INSURANCE 101: Insurance Company Regulation

 Insurance Company Regulation

The insurance industry is a highly regulated industry, regulated by each state independently, as well as through federal legislation.  This means that although each state follows federal regulation, the individual states maintain the power and authority to regulate insurance laws within each state.  Insurance carriers, agencies, and all insurance agents are required by law to be licensed in each state in which they conduct business.

Each state maintains its own division or department of insurance, consisting of regulating officers and an insurance commissioner or superintendent. Upon review of a business or individual insurance license application, the state’s insurance commissioner or superintendent has the authority to approve or deny the application to solicit insurance within the state.

A Certificate of Authority is provided to an insurance company as proof of licensure within the state.  Once certified by the state, the insurer is considered to be Admitted and is authorized to conduct insurance business within the state.

A Non-admitted, or non-licensed, insurer is prohibited from conducting business within a state until it becomes licensed by that state.  Whether it be an individual agent or an insurance company, unauthorized solicitation of insurance without the approval of the state’s insurance commissioner or superintendent is prohibited.

Authorized insurance companies oftentimes conduct business in multiple states, and as such, they are authorized based on the state in which the insurance company’s home office is incorporated. Domicile of Incorporation refers to the state (or country) in which the insurance company is incorporated.

The following categories determine the status of an insurance company based on its location of incorporation in relation to the location in which it is conducting business.

Domestic Insurer
A domestic insurer is an insurance company that conducts insurance business in the same state in which it is incorporated, such as an insurance company that is incorporated in Florida and conducts insurance business within Florida.

Foreign Insurer
A foreign insurer is an insurance company that conducts insurance business in any state that it is not incorporated, such as an insurance company that is incorporated in Florida and conducts insurance business in California or New York.  Although the insurer is considered to be domestic in its home state, it is considered to be foreign in any other state it conducts insurance business.

Alien Insurer
Any insurance company incorporated outside of the United States is considered to be an ‘alien’ insurer while conducting business within the U.S. and must follow all federal and respective state laws.

Remember, Puerto Rico, Guam, and the U.S. Virgin Islands are U.S. territorial possessions and are within U.S. federal law; therefore, insurance companies incorporated in these territories are categorized as domestic or foreign insurers, depending on the location in which they conduct business.

Financial Structure and Requirements of Insurers
As mentioned, insurance companies are regulated on the state level and are required to maintain adequate capital and company surplus to satisfy insurance claims and pay annual operating expenses.  Financial investments made by an insurance company must not endanger the insurer’s solvency or financial wellbeing; therefore, they typically invest in low-risk bonds such as corporate and municipal bonds to ensure that the insurer receives positive returns.

To protect against insurer insolvency, each state’s department of insurance mandates company compliance in reporting financial conditions and results of operations on a quarterly basis.  In addition, an annual audited report must be filed with the department and must be completed by an independent certified public accountant chosen by the insurer.

The following financial reports must be provided by the insurer to the department for review:

• An audited annual report from an independent certified public accountant
• A statement of the company’s financial condition
• Balance sheets and statements of cash flow
• A summary of insurer operations
• A statement of the changes in the company’s capital and surplus

The company’s notes related to its financial statements which reconcile any differences between the audited annual report and its quarterly reports


Insurance Company Financial Ratings
An insurer’s ‘financial rating’ represents its financial strength and is based on its claims experience, investment performance, and dividend returns, as well as an insurer’s management team among other factors.  Similar to how Consumer’s Reports rates its member companies, financial rating companies such as Standard & Poor’s, Moody’s, and AM Best provide consumers with its financial rating of each insurance company.  While each rating company follows its own rating scale, a letter grade ranging from A++ or Aa1 to D is given to each insurer.  The higher the rating grade that is given to an insurance company, the better the insurer is financially fit.

Self-Insurance & Inter-Insurance

Self-Insurance
Many businesses choose to self-insure to cover smaller employee claims that can be paid by the company instead of filing a claim through the insurer.  A business will ‘self-insure,’ or pay for smaller claims from an established fund maintained by the business mainly to avoid costly insurance premiums for relatively small claims.

Reciprocals
‘Reciprocal’ Insurance, also known as Inter-Insurance, is a type of risk retention between members, known as subscribers, consisting of individual business owners, corporations, or municipalities. Subscribers ‘reciprocate’ in sharing risks and participate in indemnifying members who encounter loss.

As a type of insurance, each member can absorb larger loss by sharing it and through its participation in the reciprocal, it pays a lesser amount of loss since it is shared by the other subscribers in the reciprocal.

A reciprocal is another form of insurance for a business, corporation or municipality that helps spread the risk and costs of loss.  This type of self-insurance is administered by an attorney, called an Attorney in Fact (AIF), and is often used by municipalities to ‘cross-indemnify’ each other against potential loss in addition to purchasing formal insurance.

Stock vs. Mutual Insurers

Stock Insurance Company (Non-Participating or ‘Non-Par’)
The majority of private commercial insurance companies in America are considered to be either stock or mutual insurance companies. While both types of organizations provide insurance to consumers, they differ in how they operate.

A Stock insurance company is a private insurance company that is established to provide insurance to policyowners and to make a profit for its stockholders.

This type of insurer is considered to be a Non-Participating, or Non-Par company because the insured policyowners do not own the company, nor do they receive any dividends that the company returns.  Stock insurers do not issue participating policies; therefore, two groups exist: shareholders and policyowners – although a shareholder could also be a policyowner.

Mutual Insurance Company (Participating or ‘Par’)
A Mutual insurance company is a private insurance company that is established to provide insurance to policyowners who are also the company’s stockholders (owners).

This type of insurer is considered to be a Participating, or Par company because it issues ‘participating policies’ in which policyowners share in the company’s ownership and receive dividends from the earned surplus of the company’s profits.

Individuals who purchase insurance from a mutual insurer are both a customer (insured) and an owner (shareholder).  The insurer’s Earned Surplus is paid out to its shareholders in the form of Dividends, which are an annual reimbursement of excess premiums that remain after the company has set aside its needed reserves and has deducted the necessary amount to cover annual claims and other company expenses.

Demutualizaiton
A mutual insurance company has the ability to change its corporate structure to a stock company status, often to help increase capital needs that is more easily accomplished as a stock insurance company. This process is called ‘demutualization.’

Mutualization
Just as a mutual insurance company can ‘demutualize’, a stock insurance company can also change its corporate structure to become a mutual insurance company, a process called ‘mutualization.’

Reinsurance
The concept of ‘reinsurance’ is the sharing of risk between an insurance company and a re-insurance company, known as a Reinsurer, to provide additional insurance coverage for risks that are too large for the single insurer to adequately cover.

When an insurance company cannot assume an entire risk of an applicant’s request at the time of application, it will transfer part of the risk by purchasing additional insurance coverage from a reinsurance company.  A Reinsurance Agreement provides the details of the agreed reinsurance policy, and a reinsurance premium is paid by the Cedent Insurer, to the reinsurer in exchange for the additional coverage.

The agreement between the cedent insurer and the reinsurer does not affect the agreement between the cedent insurer and the insured individual or business and is often times not even known by the insured individual or business.  The insured is covered by the insurer, and if necessary, the insurer shares part of its risk with a reinsurer.

As an example, if a business applies for a large insurance policy equaling $20 million and an insurance company is only able to cover a single loss up to $10 million, the insurer will purchase additional insurance from a reinsurer for the remaining $10 million to adequately cover the $20 million request.

Private vs. Government Insurance
The Federal Government provides various programs including health insurance to military veterans, as well as programs that provide catastrophic protection often excluded from private insurance, such as flood insurance, insurance on mortgage loans and unemployment insurance above state limits, to name a few common examples.

The State Government also provides various programs such as state-administered unemployment insurance, workers’ compensation insurance, and state-administered medical expense insurance plans for eligible individuals.

Known as Social Insurance, Social Security, Medicare, and Medicaid are provided to U.S. citizens through federal and state legislation. In comparison to private insurance, government-administered insurance is funded by tax money and is regulated by state and federal laws. These programs are available to all qualified U.S. citizens and are determined based on the qualifying status of the applicant’s age or income status.

Fraternal Associations & Benefit Societies
Fraternal associations are non-profit organizations that are recognized for their social and charitable activities. Associations often consist of social or religious groups such as the Knights of Columbus, local community lodges, or religious organizations. These associations, often called ‘societies,’ offer insurance to its members in addition to other membership benefits.

A social ‘club’ consisting of friends or neighbors that is not established under the law as an organization is not considered to be an association and cannot form a group policy simply for the purpose of providing insurance to friends or neighbors.

Lloyd’s of London
Lloyd’s of London is not actually an insurer, but rather an exchange marketplace consisting of individuals, companies and underwriters who provide ‘high-risk’ insurance products. Lloyd’s is considered the oldest insurance marketplace, essentially serving as a reinsurer, providing services in over 200 countries around the world.

The Lloyd’s marketplace is best known for its diverse and wide range of coverage including property, marine, aviation, and ‘specialty’ coverage policies on the human condition, such as insurance on a ping pong champion’s hands or on a musician’s voice (Bob Dylan and Bruce Springsteen for example), in addition to other unique items.