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RISK MANAGEMENT FOR ENTERPRISES AND INDIVIDUALS Chapter 8 Insurance Markets and Regulation
1 - 2 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Learning Objectives In this section we elaborate on: Hard and soft insurance market conditions. How underwriting standards are influenced by cyclical market conditions. The significance of the combined ratio as an indicator of profitability. Reinsurance organizations and the marketplace. Why insurance is regulated and the objective of regulation.
1 - 3 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Learning Objectives In this section we elaborate on: How regulatory authority is structured. The licensing requirements of insurers. Specific solvency regulations. The features of rate regulation, control of agents’ activities, claims adjusting, and underwriting practices. Arguments in the debate regarding state versus federal regulation.
1 - 4 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insurance Market Conditions Property/Casualty Market Conditions Soft market conditions occur when insurance losses are low and prices are very competitive. Hard market conditions occur when insurance losses are above expectations and reserves are no longer able to cover all losses. Combined ratio is the loss ratio (losses divided by premiums) plus the expense ratio (expenses divided by premiums).
1 - 5 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insurance Market Conditions When the combined ratio is low, the industry lowers its underwriting standards in order to obtain more cash that can be invested—a strategy known as cash flow underwriting. The level of combined ratio that is required for each line of business to avoid losing money is called the break-even combined ratio level.
1 - 6 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insurance Market Conditions Life/Health Market Conditions Health insurance consists of coverage for medical expenses, disability, and long-term care. As with life insurance, emphasis on product offerings in the health segment has seen a transition over time in response to the changing consumer attitudes and needs.
1 - 7 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Table Top Ten Global Reinsurance Companies by Gross Premiums Written, 2007
1 - 8 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Table Common Types of Insurance Regulatory Laws
1 - 9 © 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insurance Regulation Every state has an insurance department to administer insurance laws; it is known as the commissioner (or superintendent) of insurance. The National Association of Insurance Commissioners (NAIC) deals with the creation of model laws for adoption by the states to encourage uniformity.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insurance Regulation The state insurance commissioner is empowered to: Grant, deny, or suspend licenses of both insurers and insurance agents. Obtain an annual report from insurers (financial statements). Examine insurers’ business operations. Act as a liquidator or rehabilitator of insolvent insurers. Investigate complaints and originate investigations.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Insurance Regulation Decide whether to grant all, part, or none of an insurer’s request for higher rates. Propose new legislation to the legislature. Approve or reject an insurer’s proposed new or amended insurance contract. Promulgate regulations that interpret insurance laws.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Licensing Requirements An insurer must have a license from each state in which it conducts business. Companies chartered in a state are known as domestic insurers. Foreign insurers are those formed in another state. Alien insurers are those organized in another country.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Licensing Requirements Holding a license implies that the insurer: Meets specified regulatory requirements designed to protect the consumer. Has greater business opportunities. Excess and surplus lines insurers: Companies that provide coverages that are not available from licensed insurers. Surplus lines agents or brokers: Persons who hold special licenses to provide access to nonadmitted insurers.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Licensing Requirements A license may be denied under certain circumstances. If the management is incompetent or unethical, or lacking in managerial skill. If any company has been in any way associated with a person whose business activities the insurance commissioner believes are characterized by bad faith.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Financial Requirements Stock insurers must have a specified amount of capital and surplus. Mutual insurers must have a minimum amount of surplus. A multiple-line insurer must have more capital (and/or surplus) than a company offering only one line of insurance.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Accounting Compliance Insurance companies are required to submit uniform financial statements to the regulators. These statements are based on statutory accounting as opposed to the generally accepted accounting (GAP) system, which is the acceptable system of accounting for publicly traded firms. Statutory accounting (SAP) is the system of reporting of insurance that allows companies to account differently for accrued losses.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Accounting Compliance The Sarbanes-Oxley (SOX) Act of 2002 mandates that companies implement improved internal controls and adds criminal and civil penalties for securities violations. This act has been successful at improving corporate governance.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Solvency Regulations Investment and reserve requirements Risk-based capital Describes assets, such as equities held as investments, with values that may vary widely over time. State guaranty fund associations are security deposit pools made up of involuntary contributions from solvent, state-regulated insurance companies doing business in their respective states to ensure that insureds do not bear the entire burden of losses when an insurer becomes insolvent.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Policy and Rate Regulation The state insurance commissioners have extensive power in approving policy forms and controlling the rates for insurance. Rates are regulated for auto, property, and liability coverages, and workers’ compensation. Prior approval: Method of regulation in which an insurer or its rating bureau must file its new rates and have them approved by the commissioner before using them.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Policy and Rate Regulation File-and-use: Method of regulation that allows an insurer to begin using a new rate as soon as it is filed with the commissioner. Open competition: Method of regulation that requires no rate filings by an insurer, as the underlying assumption is that market competition is a sufficient regulator of rates.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Control of Agent’s Activities Insurance laws also prohibit certain activities on the part of agents and brokers, such as twisting, rebating, unfair practices, and misappropriation of funds belonging to insurers or insureds. Twisting: Inducing a policyholder to cancel one contract and buy another by misrepresenting the facts or providing incomplete policy comparisons. Rebating: Providing substantial value as an inducement to purchase insurance.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Control of Agent’s Activities Unfair practice: A catch-all term that can be applied to many undesirable activities of agents, claim adjusters, and insurers. Misappropriation of funds: Situations in which the agent keeps funds belonging to the company, the policyholder, or a beneficiary.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Control of Claims Adjusting Insurance commissioners control claims adjusting practices primarily through policyholder complaints. The most common form of punishment for wrongdoing is either a reprimand or fine against the insurer.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Impact of the Gramm-Leach-Bliley Act on Insurance Regulation The Gramm-Leach-Bliley Financial Services Modernization Act (GLBA) of 1999 allowed financial institutions to consolidate their services. The NAIC started to work on the speed-to- market concept of expediting the introduction of new insurance products into the marketplace.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Impact of the Gramm-Leach-Bliley Act on Insurance Regulation Other areas of improvements are: Regulatory reengineering, a movement that promotes legislative uniformity. Market conduct reform, which creates a process to respond to changing market conditions, especially relating to e-commerce.
© 2010 Flat World Knowledge, Inc © 2010 Flat World Knowledge, Inc. Summary Insurance markets are described as either hard or soft depending on loss experience. Market cycles are cyclical and are indicated by the industry’s combined ratio. The National Association of Insurance Commissioners (NAIC) encourages uniformity of legislation across different states. An insurer must have a license from each state in which it conducts business, or conduct business through direct mail as a nonadmitted insurer.
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