2/9/11

INSURANCE REGULATION
Insurance in the United States has been regulated at the state level for a long time; in modern
times it has been heavily regulated. We stated last class that contracts, including insurance
contracts, are a method to transfer risk. But you might wonder why the insurance industry,
based upon a contract between the insurer and the insured, is so heavily regulated…

The three principal reasons are to control or influence insurance industry solvency, pricing, and
contract terms,
- B/c for the most part, insurance involves dealings between an insurance company and the
relatively unsophisticated public.
- Industry abuses and problems over the years have led to increasing regulation of the
insurance industry
as a matter of public policy.

Landmark legal actions which laid the foundation for today’s insurance regulatory structure
throughout the United States are as follows:

Paul vs. Virginia, 1869: held that insurance (fire insurance here) is not commerce,
therefore it is not subject to federal regulation as interstate commerce.
Sherman Antitrust Act, 1890: the antitrust provisions of this Act could not be applied to the
insurance industry
because of the Paul case above.
Armstrong Investigation, 1905: spectacular publicity surrounding abuses and misconduct of
the life insurance industry
in New York in 1905 led to numerous regulatory reforms across the U.S.
U.S. vs. Southeastern Underwriters, 1944: indictment of insurance companies for price-
fixing and boycotting in violation of the Sherman Antitrust Act, and overruled the Paul vs. Virginia
case, exposing the insurance industry to federal regulation.
McCarran-Ferguson Act, 1945: extreme concern of federal intervention due to the
Southeastern case led the National Association of Insurance Commissioners (NAIC) to urge
Congressional passage of a law (Public Law 15) which reaffirmed the right of the federal
government to regulate insurance, but which agreed that the federal government would not
exercise that right as long as the industry was adequately regulated by the states (i.e., if states
do a good job of self-regulation). In effect, states were given the power to regulate insurance in
their respective jurisdictions, and following the passage of the law, many states acted quickly to
improve their regulatory systems to be in compliance with the spirit of the federal law (rating
laws, unfair trade practices, solvency standards, and licensing requirements).
Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010: Created the
Federal Insurance Office (FIO) to monitor the insurance industry, while maintaining state
regulation of insurance; it remains to be seen what impact this new legislation will have on the
insurance industry. (See MOODLE for a legislative summary of this Act).

Elements of Insurance Regulation at the State Level in Louisiana (and similar in other
states)

A. Solvency Regulation
a. Licensing authority allows the commissioner of insurance
(appointed by the governor in most states, elected in Louisiana)
to decide which companies are allowed to do business within the state
b. Licensing attests the financial stability of the applicant company, such as the capital &
surplus requirements
outlined in the insurance code of the state (varies from state to state)
 c. In addition to capital & surplus requirements, the commissioner typically reviews
information about the management of new company applicants to assess their
competence and experience
d. In the 1990s, NAIC developed risk-based capital standards for life, property and
liability, and health insurers

e. Insurers must comply with significant regulatory reporting requirements.

i. Insurance code requires every licensed insurer to submit annual and quarterly
reports
to the commissioner of insurance for analysis
& actuaries must sign opinions certifying the adequacy of reserves.
ii. The NAIC facilitates this role, by maintaining a database of financial information
filed by insurers,
& by providing financial analysis capabilities to identify potentially troubled
insurers.

f. The commissioner’s office may conduct periodic inspections of all companies doing
business in the state at any time,
but the insurance code usually requires a comprehensive examination every 3-5 years.

g. Policy reserves are also regulated by the commissioner of insurance

i. The insurance code of most states specify the way reserves are computed, and
requires that
insurance company deposit cash/securities with the commissioner of insurance
based upon the level of reserves
ii. The insurance code of each state also specifies the types of investments allowed
by each type of insurance company in the state.

h. Prevention rather than cure is the regulatory preference for insurance insolvency, but
when insolvency occurs,
the commissioner of insurance moves to have the insurer’s assets liquidated through
judicial proceedings,
unless the company can be rehabilitated or merged with another company
i. Insolvency guarantee funds exist in all states to compensate those who suffer
loss due to the failure of an insurer (life, property and liability, and health).
1. The fund generally includes a deductible and a maximum amount that will
be paid.
2. Most funds in the U.S. are funded after insolvencies occur,
with the assessment of a proportionate share of insolvency losses to state
insurance companies.

Rate (Pricing) Regulation

Most states regulate insurance rates, requiring that they be adequate and fair. A concept of
adequacy is when income from premiums and investments are sufficient to fund losses as they
occur, and to provide for ongoing expenses and reasonable profits of the business. Fair rate
guidelines prohibit charging excessive rates and charging significantly different rates to
policyholders (discrimination) without justifiable differences in risk. Systems of rate regulation
vary by state.

Fair Trade Practices (Contracts/Competition)

All states have Unfair Trade Practices Acts prohibiting insurers from using unfair methods of
competition. State insurance commissioners also review insurance contracts (most are
standard-form) to ensure that unfair provisions are not included, because most consumers do not
read the insurance contract, and may not understand them if they did. Commissioners also
provide the valuable service of ensuring that insurance agents understand the contracts they
wish to sell to the public, as well as the applicable laws of the state, by requiring the successful
completion of examinations before licensing, and by requiring minimal levels of continuing
education thereafter. All state insurance regulatory bodies also offer assistance to people in
resolving disputes with insurers and insurance agents, as well as consumer information such as
educational brochures and websites.

Legal Aspects and Principles of Insurance

The transfer of risk from an individual to the insurer is accomplished by a contract between the
two parties. A contract is a binding agreement that is enforceable by the courts. Much of the
law that has influenced the insurance industry derives from the general law of contracts. But the
many unique aspects of the insurance transaction have necessitated modifications of the general
law to address the specific needs of the insurance industry.

Insurance policies, like all contracts, must contain certain elements to be legally binding, as most
of you have probably already learned in your business law courses:

Offer and acceptance

Consideration
Legal object
Competent parties
Legal form

Offer and Acceptance For a contract to be legally enforceable, a definite, unqualified offer must
be made by one party, and the other party must accept this offer in its exact terms. In insurance
contracts, the offer is usually made by an individual when applying for insurance. The
acceptance takes place when the agent binds coverage or when the policy is issued. In general,
most insurance contracts are written rather than oral. An oral contract may be just as binding on
both parties as a written one, but the difficulty of proof makes it advisable to use written
agreements. Often, however, due to convenience or expedience, insurance customers request
property and liability coverage from an insurance agent orally, in person or on the phone;
coverage in this case would begin immediately, assuming the absence of legally contestable
issues, and if a loss occurs before a written agreement is issued, the insurer would be liable for
the loss.

Consideration Another necessary contract element is consideration, which is the value that each
party gives to the other. The considerations of the insurance company are the promises within
the insurance contract, such as the promise to pay in the event a loss should occur. The
consideration of the insured is the payment of, or the promise to pay, the premium plus an
agreement to honor the conditions of the contract. The promise to pay the premium is normally
sufficient consideration for a legally binding contract in property and liability insurance. In life
insurance, however, the convention has evolved that the first premium must be paid before the
contract will take effect. (i.e. the first payment is regarded as consideration).

Legal Object A contract must be legal in purpose. A common example of an insurance contract
lacking a legal object is one in which an insurable interest does not exist, and which the courts
generally will refuse to enforce. For example, if stolen goods are insured by the thief, insurance
recovery on the goods by the thief would not be enforceable.

Competent Parties The parties in an agreement must be capable of entering into a contract for it
to be legally binding. In most cases the rules of competency are associated with minors and the
mentally incompetent. The basic principle is that some parties are not capable of understanding
the contract entered into, therefore the courts have ruled that they are as a consequence not
bound to them. The general legal rule is that the contract is voidable at the option of the minor.
If, for example a 14 year old minor purchased automobile insurance for a period of a year, and
just before the expiration of the policy, repudiates the contract, the minor could demand and
receive a return of premium despite having had the protection while the contract was in
existence.

Legal Form In many cases the form and content of a contract are governed by state law. In
some cases, a standard policy form may be required, and in other cases, the state may prescribe
mandatory provisions for particular types of policies. In addition to the use of standard contracts
and provisions, states require that all types of policies be filed with, and approved by, the state
regulatory authorities before the policy may be sold in the state. (i.e. to ensure policy
compliance with the law and to protect policyholders from crooked insurance companies).

Void and Voidable A contract that is void is not a contract, but is instead an agreement without
legal effect. It lacks one or more of the requirements specified by law for a valid contract. A
void contract cannot be enforced by either party. For example, a contract having an illegal
object is void, and neither of the parties to the contract can enforce it. A voidable contract,
however, is an agreement that may be set aside at the discretion of one of the parties; that is,
the contract is binding unless the party with the right to void it wishes to do so. For example, if
the insured has failed to comply with a condition of the agreement, the insurance company may
elect to fulfill its agreement in the contract or to avoid it and revoke coverage. Alternatively, if a
15 year old minor buys life insurance, the contract would be binding on the insurer, but in most
cases would be voidable at the option of the insured minor. Contracts may be voidable for a
number of other legal reasons such as duress or fraud.

Legal Principles Unique to Insurance

Indemnity In many forms of insurance, particularly in property and liability insurance, the
contract is based upon the concept of indemnity. The principle of indemnity asserts that the
individual should not be allowed to profit from the existence of an insurance contract but should
only be restored to the same financial condition that existed prior to the occurrence of the loss.
The indemnity principle is enforced through legal doctrines and insurance policy provisions
designed to limit the amount the insured can collect to the amount of the loss.

The most important legal doctrine giving substance and support to the indemnity principle is
insurable interest. For property insurance, an insurable interest generally exists only if the
insured would suffer a financial loss in the event of damage to, or destruction of, the property,
such as a dwelling or an automobile that he/she owned, but it may also exist when an asset has
been pledged as security for a loan, as in the case of a mortgage. The doctrine of insurable
interest was developed to ensure that insurance would not be used for wagering purposes and to
lessen the chances of moral hazard. (Example: ‘A’ purchases insurance on ‘B’s’ home to collect
if B’s home is damaged or destroyed, because ‘A’ intends to commit the crime.).

The insurable interest doctrine is used in life insurance to control wagering with human lives, and
to reduce the threat of murder, just as it is used in property insurance to reduce the threat of
intentional destruction of property. Restricting the people who can legally insure the life of
another to those who are closely related to the insured, or who have a financial relationship to
the insured such that they stand to gain more by in the insured’s continued life than by death,
greatly reduces the temptation to murder of the insured. An individual who takes out a policy on
himself/herself has an unlimited insurable interest in his or her own life, but in general, members
of the person’s immediate family may also have an insurable interest in his or her life because a
sentimental interest or one based upon love or affection is usually sufficient to satisfy the
requirement for insurable interest even though a financial loss would not necessarily be involved.
Remote kinships such as cousins are generally rejected by the courts as insurable interests. In
business relationships, insurable interest is often justifiable for “key person” life insurance
(officers, key management), with the corporation named as beneficiary, but for other employees,
the issue is less certain and varies by circumstances and by state.

The requirement of insurable interest originated in 18th century English statutes (1774) which
sought to limit the use of life and marine insurance for gambling purposes. In the United States,
the courts first adopted the principle, but were soon followed by statutes at the state level. For
life insurance, an insurable interest is generally required only at the inception of the policy, not
when death occurs. (Example: A creditor who purchases a life insurance policy on the debtor
may legally continue to carry the policy after the debt has been paid.) In contrast, for property
insurance, an insurable interest at the time of loss is usually sufficient.

Another doctrine used to support the principle of indemnity is the concept of actual cash value,
commonly used in property and liability contracts, which means that the amount one may
recover in an insurance claim is limited to the amount of the actual loss, up to the limit of the
face value of the policy. Without this doctrine, over-insurance would be common and result in
willful destruction of property, which would also thwart accurate estimates of losses by insurance
companies. Both results are socially and economically undesirable. Actual cash value is
frequently defined as “replacement cost less depreciation” (Example: Original cost of your
computer, which was recently stolen from your apartment, cost $1,500 when purchased four
years ago, but replacement cost today is $2,000 due to inflation. If the stolen computer is
judged to be 50% depreciated, the insurer will pay $1,000 for the loss.) Many property and
insurance companies also offer “replacement cost” provisions, not subject to the depreciation
deduction, provided that the insured maintains coverage equal to the full undepreciated value of
the property.

In business interruption and in rent insurance, the measure of financial loss is the insured’s loss
of income that arises because of inability to use and occupy the premises because of physical
damage to the property. In liability insurance, the measure of financial loss is the amount of
damages the insured is obligated to pay a third party when the negligence of the insured causes
injuries to the third party. But regardless of the method used in measuring the loss, the
indemnity principle still apply. The insurance company will pay only if a loss has occurred and
only to the extent of the financial loss of the insured, not to exceed the limits of the coverage
purchased.

The principle of indemnity has limited application in life insurance. In life insurance the
insurance company contracts to pay a stated sum of money in the event of death without
reference to the amount of financial loss. These policies are referred to as cash payment
policies. This principle is universally applied in life insurance.

Most insurance contracts, other than life, contain some clause relating to coverage by other
insurance primarily to prevent the insured from collecting for the same loss under two policies
and profiting from duplicate coverage.

Another contractual provision designed to prevent the insured from making a profit is the
subrogation clause, which gives the insurance company the right to pursue and collect damages
from a third party whose negligence caused losses to the insured, who subsequently recovered
damages from his/her insurance company. If the right of subrogation did not exist, the insured
could collect twice for the loss, once from the insurance company and again from the negligent
party. The doctrine of subrogation applies in property and liability insurance, but not in life
insurance. For example, the survivors of a person who is killed by a negligent driver can collect
the life insurance proceeds of the deceased and sue/recover damages from the negligent driver.
The insurance company has no right to reimbursement from the negligent party, because life
insurance policies are not contracts of indemnity. This is also generally true of disability
insurance policies.

Other Characteristics of Insurance Contracts

Insurance is a personal contract. Although insurance coverage may apply to property, the risk
is transferred to the company from an individual. If a property owner sells his/her insured
property and assigns the existing insurance policy on the property to a new owner, the insurance
policy usually becomes void and is not binding in favor of the new property owner without the
prior written consent of the insurer. Life insurance policies, however, are generally freely
assignable without permission from the insurer. The difference in application of the assignment
rules in life insurance vs. property and liability insurance is largely due to the following widely
held insurance industry and legal theories that have evolved over time: assignment of a life
insurance policy is a mere change of the ownership of the contract, with no alteration of the
nature of the risk to the insurer; assignment of a property insurance policy, however, could result
in a significantly higher risk to the insurance company. (Example: an adult transfers an
automobile insurance policy to a teenage boy who bought the car from the adult.)

Insurance is a unilateral contract because only one party (insurance company) is legally bound
to do anything; however, the insurance contract is also conditional, meaning that the insured
may not be legally obliged to honor the conditions of the contract, but not doing so may bar the
insured from collecting in the event of a loss.

Insurance is a contract of adhesion, a standardized contract prepared by the insurance

company; therefore the insured must accept the contract as “take-it-or-leave-it”, since the terms
of the policy are not negotiable. Correspondingly, the courts have generally held that any
ambiguity in the contract should be interpreted in favor of the insured.

Insurance is a contract of utmost good faith, which requires that the applicant for insurance
make full and fair disclosure of the risk to the agent and the company. The application is part of
the insurance contract, and is usually attached to it. If the insured fails to inform the insurer of
any facts that would influence the issue of the policy or the rate at which it would be issued, the
insurer may have grounds for voiding coverage.

Representations are answers to certain questions that are given by the applicant for insurance.
If an applicant for life insurance makes a false statement that he has never has tuberculosis, this
is a misrepresentation and may provide grounds for the insurer’s avoidance of the contract
later on. Voidance by misrepresentation is generally only valid if it involves a “material fact”,
which is information, had it been known, which would have caused the insurance company to
reject the application or issue the policy on substantially different terms.

Concealment is another element of the principle of utmost good faith. Since insurance
companies cannot be expected to inquire about everything that may be material to the subject
matter of the insurance, the insured is obliged to disclose important and material facts within
the scope of his/her knowledge. (Example: An applicant for homeowner’s insurance is signing a
policy on his house knowing that the house to be insured is currently burning down.)

Insurance Policy Structure

Insurance policies generally contain four parts:
Declarations: Statements made by the insured and other information (property location
insured, name of policyholder, and other information relating to the person/property insured)
Insuring Agreements: Promises to pay for losses that fall within the scope of the insuring
agreement, which may be narrow and specific or broad and comprehensive.
Exclusions: Statements about what losses are not covered by the insurance company.
Conditions: Details of the duties and rights of both parties, usually in standard language.