12 Slide

The “Why” of Government Regulation 1. Some economists believe in an efficient market and would like the role of government to be making sure that competition can exist. 2. Other economists have less confidence in the market, and believe that direct intervention (i.e., regulation) is needed to correct market failures.

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Approaches to Government Control 1.

Antitrust concentrates on maintaining competition. The principal thrust of antitrust is to curtail monopoly power

2.

Regulation direct intervention in the decisions of firms, forcing them to behave in a way that will produce results as near as possible to those that would occur in a competitive market 12-2

Rationale for Regulation of Insurance 1. Vested in the Public Interest Rationale •

failures in this field can affect persons other than those directly involved in the transaction

•

fiduciary nature of insurance and extensive influence requires regulation

2. Destructive Competition Rationale •

competition, if left unregulated, can become excessive 12-3

Goals of Insurance Regulation 1. Originally: solvency and equity 2. Emerging goals: availability and affordability

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History of Insurance Regulation 1869 Paul vs. Virginia 1905 Armstrong Committee Investigation 1910 Merritt Committee Investigation 1944 South-Eastern Underwriters Association case 1945 Public Law 15 (McCarran-Ferguson Act) 12-5

Regulation Today 1. Legislative branch 2. Judicial branch 3. Executive branch: the Commissioner of Insurance 4. the NAIC

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NAIC State Accreditation Program In 1989, in an effort to address deficiencies in state regulation, the NAIC established a solvency-policing agenda. 1. Provides for NAIC certification of states that meet requirements of the program. 2. Measures that must be adopted by states include enactment of NAIC model laws. 3. By September 1995, 45 states had been accredited. 12-7

Licensing of Insurers • Before licensing an insurer to do business in the state, the commissioner must be satisfied that the company meets the requirements specified in the Insurance Code. • To qualify, an insurer must have capital and surplus in the amount required by the Code. • Normally, foreign companies must have the same capital and surplus as domestic insurers. 12-8

Statutory Accounting 1.

NAIC Annual Statement Blank

2.

Differences between Statutory Accounting and GAAP •

admitted and non-admitted assets

•

valuation of assets (stocks, bonds)

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matching of revenues and expenses

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Terminology Policyholders’ Surplus •

excess of assets over liabilities

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for capital stock insurers, capital and surplus

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for mutual insurers, surplus

Reserves •

synonymous with liability in insurance company accounting 12-10

Property and Liability Insurers 1. Earned premiums 2. Unearned premium reserve 3. Incurred losses/loss reserves 4. Incurred expenses 5. Summary of operations 6. Investment results 7. The combined ratio 12-11

Property & Liability Insurer Surplus Drain Premiums Written Premiums Earned Expenses Incurred Incurred Losses Net Operating Loss

$100,000 50,000 -40,000 -25,000 -15,000

Statutory operating loss is an illusion that stems from mis-matching revenues and expenses. 12-12

Property & Liability Insurer Surplus Drain 1.

Incurred expenses must be charged before income is earned.

2.

Premiums earned on existing policies could offset the statutory underwriting loss.

3.

When premiums are increasing, statutory profit is understated.

4.

When premiums are decreasing, statutory profit is overstated. 12-13

Regulation of Reserves • State Insurance Code specifies the manner in which reserves must be computed. • Code also requires the insurance company to deposit cash or securities with the state insurance department, based on the amount of the reserves. • Two major classes of reserves are Unearned premium reserve Loss reserves 12-14

Regulation of Reserves Unearned Premium Reserve • represents premiums received from insureds for which protection has not yet been provided. • sometimes called the “reinsurance reserve” since it represents the amount that would be required to transfer the insurance in force to another insurer. 12-15

Regulation of Reserves • Because there is a delay between the occurrence of a loss and the time it is paid, statutory accounting distinguishes between incurred losses and paid losses. • Two major classes of loss reserves reported but not paid incurred but not reported 12-16

Regulation of Investments • To the extent that an insurer’s promises depends on the value of its investments, those investments must be sound. • Insurance Code of each states spells out the investments that are permitted. • Investments usually permitted include U.S., state, and municipal bonds, mortgages, preferred stocks and, subject to limits, common stocks. 12-17

Examination of Insurers • State Insurance Code requires that every insurer submit an annual report to the insurance department. • In addition to the annual reports, insurance departments make periodic examinations of insurers doing business in the state.

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Examination of Insurers • To eliminate duplication of effort, each insurance department examines the companies domiciled in the state. • For foreign companies, a zone examination system is used, in which insurers in state in a zone accept the examination in which a representative of the zone participates.

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Insurer insolvencies State insolvency funds • All states have insolvency guarantee funds designed to compensate members of the public who suffer loss because of the failure of an insurer. • Most funds operate on a post-insolvency basis, in which insurers are assessed their share of losses after an insolvency occurs. 12-20

Insurer insolvencies Early detection of potential insolvencies Although insolvency funds provide some protection to policyholders, the preferred approach is to prevent insolvencies. Regulators employ to mechanisms in their efforts to detect financial problems in insurers. • Insurance Regulatory Information System (IRIS) • Risk Based Capital requirements 12-21

Insurance Regulatory Information System • The NAIC Insurance Regulatory Information System (IRIS) was adopted by the NAIC in 1974. • It is designed to indicate financially troubled insurers by the computerized analysis of selected audit ratios. • There are 11 ratios for property and liability insurers and 12 ratios for life insurers. 12-22

IRIS Ratios (1) Premium to Surplus Ratio

(2) Change in Premiums Written (3) Surplus Aid-to Surplus (4) Two-Year Overall Operating Ratio

Net Premiums Written Policyholders’ Surplus Net Premiums – Net Premiums Current Year Prior Year Premiums Written Prior Year Surplus Aid Surplus Combined Ratio

–

Investment Income 12-23

IRIS Ratios (5) Investment Yield

Net Investment Income Average Invested Assets

(6) Change in Surplus Ratio

Change in Adjusted Surplus Adjusted Surplus Prior Year

(7) Liabilities to Liquid Assets

Stated Liabilities Liquid Assets

(8) Agents Balances-toSurplus

Agents Balances in Collection Surplus

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IRIS Ratios (9)

One-Year Reserve Development to Surplus

1-year Reserve Development Prior year’s Surplus

(10) Two-Year Reserve Development to Surplus

2-year Reserve Development Second Year’s Surplus

(11) Estimated Current Reserve Deficiency to Surplus

Estimated Reserve Deficiency Surplus

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Regulation of Rates General Requirements are that rates must be •

Reasonable

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Adequate

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Not unfairly discriminatory

Life insurance rates only regulated indirectly

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Regulation of Rates Approaches to regulation of property and liability rates •

Prior approval

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Open competition

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File-and-use

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Use-and-file

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Flex rating

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Regulation of Policy Forms States differ in their approach. • In some states, new policy forms and endorsements need only be filed with the commissioner before it is used. • In other states, the law requires that the insurer receive prior approach before a form is used.

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Competence of Agents • Most states require applicants for an agent’s license to demonstrate by examination that they understand the contracts they propose to sell. • Many states now require agents and brokers to complete some specified minimum number of continuing education each year.

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Approval of Non-Admitted Insurers •

States vary in their approach to approval of insurers that are allowed to participate in the non-admitted market.

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Some states issue a "black list," indicating insurers with which insurance may not be placed.

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Other states use a "white list" of insurers that are eligible to participate in the nonadmitted market.

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Approval of Non-Admitted Insurers •

Some states leave it up to the agent to look into the qualifications of the insurer and make certain that the company is financially solvent and meets the criteria established by the law.

•

The NAIC screen insurers for approval and publishes a Non-Admitted Insurers Quarterly listing, indicating insurers who satisfy the eligibility requirements of one or more states and who have a trust fund in the U.S. 12-31

Unfair Practices An insurer may be sound financially and still engage in unfair practices such as unfair discrimination or unethical claim practices. Among the many unfair practices specifically forbidden by many insurance codes are rebating and twisting.

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Rebating Rebating consists of directly or indirectly giving or offering to give any portion of the premium or any other consideration to an insurance buyer as an inducement to the purchase of insurance.

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Twisting Twisting is the practice of inducing a policyholder to lapse or cancel a policy of one insurer in order to replace it with the policy of another insurer in a way that would prejudice the interest of the policyholder.

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Access to Insurance Public dissatisfaction with the increasing cost of insurance, the inability of some consumers to obtain insurance at a price they are willing and able to pay, and a growing philosophy of entitlement have created pressure from some quarters for regulatory programs designed to guarantee the availability of insurance to all who desire it at affordable rates.

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Access to Insurance • Increasingly, those who cannot obtain insurance at a price they feel they can afford are demanding a subsidy from the rest of society. • The traditional approach to this subsidy has been a residual-risk pool.

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Distressed and Residual Risk Pools •

Property and liability insurers in all states are required to participate in shared markets, a euphemism for the involuntary markets in which insurance is provided to applicants that do not meet normal underwriting standards.

•

In some instances, applicants are shared on some predetermined basis. In others, losses are shared. 12-37

Distressed and Residual Risk Pools 1. The automobile shared market 2.

Workers compensation assigned risk plans

3.

Medical malpractice pools

4.

FAIR plans

5.

Beach and windstorm pools

6.

State health insurance plans

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Distressed and Residual Risk Pools •

Virtually without exception, the various assigned risk plans and pools have generated losses far in excess of the premiums collected.

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These losses must, by definition, be passed on to other insurance buyers in the form of higher premiums or they must be borne by the insurers’ stockholders.

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In either case, they represent a redistribution of wealth through the insurance mechanism. 12-39

Redlining •

Redlining, which refers to the policy decision by an insurer to avoid insuring property located in areas where the expected losses are higher than average.

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Generally, the areas in which it is alleged that redlining occurs are in urban centers where insurers have experienced excessive losses due to vandalism, arson, and riots. 12-40

Redlining • The debate over redlining is based on the premise that redlining is an unfair restriction of insurance availability based on geographic location. • All state insurance codes outlaw unfair discrimination in insurance. • The issue, of course, is whether an underwriting decision based on the excessive hazard for a particular geographic area constitutes unfair discrimination. 12-41

Taxation of Insurance Companies State premium taxes • sales tax on all premiums sold in state • varies from 2% to 4% • some states tax domestic insurers at a lower rate

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Taxation of Insurance Companies Federal income taxes •

same tax rates as other corporations

•

computation of taxable income is different to reflect effect of reserves and prepaid expenses

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Taxation of Life Insurers Special I.R.C. provisions for life insurers 1. Small Company deduction - 60% of first $3 million in life insurance company taxable income (LICTI) 2. Mutual insurers deduction for policyholders dividends reduced by differential earnings amount (imputed return equity) 3. Policy acquisition expense must be capitalized and amortized 12-44

Taxation of Property & Liability Insurers Tax Reform Act of 1986 1. Only 80% of increase in unearned premium reserve is deductible. 2. Loss reserves are subject to statutory discounting. 3. 15% of tax exempt interest and dividends is disallowed. 12-45