Insurance Regulation in a Nutshell

From PLI’s Course Handbook

Understanding Insurance Law 2008

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insurance regulation in a nutshell

John Dembeck

Debevoise & Plimpton LLP

INSURANCE REGULATION IN A NUTSHELL

© 2008 Debevoise & Plimpton LLP. Portions of this presentation have appeared, or may appear, in other materials published by the author or his colleagues.
Biographical Information

Name:John Dembeck

Position/Title:Counsel

Firm or Place of Business:Debevoise & Plimpton LLP

Address:919 Third Avenue,New York, New York 10022

Phone:212-909-6158

Fax:212-909-6836

E-Mail:

Primary Areas of Practice:Corporate, Insurance Regulatory and Reinsurance

Law School/

Graduate School: Brooklyn Law School

Work History: Debevoise & Plimpton LLP (1990-present)

Other law firms and insurance companies
(1976-1990)

Professional Memberships: American Bar Association, Tort and Insurance Practice Section

Table of Contents

(continued)

Page

ARTICLE I History of Insurance Regulation......

Section 1.01. Early Insurance Companies and State Regulation

Section 1.02. Paul v. Virginia (1869)......

Section 1.03. Development of State Insurance Law......

Section 1.04. U.S. v. South-Eastern Underwriters Ass’n (1945)

Section 1.05. McCarran-Ferguson Act (1945)......

ARTICLE II Purposes of State Regulation of Insurance....

Section 2.01. Solvency of Insurers......

Section 2.02. Market Conduct of Insurers and Their Producers

Section 2.03. Regulation of Intermediaries and Other Service Persons

ARTICLE III Solvency Regulation......

Section 3.01. Solvency Margins......

Section 3.02. Financial Reporting to Regulators (Unaudited)

Section 3.03. Audited Financial Statements......

Section 3.04. Statutory Accounting Practices......

Section 3.05. Annual Actuarial Opinion......

Section 3.06. Risk-Based Capital......

Section 3.07. Insurance Holding Company Regulation...

(a) Acquisition of Control......

(b) Affiliate Transactions......

Section 3.08. Financial Examination......

Section 3.09. Regulation of Investments......

Section 3.10. Regulation of Reinsurance......

ARTICLE IV Market Conduct Regulation......

Section 4.01. Regulation of Insurance Policy Forms.....

Section 4.02. Regulation of Rates......

Section 4.03. Unfair Trade Practices......

Section 4.04. Unfair Claims Practices......

Section 4.05. Market Conduct Examination......

ARTICLE V Enforcement Actions Against Insurers......

Section 5.01. In General......

Section 5.02. Monetary Penalties......

Section 5.03. Injunctions......

Section 5.04. License Non-Renewal......

Section 5.05. Criminal Sanctions......

Section 5.06. Receivership......

Section 5.07. Restitution......

ARTICLE VI Regulation of Intermediaries and Service Persons

Section 6.01. In General......

Section 6.02. Agents, Brokers and Producers......

Section 6.03. Consultants......

Section 6.04. Surplus Lines Brokers......

Section 6.05. Reinsurance Intermediaries......

Section 6.06. Managing General Agents......

Section 6.07. Third Party Administrators......

Section 6.08. Adjusters......

Section 6.09. Enforcement Actions......

ARTICLE VII The NAIC......

Section 7.01. History; Purpose......

Section 7.02. Model Law and Regulations......

Section 7.03. Statutory Financial Statement Forms......

Section 7.04. Statutory Accounting Practices......

Section 7.05. Risk-Based Capital Formula......

Section 7.06. Securities Valuation......

Section 7.07. International Insurers Department......

ARTICLE VIII State Insurance Insolvency Laws......

Section 8.01. In General......

Section 8.02. Remedial Action (Licensed Insurers)......

Section 8.03. Supervision (Licensed Insurer)......

Section 8.04. Rehabilitation or Liquidation (Domestic Insurer)

(a) Grounds for Commencing Proceeding......

(b) Liquidation or Rehabilitation Order......

(d) Automatic Stay......

(e) Secured Claim......

(f) Priority of Distribution......

(g) Status of Policies of Failed Insurer......

ARTICLE IX State Guaranty Association Laws......

Section 9.01. Purpose of Guaranty Associations......

Section 9.02. Kinds of Guaranty Associations......

Section 9.03. Life and Health Guaranty Association.....

(a) Member Insurers......

(b) Coverage......

(d) Amounts of Coverage......

(e) Assessments......

(f) Trigger of Guaranty Association Involvement.....

Section 9.04. Property/Casualty Guaranty Association...

(a) Member Insurers......

(b) Coverage......

(d) Amount of Coverage......

(e) Assessments......

(f) Trigger of Guaranty Association Coverage......

ARTICLE X Proposed Federal Regulation of Insurance....

Section 10.01. Early Proposals for Federal Regulation of Insurance

Section 10.02. Recent Proposals for Federal Regulation of Insurance

(a) The State Modernization and Regulatory Transparency Act

(b) Nonadmitted and Reinsurance Reform Act......

(d) National Insurance Act of 2007......

Section 10.03. Summary of National Insurance Act of 2007

(a) Title I – Establishment of Office of the Insurance Commissioner

(b) Title II – National Insurance Companies and National Insurance Agencies

(d) Title IV – Holding Companies......

(e) Title V – Receivership......

(f) Title VI – Insolvency Protection......

(g) Title VII – Conforming Amendments and Miscellaneous Provisions

(h) NIA Timetable......

Section 10.04. Recent Congressional Hearings – Insurance Regulation Reform

ARTICLE IHistory of Insurance Regulation

Section 1.01.Early Insurance Companies and State Regulation

Fire insurance companies were first organized in the U.S. in the mid-1700’s. The oldest of these was a fire insurance company whose organization was facilitated by Benjamin Franklin called The Philadelphia Contributionship for the Insuring of Houses from Loss by Fire. This mutual company has been in continuous operation since March 25, 1752 and was incorporated under the laws of Pennsylvania on February 20, 1768. The company remains in existence today and does business under its original name.

The oldest stock property/casualty insurers in the U.S. are the Insurance Company of North America (incorporated in Pennsylvania on April 14, 1794 under the name The President and Directors of the Insurance Company of North America) and The Insurance Company of the State of Pennsylvania (incorporated in Pennsylvania on April 18, 1794). Both insurers continue to operate – Insurance Company of North America is a member company of the ACE group and The Insurance Company of the State of Pennsylvania is a member of the AIG group.

Among the oldest life insurance companies in New York (and the United States) are MONY Life Insurance Company (organized as Mutual Life Insurance Company of New York and licensed in New York on April 12, 1842), New York Life Insurance Company (organized as Nautilus Insurance Company and licensed in New York on April 17, 1845), AXA Equitable Life Insurance Company (organized as Equitable Life Assurance Society of the United States and licensed in New York on July 25, 1859) and Metropolitan Life Insurance Company (organized as National Travelers Insurance Company and licensed in New York on May 14, 1866).

For these early years, the insurance business was regulated by the states.

Section 1.02.Paul v. Virginia (1869)

In 1869, the United States Supreme Court, in Paul v. Virginia,[1] held that the business of insurance did not constitute interstate commerce and, therefore, constituted local transactions to be governed by state law.

Section 1.03.Development of State Insurance Law

State regulation of insurance came into its own in the late 1800s. The New York Superintendent of Insurance was first created in 1859,[2] and the first comprehensive insurance law was enacted in New York in 1892.[3] The New York insurance law was substantially revised in 1906 (following the issuance of the Armstrong Committee Report)[4] and was recodified in 1939.[5]

Section 1.04.U.S. v. South-Eastern Underwriters Ass’n (1945)

In 1945, the United States Supreme Court overruled the doctrine of Paul v. Virginia and held that the federal antitrust laws applied to an association of underwriters which was indicted and charged with conspiracy to restrain and monopolize commerce in fire insurance. In U.S. v. South-Eastern Underwriters Ass’n,[6] the Supreme Court held that (i) the Sherman Anti-Trust Act applied to the interstate insurance business, and (ii) fire insurance transactions which stretched across state lines constitute “commerce among the several states” as to make them subject to regulation by the U.S. Congress under the Commerce Clause of the U.S. Constitution.

This ruling threatened the very viability of state regulation of insurance. Because of this, the U.S. Congress acted quickly and, by act of Congress, placed the regulation of insurance back into the hands of the states.

Section 1.05.McCarran-Ferguson Act (1945)

In 1945, the U.S. Congress passed the McCarran-Ferguson Insurance Regulation Act, the purpose of which was to assure that primary responsibility for insurance regulation would remain with the states.[7]

Codified as 15 U.S.C. §§ 1011-1015, the McCarran-Ferguson Act (15 U.S.C. §§ 1011-1012) provides as follows:

Section 1011. Declaration of policy. Congress hereby declares that the continued regulation and taxation by the several States of the business of insurance is in the public interest, and that silence on the part of the Congress shall not be construed to impose any barrier to the regulation or taxation of such business by the several States.

Section 1012. Regulation by State law; Federal law relating specifically to insurance; applicability of certain Federal laws after June 30, 1948.

(a) State regulation. The business of insurance, and every person engaged therein, shall be subject to the laws of the several States which relate to the regulation or taxation of such business.

(b) Federal regulation. No Act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, or which imposes a fee or tax upon such business, unless such Act specifically relates to the business of insurance: Provided, That after June 30, 1948, the Act of July 2, 1890, as amended, known as the Sherman Act, and the Act of October 15, 1914, as amended, known as the Clayton Act, and the Act of September 26, 1914, known as the Federal Trade Commission Act, as amended (15 U.S.C. 41 et seq.), shall be applicable to the business of insurance to the extent that such business is not regulated by State Law.

The McCarran–Ferguson Act was upheld as constitutional by the U.S. Supreme Court in 1946.[8]

ARTICLE IIPurposes of State Regulation of Insurance

The major purposes of state insurance regulation are described briefly in this Article and in further detail in the following Articles.

Section 2.01.Solvency of Insurers

Insurers promise to make certain payments to insureds, beneficiaries and claimants upon the happening of certain fortuitous events. These promises are of little value if the insurer has no funds with which to pay claims. Thus, the principal focus of state regulation of insurance is to assure the solvency of U.S. insurers so that they have funds available to pay policy claims when claims are due. This is of special importance for long term liabilities like life insurance where the promise is made currently but the payment obligation may not be due for 60 or more years.

Section 2.02.Market Conduct of Insurers and Their Producers

Market conduct regulation seeks to assure that insurers and their producers act in a fair manner. Thus, state insurance regulation regulates the actual insurance policies sold by insurers, may regulate the premiums to be paid for insurance (e.g. rates), prohibits misrepresentation, unfair discrimination, discrimination based on protected classes (e.g. race, color, creed, national origin, sex or marital status) and rebating and prohibits unfair practices in adjusting and settling claims.

Section 2.03.Regulation of Intermediaries and Other Service Persons

Most insurance is sold or bought through insurance agents or brokers. Under state insurance regulation, these intermediaries must generally be licensed to sell, solicit or negotiate insurance in each state in which they do business. If a licensed individual fails to comply with regulatory requirements imposed on her, the state insurance regulator may suspend or revoke her license.

In addition, many state insurance laws also regulate other insurance intermediaries and service persons, including consultants, surplus lines brokers, reinsurance intermediaries, managing general agents, third party administrators and adjusters.

ARTICLE IIISolvency Regulation

Section 3.01.Solvency Margins

Most states require that an insurer have a minimum capital and surplus in order to be licensed to write any given kind or kinds of insurance. For example, in New York, a domestic stock life insurer must have initial capital and surplus of at least $6 million and thereafter maintain a minimum capital of $2 million.[9] This requirement is the same for the largest and the smallest domestic stock life insurer in New York.

In recognition that fixed capital requirements provide little protection from insurer failure (especially in the case of large insurers), the National Association of Insurance Commissioners (the “NAIC”) adopted its Risk-Based Capital (RBC) For Insurers Model Act in 1993. This Model Act requires that an insurer maintain capital based on the risk inherent in its total business – its assets, liabilities and the amount and kinds of insurance it does. New York enacted a law based on the Model Act for life insurers in 1993 and for property/casualty insurers in 2007.[10] An expanded discussion of risk-based capital is found in Section 3.06

Section 3.02.Financial Reporting to Regulators (Unaudited)

One key element of solvency regulation is standard reporting of the financial condition of U.S. insurers to state insurance regulators in states in which they are licensed on an annual and quarterly basis.[11]

The NAIC prepares standard forms of financial statements for life and property/casualty insurers (and other forms for other kinds of insurers). Each state law generally incorporates by reference the NAICstandard form of financial statement as the form to be filed by insurers licensed in its state.[12] Each annual financial statement requires disclosure of great detail on the business of the insurer including a balance sheet and income statement, statement of cash flows, schedules of premiums, losses and expenses, a listing of every invested asset owned, acquired and sold by the insurer, reporting of all derivative transactions, ceded and assumed reinsurance, loss development (for property/casualty insurers), premiums by state and transactions within the insurer’s holding company system.

The annual statement is due to be filed by the insurer by March 1 for the prior year ended December 31. Quarterly statements are due to be filed by the insurer within 45 days after the end of each of the first three calendar quarters of each year.

Section 3.03.Audited Financial Statements

The NAIC Model Regulation Requiring Annual Audited Financial Reports requires that all insurers (other than certain exempted insurers) have an annual audit by an independent certified public accountant and file an audited financial report with the state insurance regulator on or before June 1 for the prior year ended December 31.[13]

The audited financial report must include (i) a report of the independent certified public accountant, (ii) a balance sheet reporting admitted assets, liabilities, capital and surplus, (iii) a statement of operations, (iv) a statement of cash flows, (v) statement of changes in capital and surplus, and (vi) notes to financial statements.[14]

Filing of an audited financial statement is a key to insurance solvency regulation. Instead of relying on the word of the regulated insurer with respect to matters reported in unaudited financial statements, each state insurance regulator relies on an independent third party expert to confirm the accuracy of the financial statements of U.S. insurers.

Section 3.04.Statutory Accounting Practices

Like the form of annual and quarterly financial statement filed by U.S. insurers with state insurance regulators, the accounting rules applicable to U.S. insurers are also established and maintained by the NAIC. The accounting rules are published by the NAIC in a multiple volume set called the “Accounting Practices and Procedures Manual” of the National Association of Insurance Commissioners. The manual is updated each March. These accounting rules are often referred to as “statutory accounting practices” or “SAP” (compared to “generally accepted accounting principles” or “GAAP” for U.S. public businesses). SAP is considered more regulatory by nature and gives a more conservative depiction of an insurer’s financial condition.

Like the form of unaudited annual and quarterly financial statements, the NAIC Accounting Practices and Procedures Manual is usually incorporated by reference by state law or regulation.[15]

Section 3.05.Annual Actuarial Opinion

Another core element of U.S. insurance solvency regulation is the actuarial opinion that must accompany the annual statement. The main liability of an insurer is the reserves it establishes for its insurance policy obligations. Here again is an instance where state insurance regulators rely on experts – a qualified actuary engaged by the U.S. insurer to verify the accuracy of reserves. The form and content of the actuarial opinion differs between life and property/casualty insurers.

A life insurer must include with its annual statement the statement of a qualified actuary, titled “Statement of Actuarial Opinion,” setting forth her opinion relating to policy reserves and other actuarial items. The opinion must include the life insurer’s general account and its separate accounts.

A property/casualty insurer must include with its annual statement the statement of a qualified actuary, titled “Statement of Actuarial Opinion,” setting forth her opinion relating to loss and loss adjustment expense reserves.

Section 3.06.Risk-Based Capital

The NAIC Risk-Based Capital (RBC) For Insurers Model Act requires that each insurer prepare and submit to its domestic state insurance regulator, on or prior to each March 1, a report of its risk-based capital levels as of the prior December 31.[16] The report must be in the form and contain the information required by the risk-based capital instructions, a set of instructions maintained and periodically revised by the NAIC.

The risk-based capital report reports the insurer’s “total adjusted capital” and its “authorized control level risk-based capital.” If the insurer’s total adjusted capital is less than its authorized control level risk-based capital and the insurer fails to respond to a corrective order, the state insurance regulator may (but is not required) to take action to cause the insurer to be placed in rehabilitation or liquidation.[17]

There are three other “risk-based capital” levels: (i) mandatory control level risk-based capital (measured at .7 times authorized control level risk-based capital), (ii) regulatory action level risk-based capital (measured at 1.5 times authorized control level risk-based capital), and (iii) company action level risk-based capital (measured at 2.0 times authorized control level risk-based capital).[18] There are varying remedies that a state insurance regulator can and must take if the insurer’s total adjusted capital drops below each of these risk-based capital levels. All insurers seek to maintain total adjusted capital above the company action level risk-based capital level in order to avoid any kind of regulatory action.[19] In a rare instance where state insurance laws take discretion away from the state insurance regulator, if an insurer’s total adjusted capital drops below the mandatory control level risk-based capital, the state insurance regulator is required to take action to cause the insurer to be placed into rehabilitation or liquidation if the event cannot be eliminated within 90 days.[20]