THE CONCEPT OF INSURANCE
THE CONCEPT OF INSURANCE
For more than a century, insurance has been recognized as an essential element in an individual’s or family’s financial planning program. Insurance helps to reduce the financial uncertainty of the policy owner with regard to possible future losses. A financial planning program should include the individual’s or family’s general and specific financial goals and a plan to achieve those objectives. This chapter will review the basic principles, nature, and legal concepts of insurance contracts.
In generic terms, theconcept of insurancemay be defined as the transfer of risk from one party to another through a legal contract. When a person purchases insurance, that person (as identified in insurance transactions as the policy owner or applicant) transfers the possibility of suffering a large financial loss to aninsurerin return for paying a relatively small, contractually defined premium.The insurer assumes the risk in exchange for the payment of premiums.Insurance spreads the risk of loss from one person to a large number of persons through the pooling of premiums. When the transfer of risk is accomplished by purchasing an insurance policy, the policy owner obtains a large quantity of coverage in return for a small fee (i.e., the premium).
A Solution to Economic Uncertainties and Losses
Insurance evolved as a practical solution to economic uncertainties and losses. Most insurance contracts pay off financial losses and reimburse the insured. Insurance contractsindemnifypolicyholders, which means the policies restore insureds to the financial position they experienced before the insured loss. The“principle of indemnity”states that the goal of an action is to “restore” an insured to the same financial position they were in prior to when the loss in question occurred. Insurance contracts indemnify insureds. Indemnification also holds to the principle that an insured shall not profit or gain from their loss. In other words, they will not receive more than they lost.
Most accident, health, property and casualty insurance contracts are contracts of“indemnity.”Their purpose is to reimburse for a loss. In contrast, life insurance policies are “valued contracts”because they pay a predetermined amount regardless of the actual loss that was incurred.
Death could potentially strike any person prematurely. When death takes a family provider (e.g., the family breadwinner), surviving family members suffer if they are left without adequate income. Life insurance pays death benefits and creates an instant estate, regardless of when death occurs. On the other hand, when people face the unpleasant prospect of outliving their income, annuities can generate a lifetime income stream to help solve or alleviate this problem.
Eliminating the possibility of an unplanned expense is arguably the most significant advantage of insurance contracts. Insurance also lessens the chance of the person suffering loss will be required to pay entirely for a loss out of his funds, thereby allowing for the benefit of greater management of cash flow and providing for better loss control.
TYPES OF INSURANCE COMPANIES
There are many ways to classify organizations that provide insurance. Conventional methods of insurer classification include where the company is located, how the company is owned, or whether the company is authorized in a given state. In the broadest of terms, insurers can be classified as private (commercial) insurance companies or government providers. It is important to note that the company providing the insurance is considered the insurer, while the covered person is considered the insured.
PRIVATE VERSUS GOVERNMENT INSURERS
Private Insurance
Private citizens or groups own commercial insurance companies, which may be proprietary or cooperative. An example of a proprietary insurer is a profit-motivated stock company. These private insurers offer individual, group, industrial, or blanket insurance policies.
Government (Social Insurance)
Government (Federal and state governments also offer a variety of coverage. Federal and state government provided insurance programs are commonly referred to as social insurance. Social insurance programs range from crop insurance to FDIC insurance on bank deposits.
Self-Insurers
Although self-insurance is not a method of transferring risk, it’s an important concept to understand. Rather than transfer risk to an insurance company, a self-insurer establishes a self-funded plan to cover potential losses. Large companies often use self-insurance for funding pension plans and some health insurance plans. A self-insurer will often utilize an insurance company to provide insurance above a specified maximum loss level, but the self-insurer will bear the amount of loss below that maximum amount.
SOCIAL INSURANCE
Government insurers are owned and operated by a federal or state entity. They are commonly referred to as Social Insurance.
Government insurers may either:
Write insurance to cover catastrophic perils or losses that are not insurable by commercial insurers (e.g., war, flood, or nuclear reaction) or
Write insurance on insurable risks in competition with commercial insurance or possibly instead of them. Such is the case with workers’ compensation.
Examples of social insurance programs include:
Old-Age, Survivors, and Disability Insurance (OASDI), commonly referred to as Social Security
Original Medicare (Medicare Parts A and B)
Medicaid
Serviceman’s Group Life Insurance (SGLI) and Veteran’s Group Life Insurance (VGLI)
SGLI is provided up to $400,000 for full-time members of the armed services (in $50,000 increments).
National Flood Insurance Program (NFIP)
Federal Crop Insurance Corporation (FCIC)
As the list above shows, the government plays a vital role in providing social insurance programs. These programs pay billions of dollars in benefits every year and affect millions of people.
PRIVATE (COMMERCIAL) INSURANCE COMPANIES
Commercial insurers are private companies that offer many lines of insurance. Some only sell life insurance and annuities, while others sell only accident and health insurance or strictly property and casualty insurance.Companies that sell more than one line of insurance are referred to as“multi-line insurers.”A company that only sells one line of insurance is considered amonoline insurer. Stock and mutual companies can both be considered commercial insurers, and as such, both can write life, health, property, and casualty insurance.
STOCK COMPANIES – NONPARTICIPATING
Astock insurance companyis an insurance company that is owned by private investors. Typically, these companies are publicly traded commercial entities that are organized and incorporated under state laws to make a profit for their stockholders (shareholders).
The individual stockholders provide capital for the insurer. In return, they share in any profits or losses. Management control rests with the Board of Directors, selected by the stockholders. The Board of Directors elects the officers who conduct the daily operations of the business. If cash dividends are declared, stock insurers will make the payments to their stock/shareholders. Dividends paid to shareholders are subject to taxes that are similar to long-term capital gains tax.
Stock companies seek to grow their post-tax earnings (earned surplus or retained earnings) that are not paid out in the form of cash dividends. Earnings that are retained by a company are considered equity and are owned by the shareholders.
Stock insurance companies issuenonparticipating insurance policies.Nonparticipating policies don’t pay policy dividendsbecause policy owners are not the owners of the insurance company.Also, the purchase of nonparticipating insurance policies doesn’t confer any other ownership privileges, such as electing the company’s board of directors.
MUTUAL COMPANIES – PARTICIPATING
Mutual insurance companiesare also organized and incorporated under state laws, but they have no stockholders, therefore,ownership rests with the policy owners. Any person who purchases insurance from a mutual insurer is both a customer (i.e., policy owner) and an owner of the insurer. Thepolicy owners vote for a Board of Directors, which in turn elects or appoints the officers to operate the company. Funds remaining after paying claims and operational costs may bereturned to the policy owners, in the form of policy dividends.Dividends from a mutual company may never be guaranteed. Also, mutual company dividends are not taxable. These policies are known as participating or “par” contracts because thepolicy owners participate in the distribution of dividends.
Although stock insurance companies use some of these profits to pay stock dividends to their shareholders, mutual insurers hold their excess earnings as adivisible surplus,which they return to their policyholders. Mutual insurers return this surplus to their policy owners by issuing participating policies that pay policy dividends.
Thedivisible surplusis the amount of earnings paid to policy owners as dividends after the insurance company sets aside funds that are required to cover reserves, operating expenses, and general business purposes. Policy dividends represent a partial refund of the premiums remaining after the company has set aside the necessary reserves and has made deductions for claims and expenses. Mutual companies typically distribute policy dividends to policy owners on an annual basis.
Occasionally, a stock company may be converted into a mutual company through a process called“mutualization.”Likewise, mutual companies can convert to stock companies through a process called“demutualization.”Through demutualization, existing policyholders are provided with shares of stock in proportion to their gross insurance premiums. This is often used to raise funding through the sale of stock.
If an insurance company issues both participating and nonparticipating policies, it is referred to as using a“mixed plan.”
[EXAM TIP: Participating policies allow policyholders to participate in the company by electing the board of directors and receiving dividends from the divisible surplus. Nonparticipating policies do not allow policyholders to participate in elections or receive dividends.]
Assessment Mutual Insurers
Assessment mutual companies are classified by the manner in which they charge premiums. Apure assessment mutual companyoperates based on loss-sharing by group members, and no premium is payable in advance. Instead, each member is assessed a portion of the losses that occur.
Anadvance premium assessment mutual companycharges a premium at the beginning of the policy period and, if the original premiums exceed the operating expenses and losses, the surplus is returned to the policy holders as dividends. However, if total premiums are not enough to meet losses, additional assessments are levied against the members. Typically, the maximum assessment amount that may be levied is limited either by state law or simply as a provision in the insurer’s by-laws.
FRATERNAL BENEFIT SOCIETIES
Fraternal benefit societies are noted primarily for their social, charitable, and benevolent activities, but they also issue insurance to cover their members. These societies have memberships that may be based on religion, nationality, or ethnicity.
Fraternal benefit societies have existed in the United States for more than a century and first began offering insurance to meet the needs of their low-income members. Initially, they funded these benefits on a pure assessment basis. This allowed them toassess the policy ownersin times of financial difficulty and payout non-taxable dividends in times of financial surplus. Today, few fraternal rely on an assessment system; instead, most have adopted the same advanced funding approach that other insurers use.
To be characterized as a fraternal benefit society, the organization must have the following characteristics:
It must be anon-profitorganization
It must havea lodge systemthat includes ritualistic work and must maintain a representative government form with elected officers
It must exist for reasons other than obtaining insurance
Today, most fraternal benefit societies issue group insurance and annuities with many of the same provisions that are found in commercial insurers’ policies. Fraternal benefit societies are more concerned about maintaining minimum reserves and surpluses for coverage than providing dividends or profits.
Examples of fraternal benefit societies include the Independent Order of Foresters or the Knights of Columbus.
RECIPROCAL INSURERS
A reciprocal insurer is an unincorporated organization that’s overseen by a board of governors or directors in which individual members (also referred to assubscribers) agree to insure one another. Unlike mutual or stock insurer policy holders, the reciprocal policy holders themselves insure each other’s risks. Policies don’t transfer these risks to a separate corporate entity. Instead, each policy holder individually assumes a share of the risk that’s brought to the company by the other individuals covered by the reciprocal insurer. This arrangement makes the reciprocal insurer a risk-sharing mechanism rather than a form of risk transfer.
As with policy holders who own participating contracts, policy holders of reciprocal insurers receive policy dividends and their share of the company surplus (capital) if they terminate their membership.Anattorney-in-facthandles transactions for the reciprocal insurer and is authorized to conduct the day-to-day affairs of the insurer on behalf of the subscribers.
RISK RETENTION GROUPS (RRGS)
Arisk retention groupis a specialized insurance company that’s created under the terms of the Federal Liability Risk Retention Act (LRRA) of 1986 to provide liability insurance for individuals and entities with a common bond. Participating professionals and organizations in the same business, occupation, or profession (e.g., pharmacists, dentists, or engineers) become owners and policy holders. The primary purpose of an RRG is to retain or pool risks. These group-owned liability insurers assume and spread liability risks among their members, and, in doing so, they defend claims and pay awards.
Risk-retention groups are only licensed in the state in which they’re domiciled. Federal law requires them to follow the laws of their home state. However, in other jurisdictions, federal law prevails. They’re only required to be licensed in that one state, despite the fact that they may insure members throughout the United States. Although RRGs are a specialized form of mutual insurance company (owned by its members), the insurance exam treats them as a distinct and different class of carrier (which is how this program will treat them).
RISK PURCHASING GROUPS (RPGS)
Arisk purchasing groupshares some common characteristics with an RRG. Both operate under the auspices of the Federal Liability Risk Retention Act (LRRA) of 1986. Also, both types of organizations provide liability insurance for individuals and entities with a common bond.
RPGs differ from risk retention groups in that RPGs purchase insurance from an insurance company; they don’t act as insurers. Membership in an RPG allows for increased bargaining power and streamlined administration for individuals and businesses participating in the group. The risk purchasing group becomes a master policy holder, and its members receive certificates of insurance.
REINSURERS
Reinsurers are a specialized branch of the insurance industry because they insure other insurers. Reinsurance is an arrangement by which an insurance company transfers a portion of an assumed risk to another insurer. Reinsurance typically occurs to limit the loss that any single insurer would face if a significant claim became payable. Reinsurance can also enable a company to meet specific objectives, such as favorable underwriting or mortality results.
In a reinsurance agreement, the insurance company that transfers its loss exposure (risk) to another insurer is called theprimary insurer. We also call it theceding company. The company assuming the risk is thereinsurer, also called theassuming company.The portion of the risk that the ceding insurer retains is called the net retention (or net line). In other words, reinsurance is actually insurance from one insurance company to another insurance company.
A typical reinsurance contract between two insurance companies is referred to astreaty reinsurance. Treaty reinsurance involves an automatic sharing of the risks that are assumed based on previously established criteria. In some situations, a primary insurer will seek reinsurance that’s tailored to cover a specific risk or exposure without an ongoing agreement. This type of reinsurance is referred to asfacultative reinsurance.
CAPTIVE INSURER
An insurer that’s established and owned by a parent firm or group of firms to insure the parent’s loss exposure is referred to as acaptive insurer. A risk retention group can be established as a type of captive insurance company.
SURPLUS LINES INSURANCE
Surplus lines insurance refers to the non-traditional insurance market. Surplus carriers provide coverage for unusual risks or unique situations. Surplus lines insurance is available to those who need protection which is not available through the commercial insurance carriers that are authorized to do business in the applicant’s state.
A person will seek coverage through a producer that’s licensed as an excess or surplus lines broker to secure coverage for high, substandard, or unusual risks (e.g., hole-in-one insurance at a golf tournament or non-appearance coverage). Surplus lines carriers are not regulated in the same manner as traditional insurances carriers. Therefore, consumers purchasing surplus lines insurance are typically not offered the same legal protections as consumers purchasing traditional insurance. Consequently, many states require consumers to demonstrate that they have made an unsuccessful effort to secure coverage in the authorized market before seeking coverage through a surplus lines insurer.An individual may not attempt to secure coverage just because it may be less expensive.
SERVICE PROVIDERS
Service providers sell medical and hospital care services (not insurance) to their subscribers in return for a premium payment. Benefits are in the form of services that are provided by the hospitals and physicians who participate in the plan. These services are packaged into various plans, and those who purchase these plans are referred to assubscribers.
One type of service provider is a health maintenance organization (HMO). HMOs, offer a wide range of health care services to member subscribers. For a fixed periodic premium that’s paid in advance of any treatment, subscribers are entitled to the services of specific physicians and hospitals that are contracted to work with the HMO. Unlike commercial insurers, HMOs provide financing for health care plus the health care itself. HMOs are known for stressing preventive health care and early treatment programs.
Another type of service provider is the preferred provider organization (PPO). Under the typical PPO arrangement, a group that desires healthcare services (e.g., an employer or a union) will obtain price discounts or special services from certain select health care providers in exchange for referring its employees or members to them. PPOs can be organized by employers or by the health care providers themselves. The types of services provided are identified in the contract between the employer and the health care professional (i.e., a physician or a hospital). Insurance companies can also contract with PPOs to offer services to their insureds.
LLOYD’S OF LONDON
It’s important to note that Lloyd’s of London is not an insurer but rather a syndicate of individuals and companies that individually underwrite insurance. Lloyd’s of London can be compared to the New York Stock Exchange, which provides the arena and facilities for buying and selling stock publicly. The function of Lloyd’s of London is to gather and disseminate underwriting information, help its associates settle claims and disputes, and, through its member underwriters, provide coverages that may otherwise be unavailable in certain areas.
INDUSTRIAL INSURER
Home service or debit insurers specialize in a particular type of insurance that’s referred to as industrial insurance. Industrial insurance is characterized by relatively small face amounts (typically $1,000 to $2,000). Generally, the selling agent visits the policy owner’s home each week to collect premiums.
INSURERS CLASSIFIED BY AUTHORIZATION
Before an insurance company can conduct business, it must, by law, receive the authority to do so. Insurance statutes require a company to secure a license from the Department of Insurance to sell insurance in a particular state.An insurer that’s admitted or authorized to transact insurance business in a particular state is referred to as anauthorized or admitted insurerin that state. The authorized company is issued acertificate of authority. Generally, anunauthorized (non-admitted) insurancecompany is prohibited from conducting insurance operations in that particular state.
In some cases, a non-admitted/unauthorized insurer may still offer surplus lines insurance without a certificate of authority if no authorized insurer in the market is available or willing to take the risk. The surplus insurance market is heavily regulated, requires additional licensing, and typically doesn’t provide the consumer with the same protections as the primary insurance market.
INSURER CLASSIFIED ACCORDING TO DOMICILE
Another method for classifying insurance carriers is by organizing them based on where they’re incorporated. Often this is the jurisdiction in which they have their corporate headquarters or domicile of incorporation. If an insurer is incorporated under the laws of the state in which it conducts insurance business, that insurer is considered adomestic insurer. When it is conducting insurance business in a state other than where its offices are located, it is considered aforeign insurer. If the insurer is incorporated in a country other than the United States, it is considered analien insurer.
For example, let’s say that XYZ Insurance Company is incorporated in Oklahoma and is an authorized insurer in Oklahoma. In this case, XYZ Insurance Company is recognized as a domestic insurance company when writing insurance policies in Oklahoma. However, let’s say that XYZ Insurance Company also obtains a certificate of authority to offer insurance products in Texas. Texas will recognize XYZ Insurance company as a foreign insurer when it is conducting insurance business in Texas. Further, if RST Insurance Services of Toronto, Canada, receives a certificate of authority to transact insurance in Oklahoma, it transacts insurance as an alien company in Oklahoma and any other state in which it’s authorized.
[EXAM TIP: ABC Insurance Company of Puerto Rico operates as a domestic insurer in Puerto Rico; however, it’s also licensed or authorized in the State of Florida, which means that it operates throughout the State of Florida as a foreign insurer. Rising Sun Life of Tokyo, Japan, is authorized to transact insurance business in Florida and Puerto Rico as an alien insurer.]
DEPARTMENTS WITHIN AN INSURANCE COMPANY
Throughout this program, numerous references will be made to the different departments within an insurance company. Some of the most common departments are:
Marketing or Sales– Themarketing departmentis responsible for increasing the number of prospective applicants, thereby increasing the number of insureds through various advertising mediums. Thesales departmentis typically responsible for completing the applications and face-to-face appointments with individual prospective buyers.
Underwriting– This departmentis responsible for reviewing applications, conducting investigations to gain additional information about applicants, assigning risk classifications, and approving or declining an application.
Claims– The claims departmentis responsible for processing, investigating, and paying claims for losses that are incurred by insureds.
Actuarial– The actuarial departmentcalculates policy rates, reserves, and dividends and makes other applicable statistical studies and reports that focus on morbidity and mortality tables.
PRODUCERS
The term“Producer”refers to the individuals who solicit the sale of insurance products to the public. Licensed producers are obligated to act in a fiduciary capacity on behalf of the insurers with which they place insurance business and the clients they represent in insurance transactions. Producers are typically considered to be part of the sales department. The various types of producers include:
Agents– Agents represent one or more insurers under the terms of theirappointmentcontract.
Brokers– Brokers represent themselves and the insured (i.e., the client or customer).
Solicitors– A solicitor is not licensed to sell insurance. Instead, a solicitor represents a producer and solicits prospective applicants to meet and discuss their insurance needs with that producer on their behalf.
Service Representatives– Service representatives are insurance company employees who do not engage in sales activities that pay commissions. These individuals are not required to be licensed unless they receive commissions, solicit, countersign policies, or collect premiums from policy owners.
UNDERWRITERS
Underwritersidentify, assess, examine, and classify the amount of risk represented by an applicant (proposed insured) to determine whether coverage should be provided and, if so, at what cost (premium). An underwriter approves or declines insurance applications and determines the cost to provide insurance.
ACTUARIES
Actuariescalculate policy rates, reserves, and dividends. They also make other applicable statistical studies and reports. Actuaries are concerned with the cost of insurance as a whole or the cost for a specific class of risk.
ADJUSTER
An insuranceadjusteris a person who engages in investigative work to obtain information for adjusting, settling, or denying insurance claims. An insurance adjuster will primarily rely on completed claim forms but (depending on the claim) may also investigate an insured’s identity, habits, conduct, business, occupation, honesty, integrity, or credibility. The title“public adjuster”refers to a person who, for compensation, acts on behalf of insureds or aids them with insurance claim settlements.
HOW INSURANCE IS SOLD
Most consumers purchase insurance through licensed producers who market insurance products and services to the public. Typically, insurance producers are agents who have been appointed to represent one or more insurance companies or brokers and are not tied to any particular company. In most states, producers must be contracted and appointed with an insurer before taking an application for that insurer. An agent has an agent’s contract, while a broker has a broker’s contract. A contract and appointment with an insurance company will grant the agent the authority to bind an insurer to an insurance contract. In a sales transaction, agents represent the insurer, while brokers represent the buyer.In disputes between insureds or beneficiaries and the insurer, the agent who solicits an insurance application represents the insurer and not the insured or beneficiary.
Agents are also classified as either captive/career agents or independent agents. A captive or career agent works for one insurance company and sells only that company’s insurance policies. An independent agent works for herself and sells the insurance products of many companies. In most states, an agent may represent as many insurers as will appoint her. The three most common types of agencies that support the sale of insurance are the career agency system, the personal producing general agency system, and the independent agency system.
[EXAM TIP: Career agencies recruit, train, and supervise agents through managers or general agents. These agencies primarily build staff.
Personal Producing General Agencies (PPGA) don’t recruit, train, or supervise agents. These agencies primarily sell insurance.
Independent agents (American agency system) represent any number of insurance companies through contractual agreements.]
TYPES OF AGENCY SYSTEMS
CAREER AGENCY SYSTEM
A career agency is often a branch of a major stock or mutual insurance company. Depending on the organization, the agency may represent the sponsoring insurer in a specific area. In career agencies, insurance agents are recruited, trained, and supervised by a general agent (GA) who has a vested right in any business that’s written by the agents who sell for the agency. General agents may operate strictly as managers, or they may devote a portion of their time to sales. The career agency system focuses on building sales staff.
Managerial System The managerial system is a form of career agency. In the managerial system, the insurance company establishes branch offices in multiple locations. Rather than contracting with a general agent to run the agency, the insurer employs a salaried branch manager. The branch manager supervises agents who work out of that branch office. The insurer pays the branch manager’s salary and a bonus based on the amount and type of insurance sold and the number of new agents hired.
PERSONAL PRODUCING GENERAL AGENCY SYSTEM
Although thepersonal producing general agency (PPGA)system is similar to the career agency system, the PPGAs don’t recruit, train, or supervise career agents. Instead, they primarily sell insurance, but they may build a small sales force to assist them. PPGAs are generally responsible for maintaining their own offices and administrative staff. Agents who are hired by a PPGA are considered employees of the PPGA, not the insurance company, and are supervised by regional directors.
INDEPENDENT AGENCY SYSTEM
Theindependent agencysystem—which is a creation of the property and casualty industry—doesn’t commit a sales staff or agency to any one particular insurance company. Instead, independent agents represent any number of insurance companies through contractual agreements, and they’re compensated on a commission or fee basis for the business they produce. These independent agents own and control their book of business (i.e., the renewal or expiration of the business). This system is also referred to as theAmerican agency system.
Other Methods of Selling Insurance
Although the agents or brokers who work in the systems that have been previously described sell most insurance, insurers also market a significant volume of business through direct selling and mass marketing methods. With the direct selling method, the insurer deals directly with consumers by selling its policies through vending machines, advertisements, or salaried sales representatives who are licensed.
A large volume of insurance is also sold through mass marketing techniques, such as over the internet, newspaper, magazine, radio, and television ads. Mass marketing methods provide exposure to many consumers, often using direct selling methods with occasional follow-up by agents.
EVOLUTION OF INDUSTRY OVERSIGHT
The insurance industry is regulated by multiple authorities, including some that operate inside the industry itself. The primary purpose of this regulation is to promote public welfare by maintaining the solvency of insurance companies. Other objectives are to provide consumer protection and ensure fair trade practices and fair contracts at fair prices. Insurance agents must understand and obey these insurance laws and regulations.
FEDERAL COURT CASES AND LEGISLATION AFFECTING THE REGULATION OF THE INSURANCE INDUSTRY
A selective historical review of insurance regulations shows the interaction between state and federal efforts to regulate the insurance industry. Although a balance between these two bodies has been reached, it’s a dynamic balance that is subject to change as the industry evolves. Other line-specific laws are discussed in conjunction with the products they govern.
1868 – Paul v. Virginia. As decided by the U.S. Supreme Court, this case involved one state’s attempt to regulate an insurance company that was domiciled in another state. The Supreme Court sided against the insurance company, ruling that the sale and issuance of insurance is not interstate commerce, thereby upholding a state’s right to regulate insurance.
1944 – United States v. Southeastern Underwriters Association(SEUA). The Supreme Court revisited the issue of state versus federal regulation of the insurance industry. In the SEUA case, the Supreme Court ruled that the insurance industry is a form of interstate commerce that’s regulated by the federal government and subject to a series of federal laws which often conflict with existing state laws. Although this decision did not affect states’ power to regulate insurance, it did nullify state laws that conflicted with federal legislation.
1945 – The McCarran-Ferguson Act. The turmoil created by the SEUA case prompted Congress to enact Public Law 15, The McCarran-Ferguson Act. This law made it clear that the states’ continued participation in the regulation of insurance was in the public’s best interest. However, it also made possible the application of federal antitrust laws to the extent that the insurance business is not regulated by state law. This Act led each state to revise its insurance laws to conform to federal statutes. Today,the insurance industry is considered to be state-regulated.Any person who violates the McCarran-Ferguson Act faces a fine of $10,000 or up to one year in jail.
1958 – Intervention by the FTC. In the mid-1950s, the Federal Trade Commission (FTC) sought to control the health insurance industry’s advertising and sales literature. In 1958, the Supreme Court held that the McCarran-Ferguson Act disallowed such supervision by the FTC—a federal agency. Additional attempts have been made by the FTC to force further federal control, but none have been successful.
1959 – Intervention by the Securities and Exchange Commission (SEC). In this instance, the issue was whether variable annuities are an insurance product that should be regulated by the states or a securities product that should be regulated federally by the SEC. The Supreme Court ruled that federal securities laws applied to insurers that issued variable annuities and, therefore, required these insurers to conform to both SEC and state regulations. The SEC also regulates variable life insurance.
1970 – Passage of the Fair Credit Reporting Act. This Act attempts to protect an individual’s right to privacy. This law requires fair and accurate reporting of information about consumers, including insurance applications. Insurers must inform applicants about any investigations that are being conducted following the completion of the application.If any consumer report is used to deny coverage or charge higher rates, the insurer must provide the applicant with the name of the reporting agency that’s conducting the investigation.
Any insurance company that fails to comply with this Act is liable to the consumer for actual and punitive damages. The maximum penalty for obtaining Consumer Information Reports under false pretenses is $5,000 and one-year imprisonment.
1994 – United States Code (USC) Sections 1033 and 1034 Regarding Fraud and False Statements. According to these sections of the USC, it’s a criminal offense for an individual who’s convicted of a felony involving dishonesty or a breach of trust to participate in the insurance business without first obtaining a “Letter of Written Consent to Engage in the Business of Insurance” from the appropriate state regulator.
The Fraud and False Statements Act made it illegal to lie, falsify, or conceal information (orally or in writing) from a federal official. As it applies to insurance, any person involved in interstate insurance business who intentionally engages in unfair or deceptive insurance practices or overvalues an insurance product in a financial report or document presented to a regulatory official will violate federal law. Other violations include but are not limited to, embezzling money from an insurance company, misappropriating insurance premiums, and writing threatening letters to insurance offices.
Any violation of this federal law will subject an individual to a monetary fine of up to $50,000, or imprisonment for up to 10 years, or both. In addition, if the material misrepresentation jeopardized the safety and soundness of an insurer and was a significant cause of the insurer being placed in conservation, rehabilitation, insolvency, or liquidation, the agent making the false statements may be subject to imprisonment of not more than 15 years. In other words, if the insurer’s solvency is threatened due to the material misrepresentations of a licensee, a prison sentence of up to 15 years may be assessed on the guilty individual.
An individual who’s convicted of a felony involving dishonesty may engage in the insurance business ONLY after receiving written consent from the state insurance regulatory agency and a 1033 waiver.
1999 – Financial Services Modernization Act (also referred to as the Gramm-Leach-Bliley Act or GLBA). This Act allowed commercial banks, investment banks, retail brokerages, and insurance companies to engage in each other’s lines of business.
The Financial Services Modernization Act repealed The Glass-Steagall Act of 1933, which barred common ownership of banks, insurance companies, and securities firms and erected a regulatory wall between banks and non-financial companies.
This Act also requires financial institutions, including insurance companies, to protect the privacy of their customers’ personal information. GLBA also recommends that state insurance regulators create regulations regarding the protection of consumers’ personal information. The main components of the rule are that financial institutions must:
Notify consumers about their privacy policies
Provide consumers with the opportunity to prohibit the sharing of their protected financial information with non-affiliated third parties
Obtain affirmative consent from consumers before sharing protected health information with any other parties, affiliates, and non-affiliates
2001 – Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act (USA PATRIOT Act). The USA PATRIOT Actwas adopted in response to the terrorist attacks on September 11, 2001. The law aims to detect, deter, and disrupt terrorist efforts and funding while prosecuting international money laundering. These anti-money laundering (AML) measures impact the financial services community.
2003 – Do Not Call Implementation Act. TheDo Not Call Registryallows consumers to list their phones in a registry of numbers to whom telemarketers (including insurers) cannot legally make solicitation calls. Calls made on behalf of charities, political organizations, and surveys are exempt.
2003-CAN-SPAM Act. This Act creates rules for commercial emails and messages. Specifically, the regulation outlines the right for a consumer to request a business to stop sending emails, the requirements for businesses to honor such requests, and the penalties incurred for those who violate the Act. The Act covers all electronic mail messages with the primary purpose of advertisement or promotion of a product, service, or commercial website. The Act does not apply to transactional and relationship messages. According to the Federal Trade Commission, the main requirements of the CAN-SPAM Act include the following:
Don’t use false or misleading header information (i.e., “From,” “To,” “Reply-To,” etc.)
Don’t use deceptive subject lines (i.e., the subject line must accurately reflect the content of the message.
Identify the message as an advertisement.
Include the company's valid physical postal address in every email
Tell recipients how to opt out of receiving future emails (i.e., a return email address or another easy Internet-based way to allow people to communicate their choice to opt-out).
Honor opt-out requests promptly (i.e., within 10 business days.
Don’t charge a fee, require the recipient to give personally identifying information beyond an email address, or make overcomplicate the process.
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC)
All state insurance regulators (commissioners, superintendents, or directors) are members of the National Association of Insurance Commissioners. The NAIC brings together regulators and industry personnel on committees that regularly examine various aspects of the insurance industry and recommend applicable insurance laws and regulations.
The NAIC was formed shortly after the Supreme Court decision in Paul v. Virginia. The organization has four broad objectives:
To encourage uniformity among the state insurance laws and regulations
To assist in the administration of those laws and regulations by promoting efficiency
To protect the interests of policy owners and consumers, and
To preserve state regulation of the insurance business
The NAIC recognizes and supports the efforts of individual states to regulate an industry that’s both complex and essential. As a result, the actions of individuals who solicit insurance sales are strictly regulated on the state level. Laws regarding insurance marketing, trade practices, and regulation can vary from state to state, but overall, there are more similarities than differences.
Please note, the NAIC is not a regulatory organization;it neither enacts legislation nor enforces compliance with relevant laws. Instead, the NAIC creates “model acts” and “model regulations.” These models serve as legislative and regulatory templates that help streamline and standardize the “rules of the road” for those in the insurance industry.
It’s imperative for students to examine and understand their state’s specific laws, which this course covers in a separate chapter. This section will review some of the general principles that guide regulation at the state and territorial level and will consider some of the model acts developed by the National Association of Insurance Commissioners.
NAIC Unfair Trade Practices Act Most jurisdictions have adopted their own version of the NAIC model “Unfair Trade Practices Act.” Although individual states have adjusted the model to better reflect their laws and regulations, all states use this model to base their laws on a set of common standards.
This Act gives the head of each state insurance department power to investigate insurance companies and producers, but it also authorizes them to issue cease and desist orders and to impose penalties. The Act gives officers the authority to seek a court injunction to restrain insurers from using any methods that are believed to be unfair. The individual practices which are identified in the model as unfair include misrepresentation and false advertising, coercion and intimidation, unfair discrimination, and inequitable administration of claims settlements.
NAIC Advertising Code In the past, a principal problem for states was the regulation of misleading insurance advertising and direct mail solicitations. Many states now also subscribe to the Model Advertising Code, which was developed by the NAIC. The code specifies certain words and phrases that are considered misleading by their very nature. These words or phrases cannot be used in the advertising of any kind of insurance. The code also requires the complete disclosure of policy renewal, cancellation, and termination provisions.
THE NATIONAL CONFERENCE OF INSURANCE LEGISLATORS (NCOIL)
After the Supreme Court ruled that insurance was a form of interstate commerce and subject to federal regulation, the McCarran-Ferguson Act made it clear that the states’ continued regulation of insurance was in the public’s best interest. In 1969, theNational Conference of Insurance Legislators(NCOIL) was formed. The NCOIL is a legislative organization that focuses on the insurance industry. The membership is principally comprised of state legislators from around the nation that serve on state insurance and financial institutions committees.
As with the NAIC, the NCOIL works to preserve state regulation of the industry and to educate public policymakers on related issues. The NCOIL also writes Model Laws for consideration and adoption by state legislatures. The NCOIL also helps legislators make informed decisions on insurance issues that affect their constituents and declares its opposition to any federal encroachment on state authority to oversee insurance business, as authorized under the McCarran-Ferguson Act of 1945.
FINANCIAL ADVISORS (NAIFA) AND THE NATIONAL ASSOCIATION OF HEALTH UNDERWRITERS (NAHU)
Members of theNational Association of Insurance and Financial Advisors(NAIFA) and theNational Association of Health Underwriters(NAHU) are life and health agents who are dedicated to supporting the industry and advancing the quality of service being provided by insurance professionals.These organizations created a Code of Ethics which details the expectations of agents in their duties toward clients.
Agent Marketing and Sales Practices The marketing and selling of financial products require a high level of professionalism and ethics. Some of the standards in various states include:
Selling to needs: An ethical agent learns the client’s needs and determines the best way to address those needs.
Suitability of recommended products: The ethical agent assesses the correlation between a recommended product and the client’s needs and capabilities.
Full and accurate disclosure. The ethical agent makes it a practice to inform clients about all aspects of the products being recommended, including benefits and limitations.
Documentation. The ethical agent documents each client’s meeting and transactions. He also uses fact-finding forms and obtains the client’s written agreement for the needs determined, the products recommended, and the decisions made.
Client service. The ethical agent knows that a sale doesn’t mark the end of a relationship with a client but rather the beginning.
Producer Responsibilities A producer is a conduit between the company and the insurance-buying public. Therefore, a producer must ensure that his actions are always in compliance. A producer’s responsibilities include:
Providing customers with the best service possible.
Soliciting new business for his company by helping clients acquire products from application to policy delivery.
Guiding customers to the right products that meet their needs and maintaining a relationship with them.
Building a business by keeping current customers satisfied and also actively seeking referrals.
RATING SERVICES
While not technically insurer oversight, rating services help publicize the financial health of insurers. An insurance company’s financial strength (solvency) and stability are two factors that are crucial to potential insurance buyers and insurance companies. Theprimary purposeof a rating service company (e.g., A.M. Best, Fitch Ratings, Standard & Poor’s, and Moody’s) is to determine the rated insurance company’s (i.e., the insurer’s)financial strength. An insurer’s financial strength can be evaluated by examining the company’s reserves and liquidity.
Reservesare the accounting measurement of an insurer’s future obligations to its policyholders. They are classified as liabilities on the insurance company’s accounting statements since they must be settled at a future date.
Liquidityindicates a company’s ability to make unpredictable payouts to policy owners.
States require various minimum reserves and liquidity thresholds before issuing a certificate of authority. Thereafter, states will periodically verify these thresholds by examining insurer financial records.
CHAPTER SUMMARY - BASIC PRINCIPLES OF LIFE AND HEALTH INSURANCE
The Concept of Insurance
Insuranceis a legal contract that transfers an uncertain risk from one party to another. The insured transfers the possibility of suffering a large financial loss to an insurer in return for paying a relatively small, contractually defined premium.
An insurance policy restores an insured to the financial position she experienced before an insured loss. Insurance companiesindemnifytheir insureds when covered losses occur.
Types of Insurance Companies
Stock Companies – Nonparticipating
Stockholders own a stock company.
Stockholders share in company profits, and, if these insurers declare stock dividends, they’re taxable.
Stock insurers issuenonparticipating insurance policies because policy owners are not stockholders and, therefore, are not owners.
Mutual Companies – Participating
The policy holders own mutual insurance companies.
Mutual insurance companies sell “participating policies” because policy owners receive a share of surplus revenue in the form of policy dividends.
The revenue paid out in the form of policy dividends is referred to as thedivisible surplus.
In the aggregate, policy dividends represent a refund of excess premium or that portion of premium remaining after a company has set aside the necessary reserves.
Assessment Mutual Insurers
To pay for claims, assessment mutual insurance companies assess premiums at the time members experience losses.
Pure assessment mutual companies charge no premium in advance.
Advance premium assessment insurers levy assessments if the premium is insufficient.
Fraternal Benefit Societies
Fraternal societies are not-for-profit organizations that are noted for their social, charitable, and benevolent activities.
Fraternal membership is based on a common bond, and these organizations may form around a common religion, nationality, ethnicity, charitable cause, or other affiliation.
The three defining characteristics of a fraternal organization are as follows:
It’s non-profit.
It has alodge system, including ritualistic work and a representative form of government.
It was not formed simply to provide insurance
Reciprocal Insurers
Each policy owner individually assumes a share of another’s risk, which makes reciprocal insurance contracts a form ofrisk sharingrather than risk transfer.
Policy holders receive policy dividends, and they own a share of the company surplus, which they can receive upon terminating their membership.
An attorney-in-fact is appointed to handle transactions for the reciprocal insurer.
Risk Retention Groups (RRGs)
Arisk retention group (RRG)is a specialized insurance company that provides liability insurance for individuals and entities with a common bond.
Risk retention groups retain risks (risk retention) and process claims.
Risk Purchasing Groups (RPGs)
A risk purchasing group (RPG) buys coverage for its members, which must have a common bond.
The risk purchasing group becomes a master policy holder, and its members receive certificates of insurance.
Reinsurers
Reinsurers provide insurance for other insurance companies.
The reinsurer assumes risk from aceding insurer, which is also referred to as theprimary insurer.
Primary insurance companies purchase reinsurance when they underwrite large risks that could result in claims exceeding the primary carrier’srisk retention limit.The risk retention limit is the maximum amount of exposure that the insurer can carry when insuring a single risk.
Treaty reinsurance exists when a reinsurer enters into a contract with a primary insurance company to automatically assume its excess exposure for risks that meet contractually defined criteria. This agreement is also referred to asautomatic reinsurance.
When a primary insurer seeks reinsurance for a specific exposure without an ongoing agreement, it’s referred to asfacultative reinsurance.
Acaptive insureris established to cover the loss exposure of the parent organization that owns it.
Surplus Lines Insurance Carriersare unauthorized insurers that provide coverage when authorized insurers reject buyers or authorized insurers don’t offer the type of insurance being sought.
Lloyd’s of Londonis a syndicate of individuals that individually underwrite special (unique) risks.
Self-Insurers establish a self-funded plan to cover potential losses and often cap potential losses with a stop-loss insurance policy. “Self-insurance” does NOT EQUAL “no insurance.”
Insurers Classified by Authorization
Anauthorized or admitted insurerdescribes an insurer that has been issued a certificate of authorityfrom a state's insurance department authorizing the insurer to transact insurance in that state. Insurers must receive a certificate of authority from each state they wish to transact insurance.
An unauthorized (non-admitted) insurance company is prohibited from conducting insurance operations in that particular state.
Insurer Classified According To Domicile
Adomestic insureris organized and incorporated in the state in which it’s writing business.
Aforeign insureris organized under the laws of a different state.
Analien insureris organized under the laws of a different nation.
Departments within an Insurance Company
Themarketing or sales divisionprospects for new business.
Thesales departmentmeets with clients face-to-face and completes applications.
Theunderwriting departmentreviews applications, selects risks to insure, and assigns risk classifications.
Theclaims departmentadministers claims.
Theactuarial departmentcalculates policy parameters, such as risks and costs relative to promised benefits.
Key People Within an Insurance Company
Producers
The term“Producer”describes an individual or organization that is licensed by a state to solicit, sell, or transact insurance in that state.
Licensed producers have a fiduciary responsibility to the companies they represent and the consumers they serve.
The terms “agent” and “broker” are used throughout the insurance industry to describe the legal relationship between a producer, an insurer, and a consumer.
Agents,represent one or more insurers under the terms of anappointmentcontract, which gives them limited authority to make binding commitments on the insurer’s behalf.
Brokers, represent themselves and the insured. The state licenses brokers, but they are not appointed by the insurer whose product is being considered by a consumer. Brokers cannot bind the insurer.
Underwriters
Underwriters identify, examine, assess, and classify loss exposures.
Underwriters approve or decline applications and determine the cost of insurance.
Actuaries calculate policy rates, reserves, and dividends.
Adjustersinvestigate and settle claims.
How Insurance is Sold
Most insurance purchased in the United States is sold through licensed insurance producers. Typically, these producers are agents who are appointed to represent one or more insurance companies.
Agents represent the insurer during a sales transaction and can bind insurance. In other words, they can commit the insurers that they represent to cover a risk exposure—at least temporarily.
Career Agency System
Major insurers (including direct writers) often establishcareer agencies,which recruit and train new agents. The agency is often a branch of a significant stock or mutual insurance company.
Some career agencies are contracted to represent an insurer in a specific geographical area or market.
A general agent typically runs a career agency.
Themanagerial systemfeatures career agencies that are run by a salaried branch manager.
Personal Producing General Agency System
Thepersonal producing general agency (PPGA)system is affiliated with one or more insurers, but a PPGA doesn’t recruit, train, or supervise career agents. Instead, a PPGA focuses on sales in its assigned market or territory.
PPGAs generally maintain their own offices and staff. The staff consists of employees of the PPGA rather than of the appointing insurer.
Independent Agency System
Independent agents represent any number of insurance companies through contractual agreements.
Other Methods of Selling Insurance
Insurance companies also sell coverage using mass marketing methods that expose their products to large groups of consumers, with occasional follow-up by agents.
Insurance companies that use these methods deal directly with consumers.
Direct sellers use vending machines, advertisements, or salaried producers.
Evolution of Industry Oversight
Federal Court Cases and Legislation Affecting Insurance Industry Regulation
Paul v. Virginia (1868): The United States Supreme Court ruled that insurance is not interstate commerce, thereby upholding the states’ right to regulate it.
The United States v. Southeastern Underwriters Association (SEU) (1944): The United States Supreme Court reversed Paul v. Virginia and ruled that insurance is a form of interstate commerce and is subject to federal regulation.
The McCarran-Ferguson Act(1945): Congress responded to the SEU decision by delegating the regulation of insurance to the states while requiring compliance with federal antitrust standards – either directly or through comparable state laws. McCarran-Ferguson (also referred to a Public Law 15) also levied a maximum penalty of up to one year in jail and a fine of $10,000 for violators.
The Fair Credit Reporting Act(1970): This Act was established to protect privacy by requiring the fair and accurate reporting of consumer information.
Amendments toUSC 1033 and 1034regardingFraud and False Statements (1994): This section of the United States Code (USC) prohibits felons (those guilty of crimes involving dishonesty or breach of trust) from participating in the insurance industry without a “Letter of Written Consent” from their state insurance regulator. Any person who engages in intentionally unfair or deceptive insurance practices is subject to a fine of up to $50,000, 15 years in prison, and license revocation.
The Financial Services Modernization Act (1999): This Act allowed banks to sell insurance and prompted states to create regulations for insurance companies to protect the privacy of consumer personal information.
The USA PATRIOT Act (2001): This Act focuses on the funding sources for terrorists and international money laundering in general.
The Do Not Call Implementation Act (2003) implemented theDo Not Call Registry,which allows consumers to opt-out of receiving calls from telemarketers, except for those on behalf of charities, political organizations, and surveys.
2003-CAN-SPAM Act: This Act outlines the right for consumers to request a business to stop sending emails, the requirements for businesses to honor such requests, and the penalties incurred for those who violate the Act. The Act does not apply to transactional and relationship messages.
National Association of Insurance Commissioners (NAIC)
The National Association of Insurance Commissioners (NAIC) is an industry association of state insurance regulators focused on establishing model acts and regulations that provide a common framework for state officials to address industry-wide issues. These regulatory models help streamline the legislative and administrative processes while encouraging uniform standards.
The NAIC lists four objectives: (1) To encourage regulatory uniformity among the states. (2) To promote efficient regulatory administration. (3) To protect policy owners and consumer interests. (4) To preserve state regulation of the insurance industry.
The NAIC’sModel Advertising Codelabels certain words and phrases as inherently misleading and bans their use.
NAIC Unfair Trade Practices Act (Model) Actgives a state insurance department the power to:
Investigate insurance companies and producers.
Issue cease and desist orders.
Impose penalties.
Seek a court injunction to restrain unfair activities.
The National Conference of Insurance Legislators (NCOIL) is an association of state legislators that serves on insurance and financial institutions committees to educate policymakers and preserve state regulation. NCOIL also writes model laws.
The National Association of Insurance and Financial Advisors (NAIFA) and The National Association of Health Underwriters (NAHU) created a Code of Ethics for agents.
Agent Marketing and Sales Practices standards include:
Selling to needs: Learning and addressing client needs
Suitability:Recommending products that address client needs and match clientcapabilities
Full and accurate disclosureof product information
Documentationof each client meeting and transaction
Client serviceafter the sale
Rating Services describe companies that determine an insurer’s financial strength. These services publicize the financial health of insurers after analyzing company reserves and liquidity.
