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The impact of regulations on insurance firms and consumers.

A recent report by the Subcommittee on Oversight and Investigations of the U.S. House Committee on Energy and Commerce chaired by Rep. John Dingell (the Dingell report) argues that insolvencies in the property-liability insurance industry during the 1980s were the result of weak state regulation, mismanagement, and fraud. This report on the regulation of the insurance industry coincides with considerable legislative attention given to savings and loans and banks. Indeed, the rate of insolvencies of insurance firms has increased relative to historical averages and has led to speculation that the entire insurance industry is financially fragile. The report advocates more competent regulation of the insurance industry, even suggesting the dramatic change to federal regulation if the states prove incapable of more competent regulation.

Unfortunately, the report is indicative of a general misunderstanding of insurance regulation among legislators and is expressive of the traditional confusion consumers have had concerning the value of insurance regulation and its associated costs. Recently, some insurance consumers have been confronted with the dissolution of the firms that insure their business, life, or automobile. However, even in the presence of the Dingell report there is still much misinformation about the role of solvency regulators in protecting insurance company policyholders, and almost no discussion of the costs imposed on policyholders because of the existence of statutes that constrain the insurance market from being open and competitive.


Each state and the District of Columbia have an insurance department which is funded by premium taxes levied on insurance companies that choose to do business in the state. The legal authority for states to regulate the insurance industry is grounded in the McCarran-Ferguson Act (1945) in which Congress mandated that the regulation and taxation of insurance is in the public interest. In most states, an insurance commissioner, who is either elected or appointed, has the responsibility to administer statutes, hold premium rate hearings, issue cease and desist orders to insurers, and revoke or suspend an insurer's license to conduct business in the state. Movement toward national uniformity in insurance law is given to the regulatory process through the National Association of Insurance Commissioners (NAIC), an organization of the states' insurance regulators that meets regularly to develop model bills for consideration by individual state legislatures.

Arguably, the primary purpose of state insurance regulations is to promote solidity and to enhance the financial strength of insurers who operate in the state. Financial strength of insurance companies is crucial because a feature embedded in the insurance business exists that drives the need for regulation--premiums are paid by policyholders to contractually transfer risk for a period which may extend many years into the future. Thus, to minimize the chance that an insurer will become insolvent and unable to meet contractual obligations, the state actively monitors the investments made by insurance companies through statute and financial reporting requirements, which vary by the type of insurance business an insurer conducts. For example, life insurers are typically limited to investing no more than 10% of their total assets in common or preferred stock. The reason for this is that the liabilities of life insurers, expected future death claims, are long-term and regulations promote matching these liabilities with long-term assets such as mortgages and long-term bonds.


Assuming that insurance regulators are working to increase the probability that individuals and firms will contract with financially-sound insurers, one can then identify three primary beneficiaries of solvency regulation who are better off when insurance firms are solvent. First, the policyholder. Imagine a situation where an individual purchases an automobile insurance contract to protect the asset value of the automobile from physical damage, since it affects the individual's net worth. Then after paying the premium for six months' coverage, the policyholder is hit by an uninsured motorist. Subsequently, a claim is filed by the policyholder with his insurance company only to find out that the insurer is bankrupt (insolvent). In this event, the individual has suffered two financial losses: (a) a decline in net worth because of either having to buy a new automobile or to come up with the dollars to fix the damaged automobile, and (b) the costs associated with not having a workable automobile, such as travelling by bus, taxi, or rental car. Clearly, in a world without insolvent insurance firms, such a situation would not arise.

A second beneficiary of solvency regulation is third-party claimants who hold valid liability claims. Such claimants are not necessarily insured in their own right, but have been damaged by another party. For example, say a pedestrian is struck by a motorist and incurs hospital expenses and suffers a loss of earned income because of a temporary disability. Further assume that the negligent motorist carries liability insurance but otherwise has little wealth. Assume that when the injured pedestrian files a claim against the motorist's liability insurer for payment of expenses and lost income, the pedestrian finds out that the liability insurer is insolvent, thereby making it difficult to collect from either the insurer or the negligent motorist. In the absence of any regulatory remedy, the pedestrian has a lower net worth because of having to pay the hospital expenses and the loss of earned income.

In contrast to the two preceding examples of individual beneficiaries of insurance regulation, there exists a third beneficiary of solvency regulation, notably, solvent insurance companies that, because of the presence of guaranty fund legislation, are required to pay claims of policyholders who hold contracts with insolvent insurers. Hence, to the extent the solvency regulation deters insolvencies among market competitors, financially-stable insurers are better off.

Guaranty fund legislation was adopted by a few states in 1969 and soon became widespread. In the interest of avoiding the preceding situation of a policyholder filing a claim with an insolvent insurer, each state has established a "state guaranty fund" which pays all valid claims to insolvent insurers, if the insolvent insurer has inadequate assets to pay all its creditors and claimants. A majority of states (including Tennessee) limit coverage to a maximum of $300,000 per claim, except for worker compensation claims, while a number of other states provide financial guarantees up to $300,000. The guaranty fund is subsidized through an ex post assessment method whereby all other insurers operating in the state are assessed after the insolvency occurs in proportion to the total amount of premiums they receive from policyholders in the state. So, for example, an insurer that has a 7% share of the Tennessee insurance market would be assessed by the state guaranty fund for 7% of the outstanding claims that could not be paid by liquidating the assets of an insolvent insurer. In practice, annual assessments of solvent insurers by guaranty funds are limited to a small percentage of an insurer's state premium volume, with additional assessments, if needed, following in future years.

Although it is true that solid insurance firms benefit from fewer insolvencies, it is also true that the states' taxpayers benefit. Provisions of guaranty fund laws usually permit solvent insurers to offset fund assessments with tax credits against future premium taxes. That is, when an insolvency occurs, the monies collected from insurance premium taxes that have been allocated to support the state insurance department are diverted to pay claimants of insolvent insurers, leaving general tax revenues as the only source of funding for the insurance regulators.


The large number of potential beneficiaries from solvency regulation lends stability to the insurance market by increasing the likelihood that valid claims will be paid. However, such a system has levied substantial, associated costs on insurance consumers that are reflected ultimately in the premiums consumers pay to insurance companies. First, there are administrative costs associated with the management of the state insurance department. For example, the Tennessee Department of Commerce and Insurance has approximately 100 employees who are supported by a payroll of approximately $2.5 million. As stated previously, the department is supported by premium taxes on insurers, but this is a cost transferred back to the insurance consumer, albeit implicit in the gross premium paid by the consumer.

The second cost of solvency regulation is the reduced competition in the insurance market caused by capital requirements which are imposed on insurers who wish to gain access to the insurance market in the state. That is, statutes require that insurers have a certain net worth (in Tennessee, $2.0 million) before they are permitted to sell their policies in the state. The purpose of this capital and surplus requirement is to assure that funds exist to offset unexpected underwriting or investment losses. However, such regulation is costly since it increases the minimum efficient scale by which insurance firms can operate in the insurance market. That is, small firms that might compete by offering specialty services are prohibited from entering the insurance market.

A third economic cost brought on by solvency regulation is that inefficient insurers, that have already gained access to the insurance market, are not subject to the rigors of a competitive market which would force them to either become efficient or exit the market. Cost inefficiencies appear in the expense component of an insurance premium, and simply stated, increase premiums for all policyholders. The problem becomes acute in those states that do not require individual insurers to compete on expenses by accepting, during the rate approval process, an expense percentage which is aggregated across the industry.


State insurance departments engage in both a priori and a posteriori market participation requirements to lower the probability that insurance firms will become insolvent. The previous discussion about a minimum required amount of capital to enter this market is an entrance requirement designed to deter "fly-by-night" firms from entering the insurance market, extracting premiums from near-sighted customers, then exiting the market.

The majority of regulatory effort is used to monitor firms that have already gained entry into the market. Insurance regulators impose financial reporting requirements and conduct desk audits whereby the records of the insurer are examined at the insurer's home office. The primary tool of insurance regulators is the accounting-based IRIS (Insurance Regulatory Information System) ratios, a set of 11 financial ratios scrutinized by insurance regulators for each insurance firm. Ideally, IRIS ratios reveal unstable insurers and act as an early warning system to insurance regulators. In practice, if an insurer falls out of an acceptable range on 4 of the 11 ratios, then the firm is earmarked for special regulatory scrutiny.

Unfortunately, insurance regulators currently do not use more sophisticated tools for identifying insurance firms that are more likely, on average, to become insolvent. Since the work of James Trieschmann and George Pinches (1974) in the Journal of Risk and Insurance, there have been a number of statistical/actuarial models that use a variety of financial ratios to predict the probability that an insurance firm will become insolvent. The modelling of an insurance firm's operations is an ongoing research process because the prediction of insolvency probabilities can never be 100% accurate. Still, the statistical models in existence today that go unused by regulators are much better than simple financial ratios that are subject to easy manipulation by insurance firms that choose to hide their financial vulnerability. Indeed, these statistical models are implementable in practice with no more resources than a personal computer, statistical software, and individuals who can enter the data into the software program. However, regulators in Tennessee have been slow to adopt more sophisticated techniques for reasons which, I suspect, insufficiently serve the public good.


As has already been discussed, the presence of insurance regulation in general, and guaranty funds in particular, conveys valuable economic benefits to policyholders and taxpayers. Indeed, legislators have responded to recent insolvencies in the insurance industry by introducing proposals for significant expansion in government-mandated guarantees as if there were no associated economic costs.

Clearly, the effect of expanding financial guarantees has the predictable outcome of consumers becoming indifferent to the portfolio risks undertaken by their financial institutions. In other words, if an insurance consumer knows that a claim will be paid regardless of the financial solvency of the insurer, then there is a reduced incentive for consumers to seek out safe insurers or to monitor their existing insurers. We only need to look at the financial disaster of banks and savings and loans in the 1980s subsequent to increases in deposit insurance to validate this prediction.

There is no doubt that enhancing the maximum amount paid for a valid claim made on a state guaranty fund would have a similar effect of making insurance consumers indifferent to the risks undertaken by their insurance companies. Thus, the most effective means of assuring that insurance company managers behave themselves is to offer an incentive for insurance company customers to monitor their insurers. Such a reaction could be initiated by reducing or eliminating the current guaranty fund protection. The notion that insurance consumers could monitor competing insurers is not literal, nor does it have to hold true to motivate insurers to become financially stable. Certainly, most consumers are ill-prepared to evaluate an insurer's financial strength. However, all that is needed is for consumers to express a partiality for financially-strong insurers. Such a statement of preference would force agents and brokers to sell the insurance contracts of only the strongest insurers and propel insurers to achieve high financial ratings from the ratings service organizations by increasing the strength of their capital positions.

In contrast, if our legislators quickly and comprehensively expand guaranty fund benefits, there will be a greatly diminished incentive for policyholders to care about how their insurer is operated. Indeed, expanded guaranty benefits would induce insurance companies, particularly marginal insurance companies, to increase their portfolio risk and their probability of insolvency.


The rationale for solvency regulation is to protect policyholders, other insurance firms to which the obligations of insolvent firms accrue, third-party liability claimants, and taxpayers. These potential beneficiaries are created through regulation that is administratively costly, and though less evident, raises barriers to new insurance companies that would aspire to enter the market.

State legislators should attend to modifying guaranty funds by reducing the amount of valid claims paid on an insolvent insurer. By increasing the incentive for consumers to monitor their insurance companies, legislators will promote a financially stable, more competitive insurance market that will be able to offer lower premiums to the insurance consumer. In the meantime, the sidebar shown below provides sources that insurance consumers may use to assess the recent financial performance of insurance companies operating in Tennessee and the United States.

Insurance company performance is well documented in the widely available annual volumes of Best's Insurance Reports. However, because the Reports are issued annually, they suffer from a significant time lag in transferring information to the insurance consumer. Perhaps the most up-to-date information can be obtained from the insurance department. Bond advisory rating services, such as Standard & Poors and Moody's, rate companies for financial strength and their ability to pay claims.

Dr. Puelz is an assistant professor in the Department of Finance, Insurance, and Real Estate at Memphis State University.
COPYRIGHT 1992 University of Memphis
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Author:Puelz, Robert
Publication:Business Perspectives
Date:Mar 22, 1992
Previous Article:When will the recovery really begin?
Next Article:How regulations affect the banking industry and its customers.

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