According to the United States Constitution which recognized that the free flow of commerce between states would be jeopardized by trade barriers between the various states, gave Congress the power to regulate commerce between the states and with foreign governments. The power to regulate commerce within the states (intrastate) was reserved for the states. However, no state can exercise authority over an area designated as being under the jurisdiction of the federal government. Insurance has traditionally been regulated by the states.
In 1869, in a case (Paul v. Virginia), the U.S. Supreme Court did not agree that an insurance policy is an item of commerce. Also, they stated that a state has the authority to prohibit foreign insurance companies from doing business with the state. They stated, “Issuing a policy of insurance is not a transaction of commerce.” They looked upon insurance policies as any other contract between persons which are not interstate commerce, even if the people resided in different states. They ruled that insurance companies are governed by state law and do not “constitute a part of the commerce between the states.”
Up until 1944, the accepted practice was for insurance to be regulated solely by the states. However, the U.S. Supreme Court ruled in the famous “South-Eastern Underwriters case (United States v. South-Eastern Underwriters Association, et al.) that insurance was indeed “commerce” and therefore could be regulated by the Federal government. This opened up the insurance industry to regulation by states and/or federal laws, including those already enacted that could be applied to insurance.
The Congress quickly recognized that there must be some order in the regulatory process, so in 1945 they enacted the McCarran-Ferguson Act which revisited the authority of the states and which provided a plan for cooperation in regulations between the federal and state government. This act allowed the federal government to retain control, either solely or primary, of certain matters that they determined was national in character, such as the National Labor Relations Act, the Civil Rights Act, the Fair Labor Act, and the Sherman Act, to name a few.
Furthermore, (and a very important “furthermore”) Congress was allowed to expand their regulation of insurance by passing specific legislation which would apply directly to insurance. Since that time, other legislation provided some insurance elements to be under federal regulations, such as amending the Securities and Exchange Act in 1964 to cover insurance, and other regulations concerning flood insurance, crop insurance, and more recently, Medicare.
Actually, the principal purpose of this act was to encourage more and better (and uniform) state regulations or insurance. This was done by the law stating that certain federal laws which are general in nature (i.e. do not specifically apply to insurance) are made “specific” to the business of insurance to the extent that “such business is not regulated by state laws.”
Following the enactment of the McCarran-Ferguson Act, the National Association of Insurance Commissioners (NAIC) with the readily-available assistance of the insurance industry, created “Model” legislation. This was politically important for the states to have more uniform and easily-understood regulations, but in actuality, it was to reinforce the “provision” of the McCarran-Ferguson Act as stated above.
Today, the states still maintain primary responsibility for regulating insurance within their states, but the adequacy of state regulation comes under almost continual scrutiny. In 1965, the Health Insurance Association of America, at their annual convention, felt that their very existence had been assaulted by the introduction of the federal program, Medicare, but they had to grudgingly admit that since they had not been successful in providing health insurance to the senior citizen population at affordable costs, it must be expected that Uncle Sam would step in. (Even though the Medicare regulations allowed insurers to offer “Supplemental” policies, the federal government felt that they had to step in again and a later date, and create uniform Medicare Supplemental policies and affected regulations which bound all insurance departments and insurance companies to abide by a strict uniformity.)
There are many arguments for or against state or federal regulation of the insurance industry.
Some of the arguments that favor state regulation are: there are already state regulations, states can be more responsive to local requirements and needs, the decentralization of government should always be a goal of industry, etc.
Some of the arguments in favor of federal regulation are: it is expensive for insurers (costs are passed to the policyowners) to have to file reports with various states, and abide by different (and sometimes, opposing) regulations, insurance commissioners are often overly responsive to requests by local insurance companies, federal regulations would eliminate conflicts between state regulations, many companies now have foreign ownership or interests and states cannot deal with foreign governments on an efficient basis, etc.
The federal government exercises its authority in an unusual fashion. Periodically and depending upon the political climate, Congress will hold hearings and otherwise “investigate” the insurance industry on matters of recent interest. By doing this, the federal government is sending a message to the states that the problems investigated, either real or imagined, need regulation by the states or the federal government will step in and fulfill (what they consider) their responsibilities.
Of course the Internal Revenue Service exercises considerable authority over insurance companies and insurance products and their design and values through tax laws and regulations. In addition, the IRS also influences the demand for insurance and the taxation of the insurance companies.
The Employee Retirement Income Security Act (ERISA) of 1974 probably has had more influence on insurance products and marketing than any other specific federal involvement in the insurance industry. ERISA was passed in 1974 and was originally designed to protect pension-plan funds against raids by unscrupulous labor leaders. It promulgated regulations that safeguards retirement funds, but it also included a clause which preempted any state laws from regulating certain employee benefit programs, including health insurance. This act is considered by many as an unwarranted intrusion of the Federal Government into the business of insurance.
The Securities and Exchange Commission oversees the design, operation and the marketing of variable life and annuity products. Insurance companies that are publicly owned must file with the SEC, and the sale and issuing of stock of these companies are very much under the direction of the SEC.
One of the most severe critics of the life insurance industry in recent years, has been the Federal Trade Commission (FTC) and unfortunately, it exercises various degrees of supervision over insurance activities. It still is involved in the oversight of direct-mail insurance solicitations. In the 1970’s, it was very much involved in congressional hearings in life insurance and marketing disclosures. In 1979 the FTC investigated life insurance marketing and issued a controversial report that included detailed recommendations as how to solve the reported consumer problems. This report was strongly contested by the insurance industry and the FTC has been rather quiet on this front in recent years, especially since the enactment of the NAIC Model Unfair Trade Practices Act (see discussion of NAIC Model bills later in this text).
Other federal agencies become involved with the insurance industry when insurers work with foreign insurers. NAFTA, for instance, provides that there shall be (relatively) free access between the insurance markets of the U.S., Canada and Mexico, and it prohibits discrimination between domestic and foreign insurers of those countries.
The federal government also becomes involved in the insurance business through the Bank Holding Company Act which determines and controls the extent that banks can become involved in the insurance business. There was, and still is, considerable concern in the insurance industry as to the competition that could arise if banks have more authority to enter the insurance business. Banks and financial institutions have not only names of their customers, but personal financial information not available to others, that would give a tremendous advantage to banks. Regulators are very much aware of this. However, as a practical matter, bankers have been notoriously incapable of marketing effectively – an area of expertise held by insurance companies – so many experts believe that the threat of financial institutions, particularly banks, is not as strong as it may appear to be. Be that as it may, banks have done a respectable job in marketing certain annuities and as insurance companies become more aggressive in financial products areas, the differences between financial institutions and insurance companies will diminish.
State legislatures issue laws pertaining to the regulation of insurance companies within their jurisdiction, such laws called insurance codes. These laws involving state regulation are described in more detail below, but basically they cover the make-up of the insurance department, licensing of companies and agencies, the filing and approval of insurance forms and rates, and many other areas involving the financial strength of the domestic companies.
The state courts are very involved in insurance, as they are usually the final arbiters of conflicts between insurance companies and their policyowners. Not only do they punish those who violate the insurance laws, but they are used by insurers and agents on occasion to overturn certain statutes or regulations that may be arbitrary or unconstitutional.
Within each state, there is a Department of Insurance that is under the direction of the state Insurance Commissioner. The Insurance Commissioners are usually appointed by the Governor, but in a dozen states, they are elected. In some states, they have additional responsibilities, such as state auditor or fire marshal, or the department is associated with other departments such as banking or securities. The control of the insurance industry in the state is accomplished through the issue of licenses – from the selling agent to the insurance company. Through licensing, they also control the activities of those foreign companies who are not under the direct control of the state regulatory bodies.
The NAIC is an association of the Insurance Commissioners of the states and U.S. possessions (American Samoa, Guam, Puerto Rico and Virgin Islands). Their stated purposes are to maintain and improve state regulations, ensure reliability of insurers as to financial solidity and financial guaranty, and the “fair, just and equitable” treatment of policyowners and claimants.
This Association is comprised of a number of committees which are broken down by line of business, i.e. life, health, property/liability. These committees depend heavily upon the advice, expertise and knowledge of those in the insurance industry and many insurance executives and technicians belong to various advisory groups. Of course, consumer groups criticize this format by insisting that the regulators are “in the hip pockets” of the insurance companies.
One of the most important decisions of the NAIC has been the introduction of “Model” regulations, which are bills and regulations agreed upon by the NAIC members as being worthy of consideration by all states. The models have no particular authority, but the NAIC just suggests that the various states adopt the models. In most cases the majority of the states do adopt the models either in their entirety or with modest changes to reflect the individual states political atmosphere.
The NAIC, as a matter of self-preservation, has accomplished considerable standardization of forms and solvency requirements. They also created scheduled and unscheduled insurance company examinations by teams of auditors assigned to the particular zone in which they are located. These examinations have uncovered many situations that could have cost policyowners and stockholders of insurance companies dearly. Most possible insolvencies of insurers have been discovered through this examination procedure.
The NAIC does a creditable job in policing itself through a method of state accreditation. In fact, those states which are “accredited” do not accept examination reports from states that are not accredited on examination of their domestic insurers and the companies that are domiciled in states that are not accredited, must obtain a second examination from an accredited state. Since the insurance companies pay for their examinations (and which can become quite expensive) this creates considerable pressure on the insurance department to become accredited. This system of accreditation has been subjected to a lot of criticism, but the NAIC insists that any such criticisms are either premature or unfounded – and after all, the opinion of the NAIC is the only one that counts.
The principal purpose of state regulation is that of solvency of insurance companies. There are limits as to the size of risks that insurers can assume, and there are specific requirements for capital and surplus amounts for insurers, reserve liabilities on policies, and regulation of the investments of the insurance companies. The state insurance department also is responsible for the liquidation or conservation of insurance companies that operate within their jurisdiction. Thanks to this responsibility, financial losses to policyowners because of failure of insurance companies in the United States have been miniscule.
State insurance laws dictate the requirements for organizing and licensing of insurance companies, and life insurance companies have their own special requirements. It is interesting that health insurance can be written by a life insurance company, a health insurance-only (monoline) company, or a casualty company, and a new health insurer can be organized under the laws governing the organization of life or casualty insurance companies.
There are three different types of insurers regulated by the insurance departments: (1) A domestic insurer is domiciled in the regulated state; (2) a foreign insurer is an insurance company which is domiciled in another state or territory; and (3) an alien insurer is an insurance company which is domiciled in another country. The licensing requirements for the various types of companies are similar, as they are all required to maintain specified assets within the regulated state. A foreign insurer often places assets in deposit with the insurance department of their state of domicile, and a certificate to this effect is given to the department of the regulated state. An alien insurer, on the other hand, is usually required to establish a more substantial fund or deposit in trust in the regulated state. They must also assign a resident of the state in which it wishes to do business, to serve as its attorney in case of legal matters or legal process.
There is a continuing perplexing problem for insurance department, involving the activities of unauthorized insurers. Since they do not file financial statements with the department of insurance, and since their business is usually conducted through the mail or more recently, over the internet, the insurer attempts to escape regulation. However, the states may take certain actions, some of which involve insurance agents.
States require that policy forms may not be used within their jurisdiction until it has been filed and subsequently approved by the regulating state. The states make their requirements known and in most cases they contain some “model” provisions, such as grace period, incontestability, entire contract, misstatement of age, dividends, surrender values and options, policy loans, settlement options and reinstatement. There are certain standards that must be met, such as that the policy forms must not be ambiguous or misleading, or encourage misrepresentation. Some states follow the model law that states that policy forms may be disapproved if benefits are unreasonable in relation to the premium for the policy.
Some states, in addition to state laws, issue administrative bulletins or guidelines, which, to all practical purposes, assume the legality of insurance codes, although they deal generally with administrative matters primarily.
Even though the model law requires some relationship between premiums and risk, as mentioned above, life insurance premiums are not regulated except that states establish minimum reserve requirements which would therefore affect the rates as the insurer would need to receive adequate premiums in order to have funds to post the required reserves. Also, insurance companies file annual reports which provide the department with the administrative costs of the insurer. New York and Wisconsin have very complex and demanding laws limiting the amount of expenses that can be incurred in insurance production, thereby limiting commissions on certain products and expenses on existing business.
Some states also limit the amount of dividends that may be declared, particularly by a stock insurer. Most states simply believe, and it have been proven correct, that competition is the most important regulator of insurance premiums.
No person can act as an agent or broker, and in some cases, fee-paid counselors, without first obtaining an insurance license. Requirements for licensing differ by state, but in general, there must be successful completion of a written examination for the particular license. Each agent must be appointed by an insurance company, who notifies the department of insurance as to the persons appointed by them.
An insurance license can be refused or revoked, or suspended, by the insurance department (after notice has been served and a hearing held) because of
Because of the South-Eastern Underwriters Act and the McCarran-Ferguson Act, all of the states adopted the NAIC Model Unfair Trade Practices Act. It should be noted that this Act was so thorough that it replaced the FTC jurisdiction in these matters, as mentioned earlier. This act gives the Insurance Commissioner power to investigate &/or examine companies, hold hearings on the companies transgressions, and issue cease-and-desist orders with penalties for violations.
Rebating is one of the actions addressed by this Act, and which is defined as an agent returning any portion of his commission as an inducement for an applicant to purchase insurance from him. Historically, it has been illegal, however there are those critics who feel that these laws preventing rebating prevents purchasers of insurance from negotiating with the sellers of insurance completely. Florida and California do now allow rebating, but with very strict guidelines, and with provisions that there is no unfair discrimination in the granting of rebates, i.e., an agent cannot “pick-and-chose” when and to whom they may offer rebates.
Twisting, which is where an agent or broker attempts to persuade a life insurance policyowner to cancel one policy and buy a new one by using misrepresentations, is obviously illegal and can cause an agent to quickly lose their license. Replacement, on the other hand, is legal, and is simply replacing one policy with another. Most states have laws that require full disclosure of relevant comparative information about existing and proposed policies by an agent trying to convince a customer to switch policies. These laws may provide for notification of the insurance company that issued the existing policy to give it an opportunity to respond to the agent’s proposal. States are quite specific about what information must be disclosed when one policy is discontinued so that another policy may be substituted.
Agents are also tightly regulated in respect to handling of funds that belong to policyowners, Misappropriation of funds or misusing funds, is illegal, even on a temporary basis. Also, agents are not allowed to commingle funds, or combine money belonging to policyowners with their own funds. Agents that handle large sums of money in their business are well advised to make sure that under no circumstances, do any funds that belong to the policyowners find their way into an account holding an agent’s personal funds.
Another model act is the NAIC’s Model Life Insurance Advertising Regulation and it has been quite widely accepted in regulating the advertising of life insurance. This regulation governs the form and the content of advertisements, including minimum disclosure requirements, and it provides for enforcement procedures by the insurance departments.
Every state requires that a financial statement be filed with the insurance department in each state in which the company is authorized to do business. These financial statements (called “blue books” for life insurance companies as their binders are traditionally blue, while those of non-life companies are other colors) are filed at least annually, and may be required to file more frequently if the insurance department requires it for solvency matters.
Insurance departments distinguish insurance company funds as either Capital & Surplus, or Reserve investments. Capital & Surplus funds can be invested in certain types of investments, such as cash, government bonds and mortgages. The Reserve funds may be invested in other capital investments. No company may make any investments without approval of the Board of Directors, or a committee authorized by the Board to make such investments with appropriate minutes for review by the Board.
Valuation of these assets held by the insurance company is a very complicated and detailed procedure, and the valuations are performed according to the Securities Valuation Office of the NAIC. Some states require that a certain amount of assets be allowed to be invested in certain types of funds or assets, and some simply allow the company to invest according to a prudent-person rule. For instance, in New York, an insurer may hold up to 10 percent of its assets in a Canadian investment, but no more than 3 percent in securities from any other company.
F The Prospective Reserve is the amount designated as a future liability for life (or health) insurance to meet the difference between future benefits and future premiums.
To further illustrate, a Net Level Premium is determined so that this basic relationship holds: the present value of a future premium equals the present value of a future benefit. This relationship exists only at the time that the policy is issued, and afterwards, the value of future premiums is less than the value of future benefits because fewer premiums are left to be paid. Therefore, a reserve must be maintained at all times to make up this difference. Life insurers are required to establish minimum reserves as established by an attested to by an actuary under state guidelines, as a liability.
The actuary of the insurance company must file a report wherein results of certain cash-flow testing results are required. This report, along with a required annual CPA report, allows insurance departments to receive a good financial overview of each insurer in their jurisdiction.
The insurance departments use the NAIC’s Insurance Regulatory Information System (IRIS) as an early warning measure if an insurance company is heading towards financial difficulty. This is a 2-pronged attack, as the financial reports of the company are analyzed according to pre-determined guidelines and minimums. Then auditors from various insurance departments, analyze the annual statements and other financial information. This information is given to the insurance department of the state of domicile for future action.
The state insurance departments can address any problems in their state of a potentially fraudulent nature and take action through administrative sanctions and/or civil actions, such as cease-and-desist actions, license suspension or revocation, or injunctions. The insurance departments have a special activities database which allows the states to exchange information as to the activities of insurance companies and personnel.
Every state has some type of guaranty law that gets its funding from assessments against (solvent) insurers that operate in their state. The NAIC Model Guaranty Association Act of 1985 (and amended several times) differs from state-to-state application. Generally, the association is under the supervision of the Insurance Commissioner, and the act covers policyowners who are residents of the state where the insurance company is determined to be insolvent or impaired. Beneficiaries of the insurance are covered, regardless of where they reside.
A maximum of $300,000 in life insurance death benefits will be paid, but not more than $100,000 in net cash surrender values. For annuity cash values and payments (including tax-qualified annuities and structured settlements) coverage is limited to $100,000. (NOTE: This the same amount that is protected by the FDIC on CD’s and bank accounts.) If the insurer fails, the guaranty association will protect the account up to this amount. Regardless, one is hard pressed to recall an instance of an annuity holder losing other than anticipated interest growth, as the principal was always maintained. As a note of interest, health insurance maximum payments are $500,000 for medical expenses covered, $300,000 for disability income, and $100,000 for all other health insurance coverages.
NOTE: These limits apply to an individual insured and not on a per-policy basis. If an annuitant had 2 or more annuities with an insurer, the maximum amount of $100,000 would apply, regardless of how much cash value an insured would otherwise receive.
The guaranty association funds have weaknesses, and coverage is not uniform among the states. There always exists the hazard of a large insolvency where the assessments of all of the companies in the state might not meet the requirements of the association.
Life and Health insurance companies in the United States are taxed by the federal and state governments. The states subject insurers to premium taxes which is simple in administering usually as the premiums received from the policyowners are taxed, with certain exceptions, such as dividends and assumed reinsurance. Certain health insurers are typically exempt from state taxation, such as Blue Cross and Blue Shield in some states, however this is changing and most of them are now being taxed as any other health insurer.
Many consider the state premium tax to be one of the most unfair taxes levied on U.S. citizens, with very good reasons.
States also levy various forms of taxes, such as income taxes (9 states, but 8 of these states allow offset of premium and income tax). There are also Retaliation Laws that taxes out-of-state insurers operating in its jurisdiction in the same way that the state’s own insurance companies are taxed in the second state. (For example, one state (#1) charges 4% premium taxes on its domiciles insurers. However, if these insurers are charged a higher tax when operating in another state (#2), then state #1 will charge the higher tax to insurers of state #2 who wish to do business in state #1)
Life insurance companies in the United States are taxed under the Deficit Reduction Act of 1984 and they are taxed on their life insurance taxable income (LICTI), which is the gross income less certain deductions, similar to any other corporations, but with certain differences.
For tax purposes, “gross income” of a life insurance company is divided into 5 categories:
The Internal Revenue considers as income all premiums and considerations received on insurance (or annuity) policies, which include any fees (such as policy fees), deposits, assessments, prepaid premiums, reinsurance premiums and the amount of any policyowner dividends reimbursable to the insurer by a reinsurer. (Reinsurance premiums and reimbursed dividends by a reinsurer are considered to have been taxed previously. If an insurance company must pay premium tax on business that has been reinsured under certain treaties, the usual practice is for the reinsurer to reimburse this amount to the ceding company.) Premiums or deposits on supplemental contracts and similar sources of premium are considered as gross income. This category of gross income is about 60 to 80% of taxable assets of an insurer.
Life insurance companies are allowed three types of deductions:
Life insurers are allowed the same deductions as general corporations (expenses of operations, benefit plans, etc., etc.). Those expenses that are peculiar to the life insurance business, which, simply put, are deductions for all claims, benefits and losses incurred on insurance and annuity contracts. In addition, there are deductions allowed for certain insurance reserves, such as policy reserves, unearned premium reserves, unpaid loss reserves, advance premium and other similar reserves. Policyowner dividends are another deduction, subject to strict rules.
The small company deduction is a deduction (created for political purposes) that was created to stimulate and to assist new and small businesses. This deduction is a maximum of 60% of the LICTI not to exceed $3 million, or a maximum deduction of $1.8 million (60% of $3 million).
For many years, mutual insurance companies had a distinct tax advantage over stock companies. Mutual companies often charge higher premiums than stock companies, and then return the excess amount to the policyowner in “dividends.” However, also included in these dividends are distributions of investment and underwriting earnings of the mutual company (don’t forget that a mutual policyowner is effectively an owner of the business also). Many believed, particularly stock insurers, that these earnings should not be excluded from corporate income taxation. After all, dividends payable to stockholders are not deductible by corporations.
Congress did finally assess the situation when it was attempting to determine the amount of taxation from insurance companies for budgetary purposes, and they discovered that with a 100% policyowner dividend deduction, a mutual insurer may have paid little or no tax. Conversely, however, if they did not allow any deductions, then the legitimate payments to policyowners (as customers, not owners) and which should be deductible under general tax laws, would therefore be denied to mutuals, which meant overtaxing those companies.
In order to solve this dilemma, it was determined that the dividend deduction of mutual companies would be limited. The machinations of this deduction is beyond the scope of this text, but in effect it equalized the taxation with that of the stock companies by a procedure which actually taxes mutual company’s surplus.
The acquisition of life insurance and the accounting and taxation of acquisition costs, have always been problematic. In 1990, the Revenue Reconciliation Act created the deferred acquisition tax (DAC) provision. While complicated, the theory behind it was that certain first year (or early years) expenses peculiar to insurance companies, such as commissions, issue and underwriting expenses, etc., should be amortized in order to better match deductions with revenues.
At this point, it should be pointed out that for many years, life insurance companies had to provide financial statements under two types of accounting: (1) Statutory accounting as required by the Department of Insurance and which concentrated more on solvency than other financial matters, and (2) Generally Accepted Accounting Principles (GAAP) which uses the same accounting principles as with any other type of business, and which was necessary for non-insurance financial reporting. The principal difference between the two was the accounting for acquisition expenses.
Since under Statutory accounting, high “front-end” acquisition costs were considered as an immediate expense (this is a simplistic explanation) it was frequently necessary for those smaller insurance companies who experienced rapid growth, to enter into financial reinsurance arrangements with larger reinsurance companies who assumed the drain on the surplus created by these first-year expenses. In essence this was a method of “borrowing” money to pay these expenses, which would be repaid as profits emerged from the block of reinsured business, along with interest. This puts the smaller companies at a disadvantage as their profits would be reduced by the cost of reinsurance, which would otherwise not have been necessary.
Without going into more detail – and there is considerable detail involved – the DAC provision of this act created capitalization under GAAP and it specified, by formula, the amount of the insurer’s general deductions.
Guess what? The DAC tax substantially raised the life insurance industry’s federal income tax. (Surprise, surprise) Of course the life insurers had to make up for this unexpected and unwelcome added tax by lowering interest rate credits, dividends and other non-guaranteed benefits. Of course, it “solved” the difference problem between GAAP and Statutory accounting.
Life insurance companies are usually classified as stock or mutual, although there are some well-known exceptions, such as the Blue Cross-Blue Shield organizations, fraternals, savings banks and government plans. A stock insurance company is a corporation owned by its stockholders, whereas a mutual insurance company is owned by its policyowners. Worldwide there are more mutual companies, however in the U.S. there are approximately 1500 stock insurers, and only 100 mutuals (this number has to be approximated as there is a lot of activity in company consolidations, purchases and re-structuring).
A stock company can be owned by other stock life insurance companies, by mutual insurance companies, or by non-insurance companies. A mutual company, on the other hand, is owned by policyowners and cannot be owned by anyone else. Both are organized as corporations as that is the only type of legal organization that provides permanence and a high degree of security in respect to the payment of claims.
A stock company is organized for the purpose of making profits for its stockholders, and traditionally, issue non-participating and guaranteed-cost insurance policies, and the policyowners do not share in the profits or savings of the company. Stock insurers also issue participating policies, so the difference between mutuals and stock insurers is not as distinct as originally when stock companies could not offer participating plans.
Under a stock ownership corporation, a life insurance company must have a minimum of capital and surplus to operate before it can obtain a certificate of authority to operate as a life insurer. During the late 1950’s and early 1960’s, many new insurance companies were formed and the capital and surplus requirements were quite modest, depending upon the state and the type of insurance to be marketed. After stock was sold in the company and the company obtained its certificate, the stockholders were the prime source of new business, with many of the new companies issuing a “special” policy which allowed the policyowner to share in a company profit “as declared by the Board of Directors,” typically. Due to misrepresentation and the great number of mergers and acquisitions among the “special policy” companies, the states enacted strict regulations and today, such formation and issuance of “special” policies is of interest only as history.
A mutual company is also a corporation but generally has no capital stock or stockholders, as the policyowner is both a customer and (in a limited sense) an owner of the company. The assets and income of a mutual insurance company is owned by the company and policyowners are generally considered to be “contractual” creditors that has the right to vote for the Board of Directors. In practice, a mutual insurer is administered and assets are held for the benefit and protection of the policyowners and beneficiaries, and the assets are held as insurance reserves, surplus, contingency funds, or dividends that are distributed to the policyowners as the Board of Directors deem appropriate.
Mutual companies can, and do, issue non-participating policies, in which case the policyowners are considered only as customers, as in a stock company.
It is difficult to form a mutual company, as funds must be available to cover the expenses of operation, make the proper deposits with the insurance department(s), plus a surplus and contingency fund, and this must be done before the insurer is able to collect such funds from its operations. As an example, in New York state, a new mutual must have applications for not less than $1,000 each, from 1,000 persons, plus the full amount of one annual premium for an aggregate amount of $25,000 – plus a cash surplus of $150,000. Obviously, it is not easy to find 1,000 people willing to put up an annual premium in a company that has not as yet in operation, and there is the possibility that the company may never get into operation. Therefore, there has been no formation of a mutual company for several years, and in all likelihood, there will not be any new mutual companies formed.
Holding companies are financial corporations that own or control (one or more) insurance companies, investment corporations, broker-dealer organizations, consumer finance or other financial service firms. Some stock insurers are owned by conglomerates who are non-financial holding companies that have ownership or control of several companies in unrelated fields.
A holding company formed by a stock insurer (or more than one stock insurer) is called an upstream holding company because the holding company sits at the “top” of the organization, as it is owned by the stockholders, and it can, and usually does, own subsidiaries. Conversely, a downstream holding company is usually owned by a mutual company, and the holding company sits in the middle of the corporate structure. It is owned by the mutual company that sits at the top and owns the subsidiaries.
Insurance departments prefer the downstream type, as with an insurer (usually the parent mutual company) at the top of the corporate structure, it is regulated by the insurance departments and therefore presents few problems to insurance regulators. However, if the downstream holding company is “viable”, i.e., makes financial sense, the mutual company must be in a very strong position financially in order for the holding company to make acquisitions. In addition, there are strong regulations regarding the amount an insurer (stock or mutual) can invest in subsidiaries. Practically, however, a mutual insurer is limited to making offers for acquisitions only in cash – an expensive way of acquiring other companies.
Some states have just recently changed their laws to allow a mutual company to form a mutual holding company with an active stock subsidiary. The stock of the subsidiary is held by the mutual company. This way, a mutual insurer can make acquisitions and mergers through the stock subsidiary.
Recently, there have been many mutual companies that have “de-mutualized” primarily in order to obtain equity capital and other financing alternatives, which has become necessary because of the growth of the integration of the financial service industry, making it imperative that the company have an influx of new capital.
The basic advantage of the stock life insurance company and its upstream holding company, is that the company can limit the impact of insurance regulatory controls and the restrictions on noninsurance operations placed on the companies by insurance regulators; and it allows acquisitions to be made without depleting the company’s surplus.
Because of the rapid changes in the financial services industry, insurers have been very active in corporate restructuring and affiliations, and in the way that they do business. One of newer changes is outsourcing which is the process of “farming out” many of their administrative and marketing functions.
Many insurers now “brand label” another company’s products, and many will then hire a third-party administrator to handle claims. Investments can be handled by an investment banking firm or other similar asset management company. Administration, which is nearly all handled by computers, is performed by service bureaus. Even marketing can be accomplished by third-party arrangements, direct marketing, or a combination of the two. In some situations, this new generation of insurers has been referred to as “virtual insurers.”
In a sense, insurers have become general contractors, with subcontractors performing many of their functions. Of course, management must monitor the performance of the “subcontractors” and this can cause conflict between the insurer management and the “outside” management, but in reality as more competition is available in the various “outsourcers,” the less conflict there will be.
The organization of a life insurance company is basically the same as for most other financial organizations that collects, invests and disburses funds. There are many ways of illustrating an organization, with flow-charts, tables of organization, etc., but for purposes of this text, the “departmental” approach will be used. Some of these functions are self-defining, and the various levels are not shown in any area of importance, except for the top levels of authority of course.
The operations of a life insurance company involve three basic functions: sell, service and invest. Most insurers have seven functional departments, described below (after the Board of Directors and Executive Officers descriptions):
The Board of Directors and its affiliated committees are the top level of authority in the company. In a mutual company they are elected by the policyowners; in a stock company they are elected by the stockholders. It is empowered to select the President and other principal officers, but to delegate to them the authority they need to fulfill their functions.
The executive officers are responsible for carrying out the policies as determined by the Board of Directors. They consist of the Chief Executive Officer, President (they may be the same person) and various vice presidents who are in charge of their department on a daily basis. Depending upon the size of the company, there are usually several layers of officers, each with a specified supervisory function.
The actuarial department provides several essential functions. For smaller companies, a consulting actuarial firm may be used for these functions, and even for the larger companies, consulting actuaries are used for auditing, product development, and other services. This department establishes the premium rates, establishes and calculates the reserve liabilities and nonforfeiture values, and any other mathematical operation needed. They also analyze earnings and determine dividends and excess credit. They create new policies and forms, and are responsible for filing forms with the insurance departments (if there is no in-house legal counsel to perform thisd function).
The actuarial department conducts mortality and morbidity studies, supervises the underwriting department in many companies, and works with the marketing department in the design of policies. In many of the larger companies, group and annuity operations are under the control of the actuarial department. In many smaller companies, the actuary serves as the executive vice president and is considered the “number 2” man in the company.
Marketing is responsible for the sale of new business, conservation of old business and certain policyowners’ service, supervises agents, and is responsible for advertising, sales promotion, market analysis, recruiting and training of agents. This department will be examined in more detail later.
Accounting and auditing functions are under the direction of the vice president and controller, and establishes and supervises the accounting and control functions of the insurer. They are responsible for any auditing and for tax matters. In most companies, the operational computers used by the insurer are under the control of this department.
The investment department, usually under the control of an investment vice president, is responsible for the company’s investments and is the custodian for the company’s bonds, stocks and other investments.
In addition to all legal matters, the legal department is responsible for regulatory compliance matters, representation of the company in any court matter, and any and all other legal matters.
Underwriting has been described in detail in a preceding chapter. The head of this department is typically a Vice President and Chief Underwriter, although in some companies they are two different persons.
The principal function of the Administration department is to provide home office service to agents and policyowners. They also are responsible for human resources (personnel), home office planning and other similar functions. The corporate Secretary is frequently in charge of this operation in addition to responsibility for Board of Directors minutes, and other company records. The following four areas are typical of life insurance home office Administration:
When Underwriting is finished with its function, Policyowner Service (also called Policyholder Service) takes over and performs all administrative functions from issue to termination, including policy issue, premium billing, agent compensation, and in some companies, claims administration. Not only the agents and policyowners are served by this department, but also services to beneficiaries are performed. Policyowner Service departments may be organized by region, by function (reinstatement, policy loans, etc.) or by product.
Because there are difference in claims among product – life and health insurance, for example – claims are usually divided by product. This department is responsible for obtaining all necessary information about the claim, those making the claim, and any other interested party; investigation of possible fraud or invalid claims; and processing claims. Large companies frequently have regional offices to facilitate claims payments.
The Information systems department has become very important in home office operations because so much administration of all types is performed on computers, including management information and operational information. Because of the need for computers for developing new products and premiums, some information departments (formerly “EDP” departments) are under the control of the actuarial departments. Today, so many other operations depend upon computers, the necessity of having an independent or semi-independent information department is vital. In some companies, there are two separate operations, one operation which uses the large “mainframe” computer, and the other which uses PC’s networked together.
(Formerly known as “Personnel”) – Human Resources has moved up in importance in the organization, as the value of using the skills and talents of employees to the best benefit of the company has become more apparent. In addition to being responsible for providing the necessary number and type of employees, they are heavily involved in training and professional development, performance appraisal, compensation and many other functions. Laws regarding employee-employer relationships have become more pronounced, so this has also become an important function of this department.
Marketing has been defined as “the creation of a demand for a company’s products, its distribution, and services for customers who puchase that product.” (Dictionary of Insurance Terms, Third Edition) The Marketing Department (or Agency Department), is the focus of all sales activity within an insurance company, and as a matter-of-fact, the focus of the company. Without the sales of its product, the company has no reason for existing, but it isn’t easy.
Depending upon the method of distribution, the Marketing Department personnel varies. Generally there is a Vice President of Marketing (or similar title), and several other Assistant Vice Presidents and their assistants. The responsibilities of the “Agency Secretary” is interesting, as it varies greatly from company to company. In some companies, this is a secretarial or executive administrative position, while in other companies, the Agency Secretary is the 2nd most important person in Marketing, and yet in other companies the responsibilities fall somewhere in between.
There is an old adage that “Life insurance is sold, Property and Casualty insurance is bought.” Even with all of the changes in the life insurance industry, this is still true today in most situations.
Life insurance is sold through “distribution channels” and generally speaking, there are three distribution channels, marketing intermediaries, financial institutions, and direct response.
The marketing intermediaries are individuals who sell life insurance products, usually on a one-on-one basis and usually for a commission. In North America, 90 percent of all new individual life insurance sales are marketed in this fashion, by agents and brokers.
Life insurers fall into two broad classes, those who recruit, train, finance, house and supervise their agents (agency-building); or, those which rely on established agents for their sales, (non-agency-building).
The agency-building distribution systems are career agencies and general agencies, multiple-line exclusive agencies, home service agencies, or salaried agencies.
Career Agencies usually sell one company’s products, and on a commission basis, which is the system used by the largest life insurers. With the branch office system, the agency manager is responsible for the recruiting and training of agents in his territory.
The general agency system accomplishes the same thing as the branch office system, but on a more independent basis. Many consider this to be a “theoretical approach” in today’s market, but there are still a significant of highly independent general agents, but certainly not as many as there used to be. Because of the plethora of new products being introduced constantly and the administration and training they entail, many companies have accepted much of the administration and training support previously provided only the the general agent. The general agent is compensated on a commission basis, usually on an overriding commission.
Another system is the multiple-line exclusive agency, where the agents are commissioned, but sell only the products of a multiple-line company. Allstate and State Farm insurance companies are two examples of this approach. Most of the agents are multiple licensed and can sell life, health and property & casualty insurance. Over the past 15 years, the number of these agencies has grown by 16%, probably because of the expense of maintaining two different type of agencies.
Home Service system is also known as debit, or combination agencies, as they market the small, debit policies, basically still house-to-house on their “debit.” Originally it was industrial insurance, with weekly collections. Today it is ordinary insurance (with typically small face amounts) and premiums either collected monthly, or billed through the mail. Few companies still exist, and the number of home service agents has fallen by 76 percent during the past 15 years.
The use of salaried insurer employees is the marketing method of savings bank life insurance in Connecticut, Massachusetts and New York. Many companies use salaried employees to market group insurance and who typically are paid a salary plus an incentive bonus based on certain goals.
(A note regarding the Agency Management. The responsibility of the General Agent or the Branch Manager is primarily recruiting agents. Thepersonal production of the General Agent or Manager is usually not of much importance, and since the turnover of agents is around 25% per year, recruiting is the principal function.)
The term, “Broker” in life insurance describes a commissioned sales person who works independently of the insurer with whom he places business, but he has no particular production or other similar requirements with the insurer. While most career agents “broker” business (verb), it is usually for business that is not accepted by the primary insurer of the agent because the primary insurer does not offer a policy of that type, the business has been declined or heavily rated by the primary insurer, or sometimes the client wants quotes from more than one insurer.
A broker (noun) can also refer to independent life insurance producers who have no particular loyalty to any one company, but they specialize in certain products or markets. They are highly independent and are some of the most knowledgeable of all agents.
A broker is also a salesperson whose primary product is not insurance, such as real estate agents, automobile dealers, etc.
Personal-Producing General Agents
The personal producing general agent (PPGA) are independent comissioned agents who usually work alone and market on a personal production basis. There are two types, traditional and Master General Agent (MGA). With the traditional approach, the insurer hires experienced life insurance agents with a contract that offers direct commissions and override commissions, plus an office allowance. The MGA approach is usually used for a single product, such as universal life or a health insurance product.
Independent property and casualty agents sell products for several companies on a commission basis and many times the companies that they represent will have life insurance affiliates. The agents are encouraged to take advantage of their P&C clientele as customers for life insurance. Life insurers who have P&C affiliates have tried for many years and spent a lot of money in training of non-life agents, in order for them to produce life insurance. Usually the efforts and expense of the life insurers has been for naught, because, as a general rule, P&C agents simply do not put forth the sales effort to be successful in life insurance asnd they are uncomfortable selling an unfamiliar product, particularly a product so different from their “bread and butter” products.
Producer groups are independent marketing organizations that specialize in large premium policies, frequently high substandard business or a specialized product, annuity, etc., that have special commissions from the insurers. The members must provide the necessary sales and marketing staff and assistance to the members of the group. Minimum production is usually required for all members of the group.
Life insurance can now be sold by banks, thrifts, credit unions, mutual funds organizations and investment banks. These are not large volume marketers at this time as banks are responsible for only 5% of all life insurance but they write 20% of the annuities. Securities firms are rather new entrants into the life insurance arena, and are starting to sell a significant share of variable products.
Direct response, which includes telemarketing and ads run on television, radio and in newspapers, only accounts for about 2% of total life insurance sales in the U.S. Proportionately, direct response is the area that generates (probably) the most complaints by agents and consumers alike because there is no “interface” with agents. Usually the products are rather simple and originally they were rather basic policies providing supplemental life or health coverage. However, the science of direct-response marketing has evolved to where many forms of life and health insurance are offered, as well as estate planning and annuities. The clients deal with the insurer by mail after the sale.
Direct mail is the oldest form of direct-reponse marketing of insurance products, with names and addresses available from a number of specialty companies that supply requested lists. In some cases, an organization may be a sponsor, and the insurer will make an arrangement to offer its products to the membership.
Commercial on-line networks and the Internet are now available to shoppers, with insurance quotes of several companies provided through the Internet, and many insurance companies will provide quotes and take an application through the Internet. Most insurers have a web page on the World Wide Web that can perform these functions.
The ownership of individual life insurance in family households over the past several years, has not been encouraging. In 1960, nearly 75% of all family households owned individual life insurance, but today, not quite 50% of households do. However, the number of households that owned group insurance has grown rapidly.
The average age of Americans is increasing and life insurers are having to provide insurance arrangements to facilitate the needs of an older population. The recent introduction of accelerated death benefits attest to this. Longevity has increased substantially and for many, the problem of outliving the assets in retirement is more important to many, than the problems of premature death.
At the present time, about 60 percent of the costs of health, retirement security and long-term care is borne by the government. These needs will continue to grow, but the ability of the government to pay for them at the present levels is quite questionable. If the private sector continues to provide for spending for these needs, considerable and increased financial and political pressure can be anticipated.
Life insurance still is considered as the best method of family protection in case of premature death of the family breadwinner, but even the definition of “family” can cloud this consideration. With so many single-parent families, the purpose of life insurance has to change somewhat in order to provide for children who would be orphaned upon the death of their only parent. The importance of life insurance for children’s education and for retirement, has decreased in the public’s conception in recent years. Many companies have compensated for this by establishing broker-dealer firms to help market investment products such as variable life and variable annuities, universal life and variable universal life, and mutual funds. Today, more than 40% of the insurance agents in the U.S. are licensed to sell variable products, and more than half of all individual annuity premiums are from sales of variable contracts.
In respect to retirement and health care, these areas should show increases in the future because of several factors. Perhaps the most important factor is the fact that the population is aging, and the “senior citizens” are very security-conscious. The government has reduced their desire to provide for the full individual security of every citizen, leading many to become concerned about their own personal financial security.
Another extremely important factor is that corporations will try to assist employees in becoming more independent in respect to their personal financial security, but at the employee’s expense. Insurer’s and others in the health care industry, have announced an average of 15% increase in medical insurance premiums for the year 2002. With the present political situation, especially with the terrorist war situation, companies are going to seek and find ways to reduce their own employee benefit costs.
In any event, the life insurer of the future - and not too distant future – will be larger and more efficient, and will be more market-focused. One of the biggest problems with the industry as it now exists, is that it is one of the most inefficient industries in the way that it markets its products. For a variety of reasons, inefficiencies and competition must be included as major problems, and in addition, profit margins on new products have been slipping drastically. Many companies have focused on only “high-end” markets.
Many medium-sized insurers will grow through normal growth plus mergers and acquisitions, which is in reality a continuation of the processes initiated several years ago. Smaller companies will have a difficult time surviving, except for those fortunate enough to be in a “niche” market – this too, was forseen at least 15 years ago.
Marketing will continue to be under scrutiny in its efforts to write more profitable business at a lower acquisition cost. Like it or not, it is inevitable that insurance companies will market more through non-agency building distribution channels.
Those companies who have focused on estate and financial planning and insurance products with tax implications, should continue to do what they have done. This will still be a market that is dominated by agents and it will continue to use life insurance and other financial products. It is likely that more agents, financial and estate planners, will perform their services on a fee basis. The effect on the new 2001 tax laws on estate and financial planning still remains to be seen, but it is not expected that the impact will be large after “the dust has settled.” In some fashion, it is also likely that life insurance will be more a part of a larger financial service arena, than as a stand-alone product.
The size of the middle income market will continue and will probably grow. The focus will still be on needs and marketing organizations will use the Internet, telemarketing, financial institutions and other types of distribution systems. The products that will be marketed the most successfully should continue to be interest-sensitive and variable products, as well as the basic term insurance and traditional cash-value products. The sale of annuities should continue to grow.
The lower-income, smaller product market will continue to be served by worksite marketing, direct-response marketing, financial institutions and government programs. Home service will probably continue, but in a smaller scale, while direct-marketing by using the Internet for advertising and information sources, including some direct sales, should continue to grow.
There are over 5 million firms in the United States with less than 100 employees, and many of them do not have group insurance, retirement plans or business insurance. The need for insurance continues to be great in this market. Many small companies do not offer any benefits to their employees or have any business continuation life or health insurance. Traditionally, smaller businesses are served mostly by career agents, and this should continue.
Large corporations, on the other hand, will more frequently be served directly by insurers, as many have had “cost-plus” or administrative-service-only groups which have proven quite cost effective for the employer and the insurers. There is a trend now to market products directly to corporate employees, primarily middle-income employees. This trend will continue to grow and insurance “advisors” and consultants could play a more prominent role in this trend.
Companies must devise ways to more efficiently deal with agent and field management compensation. If the companies do not take significant action in these areas, they will continue to obtain business that they may not want, and at a price they cannot afford. Proper consideration of the agent’s goals in respect to the commission structures, will determine the future of compensation and distribution.
STUDY QUESTIONS
Chapter 10
1. Congress received its power to regulate commerce
A. between states from the United States Constitution.
B. within the state (intrastate) from the United State Constitution.
C. from the state department of insurance.
2. Typically, the Federal government exercises its authority over the insurance industry by
A. appointing a new Federal Insurance Commissioner.
B. Congress holding hearings and “investigating” the industry.
C. by organizing the NAIC.
3. The principal purpose of state regulation in the insurance industry is
A. is to license insurance agents.
B. to enforce the NAIC Model Unfair Trade Practices Act.
C. that of solvency of insurance companies.
4. Life insurance premiums
A. are not regulated.
B. are regulated by the NAIC.
C. and benefits forms are not regulated by the states.
5. The state insurance department can revoke an agent’s license for
A. selling a term life insurance policy.
B. attempting to persuade a policyowner to cancel one policy and by a new one by using misrepresentation.
C. establishing a separate bank account for premiums.
6. Money the insure company receives as premiums is
A. placed in an unregulated general fund.
B. used by the insurance company as it sees fit.
C. placed in either Capital and Surplus, or Reserve investments.
7. Most states has some type of guaranty law, pertaining to life and health insurance companies.
A. The act covers policyowners who are residents of the state when the insurance company is determined to be insolvent or impaired.
B. This guaranty for an annuity owner, covers principal and anticipated interest.
C. The guarantee limit applies to each policy or contract an individual might have.
8. Life insurance companies in the United States are taxed by
A. the federal government, and exempt from the taxation by individual states.
B. each state, based on net income; gross income less deductions.
C. both the federal government and state government.
9. A company that is organized for the purpose of making a profit for it’s stockholder, and usually the policyowners do not share in the profits of the company, is
A. a mutual insurance company.
B. an up-stream holding company.
C. a stock insurance company.
10. Which department of a typical life insurance company established the premium, calculates the reserve and creates new policy forms?
A. Marketing.
B. Actuarial.
C. Accounting.
11. The U.S. Supreme Court in 1869 ruled that
A. insurance companies are governed by state law.
B. the sale of insurance by way of television, was interstate commerce.
C. foreign insurance companies can be prevented from doing business in another state by the federal government.
12. One of the main arguments used by states to maintain the regulation of insurance with the individual states is to
A. create political jobs within the department of insurance.
B. reduce paperwork.
C. be more responsive to local requirements and needs.
13. Today ____________________ still maintain primary responsibility for regulating insurance.
A. individual states.
B. federal government.
C. state insurance commissioner.
14. The stated purpose of the _________________ is to maintain and improve state regulations, ensure reliability of insurers, and the “fair, first and equitable” treatment of policyowners and claimants.
A. state legislatures.
B. the National Association of Insurance Commissioners (NAIC).
C. state insurance department.
15. ________________ has no particular loyalty to any one insurance company, but specialize in certain products or markets.
A. An independent life insurance agent.
B. A career agent.
C. An Allstate agent.
Answers to Chapter Ten Study Questions
1A 2B 3C 4A 5B 6C 7A 8C 9C 10B 11A 12C 13A 14B 15A