The states regulate insurance by regulating the companies that develop the policies and sell the insurance. States began regulating insurance companies by granting charters that authorized their formation and operation within the state, but there were few other requirements.
As the insurance industry grew, states started creating commissions that had oversight of the industry. New Hampshire created the 1st state insurance commission in 1851. In 1859, New York created a separate agency that could license insurers and their agents, and could also conduct investigations. Nowadays, every state has an insurance department that monitors and regulates insurance within the state.
Insurance regulation consists mostly of state laws and other regulations regarding the solvency and markets of insurance companies. Solvency regulations seek to ensure that the solvency of insurers is maintained and to remedy the effects of an insolvency when it does occur. Market regulations seek to ensure the fair treatment of policyholders, to prevent discrimination and dubious claim practices, and to regulate advertising and other marketing, underwriting, claims payment, rates charged, and insurance policies. States also prohibit unfair or deceptive procedures when selling policies, settling claims, and other procedures.
Purpose of Insurance Regulation
The main purposes of insurance regulation is to
- maintain insurer solvency;
- protect consumers;
- make insurance available to people who, because they are poor risks, might otherwise be unable to get it;
- regulate premium rates.
The state has an interest in maintaining insurer solvency, because people can encounter financial difficulties if an insurer becomes insolvent and is unable to pay claims.
The main methods to protect consumers includes ensuring that insurance agents and brokers do not misrepresent their products, that contracts are readily comprehensible to most consumers, and that insurance policies have specific provisions; otherwise, it would be very difficult to compare different policies.
There are specific terms that denote the relationship of the state in which insurance is sold, the location of the insurance company, and where it is licensed to do business. Domestic insurance is insurance provided within a state by an insurer domiciled, or chartered, in that state. Foreign insurance is insurance provided by an insurer domiciled in a state other than where the policy is purchased or where the coverage is provided. Alien insurance is an insurer domiciled outside of the United States. Admitted insurance is licensed by the state in which it is purchased, and the insurer can be either domestic or foreign. Nonadmitted insurance is provided by an insurer who is not licensed to do business within the state. Surplus-lines insurance is nonadmitted insurance that is purchased through a surplus-lines broker. Foreign and alien insurance companies are generally licensed to do business in the states in which they sell insurance, but if they are not, then they must sell their policies through a surplus-lines broker as a nonadmitted insurer. Indeed, nonadmitted insurers are almost always foreign or alien companies, since domestic insurers are licensed in their state of domicile.
Nonadmitted insurance can only be purchased through a surplus-lines broker, and the broker can only sell nonadmitted insurance if there are no admitted insurance policies that provide comparable coverage. A surplus-lines broker is required so that the state can regulate the broker, since it cannot regulate a nonadmitted insurer. However, many have argued that the need for a surplus-lines broker is unnecessary, since almost all nonadmitted insurance is purchased by large companies that have the legal and financial wherewithal to evaluate the insurers and their policies themselves; almost all consumer policies are admitted insurance.
Insurance companies selling insurance within a state must usually be licensed by that state. When an insurance company seeks a license, the insurance commissioner of that state will determine whether the owners of the insurance company are competent and experienced and that the insurance company has the statutory amount of capital to settle potential claims and to maintain solvency. The amount of capital that the state requires the insurance company to have will vary according to the state, to the type of insurance that the company is selling, and whether it is organized as a stock or mutual company.
Regular Audits and Solvency Testing
One major concern of the states is the solvency of the insurer. If the insurer becomes insolvent, it could hurt its customers substantially, and since the states provide assistance to those whose claims are not paid because of an insolvent insurer, the states have a vested interest in maintaining insurer solvency, and, thus, it regularly reviews domestic insurers for signs of financial problems.
Every insurance company must file quarterly and annual reports with the insurance department of each state that it does business, and with the NAIC. Independent actuaries must affirm that the insurance company has adequate reserves. About once every 3 to 5 years, each insurer is audited by the state in which it is domiciled, and there may be representatives from other states in which the insurer does business that may join the audit. Since most insurance companies are domiciled in 1 state, but do business in many states, auditing only domiciled insurance companies greatly reduces the audit expense and prevents duplication of efforts, both for the state and for the insurance company.
The NAIC Insurance Regulatory Information System (IRIS) monitors the solvency of insurers based on the annual reports submitted to it. The financial information is analyzed by the Financial Analysis Solvency Tracking (FAST) system, which assigns a score to each company based on financial ratios and other financial indicators. Ratios outside of normal ranges for most insurance companies may indicate financial problems, so those companies are flagged for greater scrutiny by state examiners. FAST is used to prioritize the examination of companies to those with the worst scores, so that corrective action can be taken before the companies fail.
Another method to help prevent the insolvency of life insurers is the risk-based capital (RBC) requirement developed by the NAIC. RBC rules changes the amount of capital and surplus that must be maintained, depending on the underwriting, investment risks, and off-balance-sheet risks of the insurer. For example, an insurer that invests in riskier assets will have a higher risk-based capital requirement than an insurer that invests conservatively.
All states have solvency laws and guaranty funds to help failing insurers, or, to at least maintain coverage and pay the claims of customers of insolvent insurers. When an insurer fails, the policyowners may be forced to give up some rights, such as access to their money for a specific amount of time, or, in the case of life insurance, the policyholders may receive less interest than the minimum that was guaranteed by the life insurance contract.
When the insurer's surplus falls below the minimum level required by the state in which the insurer is domiciled, the state department will first try rehabilitation (aka conservatorship, receivership). If that fails, then the state will use liquidation, or, if it is a small insurer, the state may arrange to have another insurer take over the business.
Although some of the laws of most states are based on the 1989 NAIC Guaranty Fund Model Act, there are differences in who is eligible and their benefits. Most of the money for the guaranty funds comes from assessments on insurers.
To protect policyholders, states restrict the investment activities of insurers, generally requiring that most investments be in safe securities, such as Treasuries. Riskier assets are limited to a small specified percentage of admitted assets. Generally, the investment limitations are stricter for life insurers than for property and liability insurers, because life insurers hold much more of the policyowner's money that will eventually have to be paid, whereas the premiums for property and liability insurance are used to cover losses within the covered period.
An insurance company that belongs to a corporate group may be exposed to risks posed by other members of the group, which was well illustrated by American International Group (AIG). Although AIG was regulated by the Office of Thrift Supervision, it had an unregulated Financial Products Division (AIG-FP) that sold credit default swaps that later caused a great liability for the company. When AIG started to fail, its life insurance companies were also financially stressed. Consequently, group supervision was required to effectively monitor the financial stability of insurance companies within corporate groups.
The NAIC has adopted the Solvency Modernization Initiative (SMI) to better assess the risks imposed on insurance companies by holding companies or other members of the corporate group and their enterprise risk management policies. To mitigate the risks imposed by insurance groups, the NAIC Model Holding Company Act was adopted by the NAIC and later modified to regulate some interactions between the insurance company and its group. For instance, interactions within the group that may pose a risk to the insurance company must be reported to the insurance commissioner and some transactions must receive prior approval, such as the payment of dividends to the parent company. This Act also allowed insurance commissioners to examine certain noninsurance transactions within the group, authorized supervisory colleges, consisting of regulators from different jurisdictions, to conduct examinations of the group, and required that the insurance companies file a new Enterprise Risk Filing form (Form F) to report on possible risks within the group.
Also as part of the SMI initiative, the NAIC has adopted the Risk Management and Own Risk and Insolvency Assessment Model Act, becoming effective in January 1, 2015. This Act created a new regulation — the Own Risk and Solvency Assessment (ORSA) — that requires insurance companies to assess their own current and future risks that may impair their ability to meet future obligations. ORSA must be conducted annually by all single-entity insurers that write more than $500 million of premiums annually or insurance groups that write more than $1 billion of premiums. Insurance companies are required to document their assessment of their current and future solvency, document the process and the results of their procedures, and provide an annual ORSA Summary Report to the insurance commissioner and, if requested, to the insurance commissioner of the domiciliary state. All states are expected to enact this regulatory framework by the end of 2017.
If a company is on a shaky financial foundation, then the insurance commissioner will often try to correct the issue confidentially. However, if the financial stress is greater, then the commissioner may petition the court to be appointed as a receiver of the company, allowing the commissioner to control it. Common rehabilitative efforts include seeking reinsurance with other companies or merging with a stronger insurer. In the worst cases, the court may be petitioned to liquidate the company, in which case, the receiver would distribute the assets of the company according to state law. Expenses of liquidation ranked 1st in priority, with policyholders ranking 2nd, so the policyholders will receive assets before any other creditors.
State and solvency funds compensate policyholders if assets are insufficient. Insolvency funds all have deductibles and a limit on payouts.
Property and liability insolvency guaranty funds operate by assessing any losses on insurers within the state proportional to the amount of business that they do in that state. Some states, such as New York, assess a tax before the insolvency occurs, to maintain a fund for insolvencies. The insurers can deduct the tax from their premium taxes.
Regulation of Reserves
Because insurance companies collect premiums before they must pay out their liabilities as a result of their insurance sales, insurance companies must maintain minimum policy reserves to cover future liabilities. Policy reserve regulations are stricter for life insurance companies, since there is a typically long duration between the collection of premiums and the payout. These policy reserves must be reported as liabilities in their accounting statements. Property and liability (P&L) insurers can only report premiums as income after the premiums have been earned, meaning that the duration of coverage purchased by the premiums has lapsed. P&L insurers must maintain an unearned premium reserve to cover expected future losses and an additional loss reserve to cover claims that have been reported but have not yet been paid and not yet reported claims. State laws determine how these reserves are to be calculated.
(Note: in many countries other than the United States, reserves are called technical provisions.)
Regulation of Investments
Insurance companies make investments to use the money that they hold, which helps to keep insurance premiums lower. However, insurance companies are not permitted to make risky investments, since the future value of those investments cannot be known with any reasonable degree of certainty. Hence, to insure solvency, states require that insurance companies invest in safe securities, otherwise known as investment-grade securities, including most government securities, Canadian bonds, mortgage loans, and investment-grade corporate bonds. Insurance companies may also own some preferred or common stock as a small percentage of their portfolio. Generally, the percentage of riskier insured investments that can be owned by life insurers is smaller than is allowed for property and liability insurers; typically, common stocks compose only 5% of the portfolios of life insurers, and 15% for P&L insurers.
To enforce the regulations for investments by insurance companies, they must file a report with the Securities Valuation Office of the NAIC, which rates the portfolios of insurers and issues the rules to determine the valuation of specific types of securities.
All states also regulate policy forms by requiring their approval by the state insurance department before they can be used in the state. The main purpose for regulating policy forms is that most insurance contracts are complex, and are difficult for most people to understand and to compare with other policies. Also, insurers could leave out important or expensive provisions to offer lower prices, which many people probably wouldn't notice. Thus, states have minimum requirements for insurance policies that may include certain provisions, minimum guarantees, and cancellation rights.
Most contract provisions of insurance policies must be approved by the insurance commissioner and, in most states, most forms cannot be presented to the public before they are approved. New endorsements must also be approved. However, in some states, new forms or changes only have to be filed with the insurance commissioner, but they may have to be withdrawn if the commissioner disapproves.
All states have various methods to regulate insurance rates. Generally, rates must satisfy the broad objectives of being adequate enough to maintain the insurer's solvency, but also be fairly priced, and not be unreasonably discriminating. Nondiscrimination means that any differences in rates should be based on actuarial criteria, where the expected loss of the class justifies the premium. And even where there is a justification, insurance companies still cannot discriminate when it is against the law. For instance, auto insurance rates for males was higher than for females because they had a higher accident rate. Now, since federal law prohibits discrimination based on gender, no consideration can be given the gender.
Also, many states have deregulated rates for commercial lines of insurance, since businesses do not generally need the protection that is provided to consumers, and allows insurers to develop policies that satisfy the specialized needs of businesses.
Sometimes the regulation of insurance rates is determined indirectly, by requiring a certain amount of reserves, for instance. The rates for life insurance are limited by competition and by regulation, especially by the requirement to have a minimum legal reserve to pay claims and benefits.
Rating laws govern how the insurers can change their rates, and generally applies to property and liability insurance, especially personal lines of insurance. Different rating laws may apply to different lines of insurance within the same state. The regulation of life insurance rates is indirect and relies more on competition.
The principal rating laws can be categorized according to whether approval is required to change rates and when the approval must be obtained in regard to the actual changing of the insurance premiums: prior-approval laws, file-and-use laws, flex-rating laws, and open-competition laws. Most states use more than one type of rating law for different lines of insurance.
- Prior-approval laws are the most onerous for insurance companies. They are generally required to get approval for a rate change before they can change it, and, often, they are required to provide justification for the change in rate, particularly if it is for a big increase. Insurers must file statistical data, showing trended loss experience and projected expenses to receive rate approval. An insurance company may file its own loss data or it may use the information provided by an advisory organization, which would have loss data from many insurance companies. Criticisms of the prior approval rate making system is that it can thwart competition and can often delay necessary premium increases, which may not be granted because of political reasons.
- Flex-rating laws only require prior approval if the rate change is substantial, such as 10% to 25%. This allows insurance companies to respond more rapidly to changing conditions.
- The file-and-use law is like the prior-approval law, but allows the insurer to use the new rates immediately after filing, rather than waiting for approval. Most states have a deemer provision, stipulating that rates are deemed approved if they are not disallowed within a certain time, usually ranging from 15 to 60 days. The insurance department retains the right to disapprove of the rate later, if it violates regulations or is deemed unjustified.
- A slight variation of the file-and-use law is the use-and-file law, which allows the insurance company to change rates immediately, but must file the new rate with the insurance department within a specific time, typically 15 to 60 days.
- Open-competition laws (aka no-filing laws) eliminate all filing requirements, but insurers may have to furnish rate schedules to the state insurance department, if requested. Rates under this law are naturally regulated by competition, as is the price of most items in a capitalist society.
The regulation of rates is often criticized because if they are set too low, then the insurance companies may be more discriminating, more determined to seek out better risks. Additionally, the prior approval laws exacerbate the underwriting cycles of insurance, because if an insurance company discovers that it is losing money, there could be an extended amount of time before increased rates are approved. The longer the delay for the approval, the more the insurance company must make up for it in higher rates later on. This leads to higher profits later on, which promotes more competition, thence to lowering rates to increase market share, sometimes below that required for solvency. Then the cycle repeats itself.
Many states require that certain risks be insured, such as that for auto insurance. But some people are too risky to insure. Insurance companies make profits by excluding risky people through their underwriting standards. Therefore, most states require that insurance companies participate in pooled risks, where they must accept some of the riskiest individuals and offer them a subsidized premium so that they can afford it or they are willing to pay for. The number of these individuals that each insurance company must insure is commensurate with the number of policies that they have written within the state. So if one insurance company writes 25% of the auto insurance policies within the state, then they must accept 25% of the individuals in the risk pool.
Property and liability insurers in all states must participate to some extent in shared markets, where they must accept applicants who do not meet their underwriting standards, i.e., those of higher risk. In most states, either the pool of insurance applicants is shared according to some basis, or the losses are shared.
- The automobile shared market is probably the most common residual risk pool, since virtually every state requires auto insurance. The Automobile Insurance Plan, formally called the Assigned-Risk Plan, operates in 42 states, while the remaining 8 states use alternative plans to achieve the same purpose.
- Workers compensation also has assigned-risk pools. Employers who do not meet the underwriting standards for any insurer within the state are assigned to insurers according to the proportion of business they write within the state.
- During the 1970s, there was a medical malpractice crisis among healthcare professionals. Juries were awarding increasingly larger amounts of compensation and many more suits were filed, causing many insurers to leave the market. Consequently, one of the solutions that many states have come up with is the medical malpractice pool that medical practitioners contribute to for coverage. Some states have created joint underwriting associations (JUAs) were all liability insurers within the state shares both premiums and losses. Retained risk groups that can operate in every state also provide medical malpractice insurance.
- Fair Access to Insurance Requirements plans (FAIR plans) are insurance industry pools that provide insurance to property owners who own property within high risk inner city areas. Before coverage is granted, the property is inspected for physical hazards that the owner must fix. If the owner cannot obtain insurance through the regular markets, then the FAIR plan assigns the property to an insurer.
- Beach and windstorm risk pools also operate as FAIR plans in Southeastern and Gulf states, providing owners with insurance ffor properties located on the Atlantic or Gulf coast that are vulnerable to hurricanes and windstorms. Each insurer is assigned a share of applicants proportional to their total written premiums within the state.
- Previous to Obamacare, most states ran state health insurance plans to cover individuals who qualified neither for health insurance nor for Medicare or Medicaid. Premiums are subsidized, but still much higher than rates for most people. Because the Affordable Care Act prohibits the consideration of health status for underwriting health insurance, health insurance pools are no longer necessary.
Some protection is also offered by government insurance for catastrophes, such as flood, earthquake, and hurricanes, since most private insurers are not willing to cover catastrophic losses, although they do offer some coverage as reinsurance or through the issuance of catastrophe bonds or contingent surplus notes.
Agents and Brokers
Governments can also maintain greater control by licensing individuals or companies in certain types of businesses, and such is the case with insurance agents and brokers. All states require insurance agents and brokers to be licensed in the state in which they do business. They must understand the applicable laws and the contracts that they are selling. All state insurance departments have websites that allow consumers to inquire about admitted insurers, insurance policies, and also provide related educational information. To promote competition, the Financial Modernization Act requires that states standardize their licensing requirements so that agents and brokers can sell in other states. Some states also require loss adjustors to be licensed. States may also require continuing education for agents and brokers.
States also regulate the conduct of agents and brokers, especially in regard to selling. Rebating and twisting are specifically prohibited. Rebating is when an insurance agent or broker gives part of his commission to the insured as an inducement to buy the policy. Twisting — duping the insured with false information or comparisons to change already owned policies to those that the agent or broker is selling — is also prohibited. Forbidden conduct also includes misrepresentations of insurance contracts.
Many states also regulate insurance policies from nonadmitted insurers with countersignature laws, which require that any non-life insurance policy be signed by a domestic agent, who is entitled to a commission, even if the agent did not solicit the business.
Insurance Premium Taxes
Most states charge premium taxes on insurance premiums, which average around 2% of the premium. The tax varies according to state, and sometimes according to the type of insurance. Premium taxes are almost never itemized on the customers' bills, but are included in the premium. Originally, the purpose of the tax was for insurance regulation. Nowadays, states collect much more than they need for insurance regulation — thus, it is just another hidden, general tax.