, 118 success of, 120 Accreditation program, NAIC, 118 Actors, political, 24 Acts, risk retention, 51 ADA (Americans with Disabilities Act), 152 ADEA (Age Discrimination in Employment Act), 151 Adhesion, contract of, 162 Adjusters, claims, 81 Adverse selection, 5 Advice, regulatory, 123 Advisory organizations, insurance, 165 Age Discrimination in Employment Act (ADEA), 151 Agencies, federal, 152 Agency, regulatory, 12 Agents and brokers, 80 Alien insurance companies, 78 Allocation of insurance regulation between state and federal governments, 134 Americans with Disabilities Act (ADA), 152 Annual reports, 102 Annuity contracts, group, 145 Antidiscrimination laws, 149 Appleton Rule, 39 Approval, prior, 76 Armstrong Committee, 39 Audits, 105

Banking, 107 Brokers, agents and, 80 Budget, of NAIC, 129 Budgeting, regulatory, 91 Bureaucratic theory, 22 Business Insurance, 177 “Business of insurance,” current definition of, 141 federal intervention in, 141 what it is, 135

C Cancellation laws, 52 Capture theory, 20 Cases, U.S. Supreme Court, the first, 137 Citizens, senior, 84 Civil Rights Act of 1964, Title VII of, 150, 154 Civil Rights Act of 1971, 150 Civil Rights Act of 1991, 151 Civil rights acts, 150 Claims adjusters, 81 Claims settlement, 162 Clause, ERISA savings, 147 Clayton Act, 45 Coalitions, 174 Collision damage waivers, 52 Commissioner, insurance, delegation of duties of, 67 duties of, 66 insurance, 64 Commissioner’s influence, 73

185

186 Index Commissioners, insurance, elected versus appointed, 64 multiple roles of, 68 previous experience of, 66 Commissions, regulatory, 93 Communication, public, 85 Communications, electronic, 127 regulatory, 86 Companies, insurance, 166 Competition, imperfect, 4 and market failure, remedies for, 8 perfect, 4 Competitive market prices, 3 Competitive markets, 4 Complex issue, 24 Conflagrations, 40 Conflict minimization theory, 22 Consumer groups, 167 influence of on state insurance departments, 168 influence of on NAIC, 171 influence of on state legislators, 171 influence of on United States Congress, 172 Consumer information, 126 Consumer protection, insolvency prevention versus, 55 Consumer services, 82 Consumers, insurance, inequitable treatment of, 52 regulation for protecting, 28 Contract of adhesion, 162 Contracts, 107 group annuity, 145 guaranteed investment, 145 Controlling and correcting mechanism, regulation as a, 14 Convention, national insurance, 38 Counsel, general, 85 Courts, direct influence of, 161 effects of on state insurance department functions, 160 influence of in insurance regulation, 159 Coverage, policy, 162

Coverage and pricing regulation, 75 Coverages, insurance, unavailable and unaffordable, 50

D Database fees, defined, 130 Databases, 124 Dedicated funding, 91 Departments and functions, regulatory, 74 Development, research and, 121 Direct legislative oversight, 101 Doctrine of reasonable expectations, 162 Domestic insurance companies, 78 Domestic insurers, 35 Drafting notes, 115 Due process rights, defined, 161

E Early 1900s, 38 Early Warning Tests, 50 Economic theories of regulation, 17 Education and training, by the NAIC, 125 Elected versus appointed insurance commissioners, 64 arguments for, 65 Electronic communications, 127 Employee Retirement Income Security Act of 1974 (ERISA), 146 Employee welfare plans, 147 Endogenous perspective, 16 Environment, political, 72 Environmental Protection Agency (EPA), 154 EPA (Environmental Protection Agency), 154 ERISA (Employee Retirement Income Security Act of 1974), 146 ERISA savings clause, 147 Evolution of insurance regulation, 33 Examinations, 77 financial, 78

Index 187 market conduct, 79 Externalities, 6

F Failure, market, 6 and imperfect competition, remedies for, 8 and noncompetitive markets, 4 FAST (Financial Analysis and Solvency Tracking) system, 50 FBI (Federal Bureau of Investigation), 153 FBI Director William Sessions, 153 Federal agencies, 152 Federal Bureau of Investigation (FBI), 153 Federal government’s role in insurance regulation, 133 Federal intervention in the “business of insurance,” 141 Federal programs, 51 Federal regulation affecting insurance industry, 148 Federal regulation of insurance industry, 144 Federal supervision, state supervision versus, 54 Federal taxation of insurance companies, 146 Federal Trade Commission (FTC) Act, 45 Fiduciary, 147 File and use, 76 Financial analysis, of NAIC, 127 Financial Analysis and Government Relations Office, 127 Financial Analysis and Solvency Tracking (FAST) system, 50 Financial examinations, 78 Financial regulation, standards of, 119 Financial regulation standards, changes in, 120 Financial services, 126 Foreign insurance companies, 78 Foreign insurers, 35, 37

Fraud, 81, 108 Freight forwarders, defined, 154 Funding, dedicated, 91 regulatory, 89 Funds, guaranty, 50

G General counsel, 84, 85 Goods, public, 8 Government intervention in the market, 8 Government relations, of NAIC, 127 Governments, state and federal, usual allocation of powers between, 134 Group annuity contracts, 145 Group Life & Health Insurance Co. v. Royal Drug Co., 138 Groups, consumer, 167 other interest, 172 risk retention, 142 Guaranteed investment contracts, 145 Guaranty funds, 50

H The Handbook for Reporters, 176 Hiring, regulatory, 92

I ICC (Interstate Commerce Commission), 154 I.I.I. Insurance Daily, 177 Imperfect competition, 4 Imperfect competition and market failure, remedies for, 8 Income, investment, 40 Influence, commissioner’s, 73 legislative, through noninsurance laws, 107 Influence of courts, in insurance regulation, 159

188 Index Influence of insurance industry, 163 Influence of state legislatures and the NAIC, 101 Information, consumer, 126 Insolvencies, insurer, 50 Insolvency, insurer, regulation for preventing, 29 Insolvency prevention versus consumer protection, 55 Institutions, political, 24 Insurance advisory organizations, 165 Insurance commissioner, 64 duties of, 66 Insurance commissioner’s duties, delegation of, 67 Insurance commissioners, elected versus appointed, 64 arguments, 65 multiple roles of, 68 previous experience of, 66 Insurance Committee for Arson Control, 174 Insurance companies, 166 alien, 78 domestic, 78 federal taxation of, 146 foreign, 78 Insurance consumers, inequitable treatment of, 52 regulation for protecting, 28 Insurance convention, national, 38 Insurance coverages, unavailable and unaffordable, 50 Insurance departments, state, 36 influence of consumer groups on, 168 overview of, 63 Insurance industry, federal regulation affecting, 148 federal regulation of, 144 forces outside, 52 influence of, 163 Insurance industry trade associations, 163 Insurance Information Institute (I.I.I.), 176

Insurance issues, 123 Insurance Issues Update, 176 Insurance regulation, allocation of between state and federal governments, 134 beginning of, 35 defined, 12 evolution of, 33 federal government’s role in, 133 influence of courts in, 159 recurring issues in, 53 role of others in, 159 theories of, and regulation, 25 Insurance regulators, state legislators as, 101 Insurance Regulatory Examiners Society (IRES), 173 Insurance Regulatory Information System (IRIS), 50 Insurance securities, sale of, 84 Insurance Services Office (ISO), 166 Insurance trade press, 177 Insurer insolvencies, 50 Insurer insolvency, early detection of, 50 regulation for preventing, 29 Insurer receivership, 81 Insurers, domestic, 35 foreign, 35, 37 Insurers department, international, 126 Interest group theory, 22 Internal subsidization, 21 International insurers department, 126 Interstate Commerce Commission (ICC), 154 Intervention, federal, in the “business of insurance,” 141 government, in the market, 8 Investment contracts, guaranteed, 145 Investment income, 40 Investments, 108 IRES (Insurance Regulatory Examiners Society), 173 IRIS (Insurance Regulatory Information System), 50 ISO (Insurance Services Office), 166

Index 189 Issues, insurance, 123 multiline, 39

J Justification for regulation, 27

L Language, policy, 161 Laws, antidiscrimination, 149 cancellation, 52 NAIC model, 113 noninsurance, legislative influence through, 107 Legislative influence through noninsurance laws, 107 Legislative oversight, direct, 101 Legislative relations, 85 Legislators, state, influence of consumer groups on, 171 Legislatures, state, as insurance regulators, 101 Liability, potential of, for NAIC, 128 Licensing, 75 Lobbying, defined, 109 Lobbyist, defined, 109 Loss, profit or, underwriting, 40 Louisiana, regulatory commission of, 93

M Market, 3 changing and improving, 8 government intervention in, 8 Market conduct examinations, 79 Market failure, 6 and imperfect competition, remedies for, 8 and noncompetitive markets, 4 Market participant, regulation as, 15 Market power, 4 Market prices, competitive, 3

Market structure, principles of, 3 Markets, competitive, 4 noncompetitive, and market failure, 4 secondary, defined, 144 McCarran-Ferguson Act, 46 era since, 49 following, 46 and the South-Eastern Underwriters Association, 43 Media, influence of on insurance environment, 175 national, 175 Model laws, of NAIC, 113 Model Laws, Regulations and Guidelines, 113 Monopoly, natural, 5 Multiline issues, 39

N NAIC (National Association of Insurance Commissioners), 110 budget of, 129 consumer information function of, 126 education and training by, 125 electronic communications of, 137 financial analysis of, 127 government relations of, 127 influence of consumer groups on, 171 international insurers, department of, 126 other services of, 124 potential for liability of, 128 publications of, 126 and state legislatures, influence of, 101 Support and Services Office, 124 NAIC accreditation program, 118 NAIC model laws, 113 National Association of Insurance Commissioners (NAIC), 110 National Board of Fire Underwriters (NBFU), 41 National Convention of Insurance Commissioners (NCIC), 39

190 Index National Council on Compensation Insurance (NCCI), 166 National Disaster Coalition, 174 National Flood Insurance Act, 143 National Insurance Convention (NIC), 38 National media, 175 The National Underwriter—Property & Casualty/Risk & Benefits Management Edition, 177 Natural monopoly, 5 NBFU (National Board of Fire Underwriters), 41 NCCI (National Council on Compensation Insurance), 166 NCIC (National Convention of Insurance Commissioners), 39 NIC (National Insurance Convention), 38 1900s, early, 38 No file, 76 Noncompetitive markets and market failure, 4 Noninsurance laws, legislative influence through, 107 Notes, drafting, 115

O Occupational Safety and Health Act (OSHAct), 148 Oklahoma, regulatory commission of, 94 Older Workers Benefit Protection Act, 152 OSHAct (Occupational Safety and Health Act), 148 Other interest groups, 172 Others, role of in insurance regulation, 159 Oversight, direct legislative, 101 Overview of state insurance departments, 63

P Paul v. Virginia, 37 Perfect competition, 4 Performance reviews, 105 Perspective, endogenous, 16 Philosophy, regulatory, 71 Philosophy and style, regulatory, 70 Policy coverage, 162 Policy issue, salient, 24 Policy language, 161 Political actors, 24 Political environment, 72 Political institutions, 24 Political support theory, 21 Political theory of regulation, 24 Power, market, 4 Powers between state and federal governments, usual allocation of, 134 Premium taxes, retaliatory, 36 Premiums, 108 Preventing insurer insolvency, regulation for, 29 Prices, competitive market, 3 Principles of market structure, 3 Prior approval, 76 Professional associations, regulatory, 173 Profit or loss, underwriting, 40 Profits, underwriting, 40 Public choice theories, 19 Public communication, 85 Public goods, 8 Public interest theories, 18 Publications, of NAIC, 126

R Reasonable expectations, doctrine of, 162 Receivership, insurer, 81 Regulation, coverage and pricing, 75

Index 191 defined, 12 defining, 9 economic theories of, 17 federal, affecting insurance industry, 148 of insurance industry, 144 financial, standards of, 119 insurance, allocation of between state and federal governments, 134 beginning, 35 defined, 12 evolution of, 33 federal government’s role in, 133 influence of courts in, 159 recurring issues in, 53 role of others in, 159 theories of, and regulation, 25 introduction to, 1 justification for, 27 political theory of, 24 principles of, 2 a system of, 12 theories of, 17 and insurance theories, 25 Regulation as a controlling and correcting mechanism, 14 Regulation as a market participant, 15 Regulation for preventing insurer insolvency, 29 Regulation for protecting insurance consumers, 28 Regulation of securities, 144 Regulation standards, financial, changes in, 120 Regulation versus social policy, 56 Regulators, insurance, state legislators as, 101 Regulatory advice, 123 Regulatory agency, 12 Regulatory budgeting, 91 Regulatory commissions, 93 Regulatory communications, 86

Regulatory departments and functions, 74 Regulatory funding, 89 Regulatory hiring, 92 Regulatory philosophy, 71 Regulatory philosophy and style, 70 Regulatory professional associations, 173 Regulatory style, 72 Regulatory system, 12 Relations, legislative, 85 Reports, annual, 102 Research and development, 121 Retaliatory premium taxes, 36 Reviews, performance, 105 Rights, due process, defined, 161 Risk Retention Act, 142 Risk retention acts, 51 Risk retention groups, 142 Role of others in insurance regulation, 159

S Sale of insurance securities, 84 Salient policy issue, 24 Savings clause, ERISA, 147 SEC (Securities Exchange Commission), 144 SEC v. National Securities, Inc., 137 SEC v. Variable Annuity Life Insurance Co., 137 Secondary markets, defined, 144 Securities, insurance, sale of, 84 regulation of, 144 Securities Act of 1933, obligations under, 144 Securities Exchange Act of 1934, obligations under, 145 Securities Exchange Commission (SEC), 144 Securities Valuation Office (SVO), 128 Selection, adverse, 5 Senior citizens, 84 Services, consumer, 82

192 Index Settlement, claims, 162 Sherman Act, 45 Social policy, regulation versus, 56 Society of Financial Examiners (SOFE), 173 South-Eastern Underwriters Association decision, aftermath of, 44 developments before, 34 leading up to, 40 South-Eastern Underwriters Association decision and the McCarran-Ferguson Act, 43 SSO (Support and Services Office), 121, 124 financial services division of, 126 Standards of financial regulation, 119 State and federal governments, allocation of insurance regulation between, 134 usual allocation of powers between, 134 State insurance department functions, effects of courts on, 160 State insurance departments, 36 influence of consumer groups on, 168 overview of, 63 State legislators, influence of consumer groups on, 171 State legislatures and the NAIC, influence of, 101 State legislatures as insurance regulators, 101 State supervision versus federal supervision, 54 Statistics, 121 Style, regulatory, 72 Subsidization, internal, 21 Supervision, federal, versus state, 54 Support and Services Office (SSO), 121, 124 financial services division of, 124 Surety Association of America (SAA), 166 SVO (Securities Valuation Office), 128 System, regulatory, 12

T Taxation, federal, of insurance companies, 146 Taxes, retaliatory premium, 36 Theories, public choice, 19 public interest, 18 Theories of regulation, economic, 17 Theories of regulation and insurance regulation, 25 Theory, bureaucratic, 22 conflict minimization, 22 interest group, 22 political, of regulation, 24 political support, 21 Trade associations, insurance industry, 163 Trade press, insurance, 177

U Underwriting profit or loss, 40 Underwriting profits, 40 Union Labor Life Insurance Co. v. Pireno, 140 United States Congress, influence of consumer groups on, 172 U.S. Supreme Court cases, the first, 137 Use and file, 76 Usual allocation of powers between state and federal governments, 134

V Variable annuities, 145

W Waivers, collision damage, 52 Welfare plans, employee, 147