Principles of risk management and insurance 12th by rejde mcnamara chapter 08

Chapter Government Regulation of Insurance Agenda • • • • • • • • Reasons for Insurance Regulation Historical Development of Insurance Regulation Methods for Regulating Insurers What Areas are Regulated? State versus Federal Regulation Modernizing Insurance Regulation Insolvency of Insurers Credit-Based Insurance Scores Copyright ©2014 Pearson Education, Inc All rights reserved 8-2 Reasons for Insurance Regulation • Maintain insurer solvency • Compensate for inadequate consumer knowledge • Ensure reasonable rates Make insurance available Copyright â2014 Pearson Education, Inc All rights reserved 8-3 Historical Development of Insurance Regulation • Insurers were initially subject to few regulatory controls • State legislatures first granted charters to new insurers; insurance commissions were first created in 1851 • In Paul v Virginia (1868), the Supreme Court ruled that insurance was not interstate commerce, and that the states rather than the federal government had the right to regulate the insurance industry Copyright ©2014 Pearson Education, Inc All rights reserved 8-4 Historical Development of Insurance Regulation • In U.S v South-Eastern Underwriters Association (1944) the Court ruled that insurance was interstate commerce when conducted across state lines and was subject to federal antitrust laws • The McCarran-Ferguson Act (1945) states that continued regulation and taxation of the insurance industry by the states are in the public interest – Federal antitrust laws apply to insurance only to the extent that the insurance industry is not regulated by state law Copyright ©2014 Pearson Education, Inc All rights reserved 8-5 Historical Development of Insurance Regulation • The Financial Modernization Act (1999) changed federal law that earlier prevented banks, insurers, and investment firms from competing outside their core area – State insurance departments regulate insurers – State and federal bank agencies regulate banks – The Securities and Exchange Commission (SEC) regulates the sale of securities – The Federal Reserve has umbrella authority over bank affiliates that engage in underwriting insurance Copyright ©2014 Pearson Education, Inc All rights reserved 8-6 Methods for Regulating Insurers • The three principal methods used to regulate insurers are: – Legislation, through both state and federal laws – Court decisions, e.g., interpreting policy provisions – State insurance departments Copyright ©2014 Pearson Education, Inc All rights reserved 8-7 What Areas Are Regulated? • All states have requirements for the formation and licensing of insurers – Licensing includes minimum capital and surplus requirements – A domestic insurer is domiciled in the state – A foreign insurer is an out-of-state insurer that is chartered by another state, but licensed to operate in the state – An alien insurer is an insurer that is chartered by a foreign country, but is licensed to operate in the state Copyright ©2014 Pearson Education, Inc All rights reserved 8-8 What Areas Are Regulated? • Insurers are subject to financial regulations designed to maintain solvency – Assets must be sufficient to offset liabilities – Admitted assets are assets that an insurer can show on its statutory balance sheet in determining its financial condition – States have regulations that address the calculation of reserves – An insurer’s surplus position is carefully monitored by state regulators Copyright ©2014 Pearson Education, Inc All rights reserved 8-9 What Areas Are Regulated? • Life and health insurers must meet certain riskbased capital (RBC) standards – Insurers must hold a certain amount of capital, depending on the riskiness of their investments and insurance operations – An insurer’s RBC depends on asset risk, underwriting risk, interest rate risk, and business risk – A comparison of the company’s total adjusted capital to the amount of required risk-based capital determines whether company or regulatory action is required Copyright ©2014 Pearson Education, Inc All rights reserved 8-10 What Areas Are Regulated? • State insurance commissioners have the authority to approve or disapprove new policy forms before the contracts are sold to the public – Insurance contracts are technical and complex – Purpose is to protect the public from misleading, deceptive, and unfair provisions Copyright ©2014 Pearson Education, Inc All rights reserved 8-14 What Areas Are Regulated? • Sales practices are regulated by the laws concerning the licensing of agents and brokers – All states require agents and brokers to be licensed – All states require agents to obtain continuing education to upgrade their knowledge and skills Copyright ©2014 Pearson Education, Inc All rights reserved 8-15 What Areas Are Regulated? • Insurance laws prohibit a variety of unfair trade practices, such as misrepresentation, twisting, and rebating – Twisting is the inducement of a policyowner to drop an existing policy and replace it with a new one that provides little or no economic benefit to the client – Rebating is the practice of giving an individual a premium reduction or some other financial advantage not stated in the policy as an inducement to purchase the policy Copyright ©2014 Pearson Education, Inc All rights reserved 8-16 What Areas Are Regulated? • State insurance departments typically have a complaint division for handling consumer complaints – Most complaints involve claims • Information is provided to consumers on insurance department websites and in brochures • Insurers pay numerous local, state, and federal taxes Copyright ©2014 Pearson Education, Inc All rights reserved 8-17 State versus Federal Regulation • Proponents for federal regulation argue that federal regulation: – would provide uniformity in state regulations – is more effective in negotiations of international insurance agreements – is more effective in the identification and treatment of systemic risk – would enable insurers to become more efficient Copyright ©2014 Pearson Education, Inc All rights reserved 8-18 State versus Federal Regulation • Advantages of state regulation include: – Quicker response to local insurance problems – Federal regulation could lead to a dual system of regulation and increase costs – Poor quality of federal regulation, e.g., in the banking industry – Reasonable uniformity of laws can be achieved by the model laws of the NAIC – Greater opportunity for innovation – Unknown consequences of federal regulation Copyright ©2014 Pearson Education, Inc All rights reserved 8-19 State versus Federal Regulation • Shortcomings of state regulation include: – Inadequate protection of consumers – Improvements needed in handling complaints – Inadequate market conduct examinations – Insurance availability Copyright ©2014 Pearson Education, Inc All rights reserved 8-20 Current Problems and Issues in Insurance Regulation • Should the McCarran-Ferguson Act be repealed? • Critics of state regulation argue: – The insurance industry no longer needs broad antitrust exemption – Federal regulation is needed because of the defects in state regulation • Counterarguments include: – The insurance industry is already competitive – Small insurers may be harmed – Insurers may be prevented from developing common coverage forms Copyright ©2014 Pearson Education, Inc All rights reserved 8-21 Modernizing Insurance Regulation • Critics believe the current regulatory system is broken, and lax regulatory oversight at both the state and federal levels contributed to the financial meltdown • The Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) contained numerous provision to reform the financial services industry – Created the Financial Stability Oversight Council (FSOC) to identify and treat systemic risk – Created the Federal Insurance Office (FIO) Copyright ©2014 Pearson Education, Inc All rights reserved 8-22 Modernizing Insurance Regulation • The Federal Insurance Office has the authority to: – Monitor all aspects of the insurance industry – Identify gaps in insurance regulation and identify issues that contribute to systemic risk – Assist the FSOC in identifying insurers that could create systemic risk – Represent the federal government in international discussions of insurance regulation – Negotiate international agreements with foreign countries that pertain to insurance regulation Copyright ©2014 Pearson Education, Inc All rights reserved 8-23 Modernizing Insurance Regulation • Another approach to insurance regulation is an optional federal charter – Proposals would allow insurers to choose either a federal or state charter – Proponents argue that national insurers are at a competitive disadvantage under the present system – Opponents suggest this creates a dual system of insurance regulation which will increase the cost of insurance regulation Copyright ©2014 Pearson Education, Inc All rights reserved 8-24 Insolvency of Insurers • Insolvency of insurers continues to be an important regulatory concern • Reasons for insolvencies include: – Inadequate rates – Inadequate reserves for claims – Rapid growth and inadequate surplus – Problems with affiliates – Overstatement of assets – Alleged fraud – Failure of reinsurers to pay claims – Mismanagement – Catastrophic losses Copyright ©2014 Pearson Education, Inc All rights reserved 8-25 Insolvency of Insurers • The principal methods of ensuring insolvency are: – Financial requirements, such as minimum capital and surplus requirements – Risk-based capital standards – Review of annual financial statements – Field examinations – Early warning system (IRIS ratios) – FAST system analysis Copyright ©2014 Pearson Education, Inc All rights reserved 8-26 Credit-based Insurance • The majority of insurers use the applicant’s credit record for purposes of underwriting and rating in auto and homeowners insurance • Proponents of credit-based insurance argue: – There is a high correlation between an applicant’s credit record and future claims experience – Most consumers have good credit scores and benefit from credit scoring Copyright ©2014 Pearson Education, Inc All rights reserved 8-27 Credit-based Insurance • Critics of credit-based insurance argue: – The use of credit data in underwriting or rating discriminates against minorities and other groups – Credit-based insurance scores may penalize consumers unfairly during business recessions • Most states have enacted legislation that regulates the use of credit-based insurance scores Copyright ©2014 Pearson Education, Inc All rights reserved 8-28 ... insurer’s RBC depends on asset risk, underwriting risk, interest rate risk, and business risk – A comparison of the company’s total adjusted capital to the amount of required risk- based capital determines... health insurers must meet certain riskbased capital (RBC) standards – Insurers must hold a certain amount of capital, depending on the riskiness of their investments and insurance operations – An... Insolvency of Insurers • The principal methods of ensuring insolvency are: – Financial requirements, such as minimum capital and surplus requirements – Risk- based capital standards – Review of annual