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.

12-1
 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

12-4
 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

12-6
 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.

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 Statutory Accounting

1. NAIC Annual Statement Blank

2. Differences between Statutory

Accounting and GAAP
• admitted and non-admitted assets
• valuation of assets (stocks, bonds)
• matching of revenues and expenses

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 Terminology

Policyholders’ Surplus
• excess of assets over liabilities
• for capital stock insurers, capital and
surplus
• for mutual insurers, surplus

Reserves
• synonymous with liability in insurance
company accounting

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 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 $100,000

Premiums Earned 50,000

Expenses Incurred -40,000
Incurred Losses -25,000
Net Operating Loss -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.

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 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.

12-18
 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.

12-19
 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 Net Premiums Written

Ratio Policyholders’ Surplus

(2) Change in Net Premiums – Net Premiums

Premiums Written Current Year Prior Year
Premiums Written Prior Year
(3) Surplus Surplus Aid
Aid-to Surplus Surplus

(4) Two-Year Overall Combined – Investment

Operating Ratio Ratio Income
12-23
 IRIS Ratios

(5) Investment Yield Net Investment Income

Average Invested Assets

(6) Change in Surplus Change in Adjusted Surplus

Ratio Adjusted Surplus Prior Year

(7) Liabilities to Liquid Stated Liabilities

Assets Liquid Assets

(8) Agents Balances-to- Agents Balances in Collection

Surplus Surplus

12-24
 IRIS Ratios

(9) One-Year Reserve 1-year Reserve Development

Development to Surplus Prior year’s Surplus

(10) Two-Year Reserve 2-year Reserve Development

Development to Surplus Second Year’s Surplus

(11) Estimated Current Estimated Reserve Deficiency

Reserve Deficiency to Surplus
Surplus

12-25
 Regulation of Rates

General Requirements are that rates must be

• Reasonable
• Adequate
• 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
• Open competition
• File-and-use
• Use-and-file
• Flex rating

12-27
 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.

12-28
 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.

12-29
 Approval of Non-Admitted Insurers

• States vary in their approach to approval of

insurers that are allowed to participate in
the non-admitted market.
• Some states issue a "black list," indicating
insurers with which insurance may not be
placed.
• Other states use a "white list" of insurers
that are eligible to participate in the non-
admitted market.

12-30
 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.

12-32
 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.

12-34
 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.

12-35
 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.

12-36
 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

12-38
 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.
• 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.
• 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.

• 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

12-42
 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

12-43
 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