Having reviewed the development of state insurance regulation, its fundamental goals, and licensing as the foundation of regulation, here the focus shifts to the substantive content of such regulation, especially that applicable to life insurance.

Since the purchase of a life insurance policy initiates a transaction whose duration may span the better part of a century, the insurance-consuming public needs (and demands) assurance that the insurer will survive and be financially able to make the payments required by its contract. This fundamental public need for security translates into the regulatory goal of insurer financial soundness (solidity). To achieve this goal, regulators try to ensure that an insurer maintains assets at least equal to its currently due and prospectively estimated liabilities (including minimum capital and surplus requirements). Thus a substantial body of regulation has evolved covering a life insurer�s assets (the bulk of which consist of investments), liabilities (the bulk of which consist of reserves), and capital and surplus.

Regulation of Insurer Investments. Although an insurer has a wide variety of assets necessary to operating an insurance enterprise (building, furniture and equipment, computers, and so forth), the bulk of its assets are held in the form of investments. It is essential that an insurer investment portfolio be of good quality so that the needed funds are available in the amounts and at the times called upon by its promises. Therefore not surprisingly, regulatory attention has long focused on the conduct of insurer investment operations.

Limitations on the Nature of the Investments Permitted. Insurance companies� investment activities are conducted within the limitations established by state insurance law and regulations. Although state laws vary, they have a degree of commonality because of the common nature of the problems, the role of the NAIC and a requirement that a foreign insurer licensed to do business in the state must comply substantially with that state�s law.

In general, state controls seek to preserve the safety of the assets standing behind policyowner reserves and to prevent a life insurer�s undue control of other companies through proportionately heavy investments in any one firm. To achieve these objectives, investment regulation has specified the eligible types of investment (such as bonds, mortgages, preferred and common stocks, and real estate) and the minimum quality criteria for individual investments within the eligible categories. In addition, quantitative limitations are imposed on the amounts that can be placed in eligible investments. (For a detailed discussion of controls over life insurer investments, see chapter 32.)

Valuation of Assets. A review of an insurer�s balance sheet gives an idea of the capital and/or surplus margins available for contingencies if the assets have been properly valued and the liabilities correctly stated. Most state laws authorize the insurance commissioner to set the rules determining the value of the securities. As a practical matter, if each state imposed its own valuations, there would be duplication of expenses incurred by the states and individual insurers; more important, there would be conflicting valuations. An insurer doing business in several states would report different values for the same securities in different states. This would constitute a burden on the filing insurers, and submitting differing asset valuations in the different states would result in virtually incomparable financial statements. In turn, this would adversely affect financial analyses and greatly complicate coordinated regulatory actions by the states.

Avoiding such problems was a major reason for the formation of the NAIC in 1871. The NAIC has created an annual statement blank (with detailed accompanying instructions) that insurers file. It is accepted by all states. The accounting and other rules governing the annual statement are continually under review and subject to change by the NAIC. In addition, the NAIC created the Securities Valuation Office to value, on a uniform basis, the securities held in the portfolios of virtually every insurer in the United States. As a consequence, every insurer holding the same security reports the same value for that security in its annual statement submitted to all states.

Mandatory Security Valuation Reserve and Its Successors. Life insurers must value common stocks at market value for annual statement purposes. To avoid giving an undue impression of instability in the insurer�s operations, the NAIC introduced the mandatory security valuation reserve (MSVR) in 1951. On the insurer�s balance sheet, the MSVR was shown as a liability even though its nature was essentially that of a contingency fund or earmarked surplus. The MSVR served to accumulate a reserve over a period of years to protect against adverse fluctuations in the value of securities (stocks and bonds). A maximum amount was established for the MSVR according to a formula. Until the maximum was reached, capital gains and losses were absorbed by the reserve to avoid affecting the level of reported surplus. However, if the MSVR balance became zero, capital losses would directly decrease surplus.

In December 1991 the NAIC adopted two reserves to replace the MSVR: the asset valuation reserve (AVR) and the interest maintenance reserve (IMR). The AVR/IMR approach improves the old system by focusing on all invested assets, rather than on just stocks and bonds. The AVR imposes reserve requirements on real estate and commercial mortgages, as well as on stocks and bonds. This compels life insurers with troubled real estate portfolios to come up with additional reserves to meet NAIC requirements. The IMR attempts to capture realized gains and losses that result from changes in interest rates and permits the insurer to amortize them over the life of the investment.

Regulation of Reserves. The majority of an insurer�s liabilities consist of policy reserves, which are the estimated amounts of funds needed, in combination with estimated future net premiums to be received, to provide the benefits promised in the insurer�s life and annuity contracts. If an insurer fails to maintain the proper amount of assets to match its liabilities, including adequate policy reserves, the insurer may become insolvent and unable to pay claims. Thus establishing adequate reserves and reporting reserves accurately are essential to ensure an insurer�s solidity. State law, based on the Standard Valuation Law (initially adopted by the NAIC in the early 1940s and brought up-to-date by periodic amendments through 1991), prescribes the method by which minimum policy reserves are calculated.

Pursuant to the law, the commissioner annually values (or causes to be valued) an insurer�s liabilities for all outstanding life insurance, annuity, and pure endowment contracts. The statutory method is set forth in terms of the mortality tables to be used, the maximum interest rates to be assumed, and the valuation methods to be applied. Over time as circumstances change, the NAIC adjusts the mandated assumptions, such as the mortality table used and the interest rates assumed.

The states prescribe only the basis upon which minimum reserves are to be computed. Insurers are permitted to use any other basis that results in reserves that are equal to or greater than those generated by the statutory method. However, the insurer must disclose the details of the basis for its policy reserves as part of the NAIC annual statement that it files.

Furthermore, along with its annual statement, every life insurer must annually submit the opinion of a qualified actuary, stating that the reserves are computed appropriately, are consistent with prior reported amounts, and comply with the laws of the state. The actuarial opinion must also state whether the reserves are adequate to meet the company�s obligations. The opinion must be based on standards adopted by the Actuarial Standards Board of the American Academy of Actuaries.

Capital and Surplus Requirements. On an insurer�s balance sheet, the excess of assets over liabilities is the insurer�s capital and surplus for a stock company and the insurer�s surplus for a mutual company.

Traditional Requirements. Traditionally, all states have established minimum capital and surplus requirements that an insurer must meet to obtain a license to do business. Although the details and the amounts vary significantly by state, a state insurance code sets forth minimum fixed-dollar capital and surplus amounts that differ according to the line or combination of lines of business to be written and the type of insurer. By the early 1990s minimum fixed-dollar capital requirements ranged from less than $500,000 to $6 million, depending on the state of domicile.

Over the years the required levels have sometimes been criticized as being inadequate. However, in determining whether the traditional system has fallen short, it is appropriate to ask what purpose the requirements are intended to serve. One function is to screen certain insurers out of the marketplace. The higher the minimum capital and surplus levels, the fewer small, undercapitalized insurers with a strong potential for failure entering the business. High entry requirements also tend to discourage operators seeking to utilize an insurance company as a source of unethical or fraudulent aggrandizement of personal wealth.

If the basic purpose of imposing capital and surplus requirements were limited to the screening function, simply increasing the fixed-dollar levels for the minimum requirements would probably suffice. However, most view capital and surplus requirements not only as a screening device but also as protection against inadequate reserves, inadequate premiums, decreases in the value of assets, uncollectible reinsurance, catastrophic events, and shortfalls in investment income. That is, higher capital and surplus requirements (assuming the absence of a corresponding decrease in the level of established reserves) are a greater buffer to absorb at least some adverse operational experience or other financial setback.

Risk-based Capital. With the failures of banks and other financial institutions (including the savings and loan debacle), the several property and liability insurer failures in the 1980s, and the financial impairment of some high-profile life insurers in the early 1990s, momentum built for strengthening the existing system of regulating the insurance enterprise�s financial solidity. The traditional fixed-dollar minimum capital and surplus�perceived as being too low and not effectively related to the riskiness of an insurer�s current operations�were a prime target.

In December 1992, the NAIC adopted risk-based capital requirements for life insurers to better enable the regulators to ensure that insurers maintained an adequate financial cushion to protect against a wide range of risks to their financial condition. At the heart of the risk-based capital requirements is a formula to calculate the minimum amount of capital/surplus an insurer should have in view of that insurer�s exposure to asset default risk, insurance risk, interest rate risk, and business risk. The riskier the individual insurer�s operations, the greater the risk-based capital required to avoid regulatory action. The regulator can compare the insurer�s actual capital/surplus with its risk-based capital to better assess whether there is need for regulatory action. The risk-based capital formula approach is incorporated into the NAIC annual statement blank effective in 1993.

The NAIC also adopted the Risk-Based Capital for Life and/or Health Insurers Model Act, which sets forth several regulatory action levels of increasing severity, each succeeding level triggered by a worsening relationship between the insurer�s actual capital and its adjusted risk-based capital (or some other specified event). At the company action level the insurer must submit proposed corrective actions to the commissioner for review and approval. At the regulatory action level the commissioner performs an examination of the insurer and orders corrective actions. If the authorized control level is reached, the commissioner is authorized to place the insurer under rehabilitation or liquidation. Finally, at the mandatory control level the commissioner causes either rehabilitation or liquidation. Thus the act is designed to enhance the regulator�s authority and willingness to intervene if an insurer experiences financial difficulty.

Monitoring Financial Condition of Life Insurers. Establishing minimum standards and imposing specific prohibitions or restrictions are of little use if the regulator lacks sufficient means to ascertain failure of an insurer�s compliance with the requirements or has inadequate methods of enforcement in the event of violation. Over the years, in addition to personal contacts and street knowledge about insurers doing business in their states, the regulators have developed a series of formal monitoring mechanisms to detect problem companies. Those used on a widespread basis have evolved in the context of state collective efforts through the NAIC. Insurance departments have three basic mechanisms for detecting financially troubled insurers: financial statements, early warning systems, and examinations.

Financial Statements. The NAIC annual statement blank filed by insurers in each state in which they do business is the foundation of financial regulation. Insurers must prepare these statements in accordance with regulatory accounting principles that have evolved in response to the overriding concern with solvency. Statements are designed to provide a conservative (liquidating) measure of statutory surplus using statutory accounting principles (as distinguished from focusing on the insurer as an ongoing concern, which would use generally accepted accounting principles, commonly referred to as GAAP). The NAIC�s establishment of a standardized annual statement promotes the basic objective of uniformity in financial reporting, an area where comparability of data is extremely important.

The annual statement (including a balance sheet and operation statements) is a source of voluminous information on the insurer�s financial condition and operations. Insurance department analysts review the annual statements, and data is extracted from them to be processed by individual states, the NAIC, and private analytical computer systems. The ensuing analysis can trigger more in-depth investigations, including a specifically targeted or a comprehensive examination of an insurer when there are suggestions of serious financial difficulty.

Failure to file an accurate annual statement, signed by a responsible officer of the insured, is a violation of law. Knowingly making a false entry of a material fact in any book, report, or insurer statement, or omitting to make a true entry of any material fact is also illegal. Violators are subject to monetary fines, license revocation, or possible criminal sanctions for fraud. The individual states and the NAIC review the annual statements, using various cross-checks and tests to detect problems in the accuracy of reporting. Nevertheless, whether due to inadvertent error, sloppy accounting practices, or intentional misrepresentation, reporting erroneous information has not been uncommon. In response, several individual states and the NAIC have moved to require independent certified public accountant (CPA) audits of annual statements and actuarial or qualified reserve specialist certification of the adequacy of policyowner reserves as a test of the validity of the information submitted in the annual statement. However, the requirement of CPA audits does not limit the commissioner�s authority (although, ideally, it reduces the need) to conduct insurance department examinations.

Early Warning Systems. In the early 1970s, the NAIC established a computer database consisting of information derived from individual insurance company annual statements. From this the early warning system known as the Insurance Regulatory Information System (IRIS) evolved. IRIS consists of two phases: (1) the statistical phase, during which the NAIC compiles information from insurer financial statements and computes a variety of financial ratios that are made available to the state insurance departments and (2) the analytical phase, during which a team of insurance department experts from different states conducts a financial analysis. The latter phase focuses on insurers that exhibit a number of ratios outside the specified acceptable ranges. IRIS and individual state early warning systems, either separately or in conjunction with each other, seek to detect insurers heading for financial trouble far enough in advance that timely remedial action can be taken or the insurer closed down as soon as possible.

Examinations. States have long had the authority to send experts into an insurance company to conduct an in-depth examination of its financial condition. However, since many insurers do business in several states�if not nationwide�if each state were to exercise its power to examine each company, there would be an immense duplication of effort, unnecessary and considerable expense, and conflicting examination reports. To avoid these problems the NAIC has established a coordinated examination system under which examiners representing different states conduct a single examination of the company on behalf of all states in which the insurer does business. In addition, the NAIC has developed (and updates on an ongoing basis) the Examiner Handbook to maintain and improve the quality and uniformity of examinations conducted under the auspices of the NAIC.

The 1990 NAIC Model Law on Examinations (replacing its 1956 version) authorizes the commissioner to conduct examinations whenever he or she deems necessary and to determine the scope of the examination. Nearly half of the states have adopted the model law (or something similar), and all states have enacted some type of law or regulation governing examinations. The objective is to focus insurance department resources on companies having or likely to have financial difficulty. However, all insurers still have to be examined at least once every 5 years. In lieu of examining a foreign insurer, the commissioner may accept the examination report of the insurer�s state of domicile.

When an insurer experiences substantial financial adversity, the commissioner has the responsibility and the authority to act. If the commissioner believes that with proper management the insurer can be made solvent again, he or she can supervise or rehabilitate the insurer. If the insurer is hopelessly insolvent at the outset or if after efforts to supervise or rehabilitate it, it is apparent that the insurer cannot be saved, the commissioner can move to place the insurer into liquidation. The commissioner�s authority to conduct rehabilitation and liquidation proceedings applies only to domestic insurers. If an insurance commissioner is concerned about the financial condition of an out-of-state company, he or she may suspend or revoke that insurer�s license to do business in the state.

In 1977 the NAIC adopted the Insurers Supervision, Rehabilitation and Liquidation Model Act. As of 1992, a substantial majority of the states had adopted the act or similar statutory provisions. The model establishes a comprehensive and modernized system for rehabilitation and liquidation.

Regardless of the efficacy of regulations to avoid it, insurer insolvency will occur. However, not until a 1960 congressional investigation highlighted numerous insolvencies, especially high-risk automobile insurers, did the insurance guaranty fund concept achieve widespread application as a way to improve insurer reliability. Responding to both the problem of insolvency and the threat of federal insolvency legislation, the NAIC adopted a Model Guaranty Fund Law in 1969 for property and liability insurance to assume the insolvent insurer�s claim-paying function and absorb the insolvent insurer�s funding deficiencies in the payment of claims. In 1970 it did likewise for life and health insurance. (The act was substantially revised in 1985 and again amended in 1987.) As of 1991, all states had enacted some type of guaranty fund law both for life and health insurance and for property and liability insurance, a few of which preceded�but most of which are patterned after�the NAIC models.

The NAIC Life and Health Insurance Guaranty Association Model Act is intended to protect policyowners, insureds, beneficiaries, annuitants, payees, and assignees against losses due to an insurer�s impairment or insolvency. The protection extends not only to paying claims, such as cash values and already owing death benefits, but also to the continuation of coverage since an insured may be elderly or in impaired health, rendering him or her unable to obtain new and equivalent coverage from other insurers. This protection is through a statutorily created Guaranty Association whose membership consists of all insurers licensed to do business in the state in coverages under the act.

Protection is afforded primarily to persons residing in the state. The act covers life, health, and annuity contracts. Coverages for certain insurance products have been excluded (nonguaranteed aspects of variable contracts, for example). The association is liable for no amounts in excess of the obligations under the covered contract; nor will its liability exceed $100,000 in cash values or $300,000 for all benefits (including cash values) with respect to any one life, $100,000 for health insurance benefits, and a total of $5 million on unallocated annuity contract benefits.

Although the association is intended to act after the insurer has been deemed insolvent pursuant to an order of liquidation, if the commissioner finds an insurer to be potentially unable to fulfill its contractual obligations, the association may guarantee, assume, or reinsure any or all of the insurer�s policies under certain conditions. This authority enables the association to provide early assistance that helps to avoid or minimize further deterioration and thereby save costs in the long run. If the insurer is found insolvent by a judicial order of liquidation, the association can either (1) guarantee, assume, or reinsure (or cause to be guaranteed, assumed, or reinsured) the insurer�s policies and contracts or assume payment of the insolvent insurer�s contractual obligations and provide money or pledges to discharge such duties or (2) with respect to life or health policies, provide benefits and coverages. Any new contracts can be offered without new underwriting.

Any person receiving benefits pursuant to the act is deemed to assign the rights under the covered policy to the association, thereby enabling the association to recoup, at least in part, the claims it pays and the costs it incurs from the insurer�s assets. When an insurer is declared insolvent, the fund assumes the responsibility for the payment of policyowner claims; funds for such payments are derived from assessments against member insurers based on a percentage of the insurer�s relevant premiums written in the state. If the assessments fail to provide sufficient funds in a given year, the association is empowered to borrow funds that can later be repaid out of future assessments.

Although there is a high degree of similarity in the overall structure of life insurance guaranty funds from state to state, few if any state laws are identical, and many exhibit significant variations from one another. Variations arise in such areas as maximum claim amounts, insurance products covered, insurer assessment limits, and assessment recoupment provisions.

While the guaranty funds have functioned reasonably well, critics have raised concerns about whether the funds are structured to handle future much larger insolvencies. Suggestions for improvement range from dealing with specific administrative and coordination problems, reducing variances in the protection afforded between states, and utilizing interstate compacts to replace the current system with a single federal insolvency fund. But no matter how the guaranty system evolves in the years ahead, in addition to regulation to prevent or minimize the size of insolvencies, some type of guaranty fund system has become a vital element in achieving the fundamental insurance regulatory goal of ensuring a reliable insurance mechanism.

As noted earlier, in addition to the goal of reliability, state insurance regulation has a second body of fundamental goals aimed at the insurer�s conduct in the marketplace: reasonableness (which seeks to bar mistreatment of the whole body of policyowners), equity (which seeks to avoid unfair discrimination between individual policyowners), and fairness (which seeks to prevent mistreatment of policyowners as individuals). The following regulatory areas foster one or more of these three goals.

Policy forms used by insurers are subject to some degree of regulation to protect policyowners, insureds, and beneficiaries against unfair and deceptive provisions and practices.

Policy Form Content. Standard Provisions. Although there is no statutory standard life insurance policy, states require life insurance contracts to contain certain specified standard provisions, either as set forth in the statute or whose effect is the same in substance to those in the statute. Provisions more favorable to the insured than those required by statute may also be used. Provisions that are unfairly prejudicial to those interests are excluded.

Generally, the standard provisions, as recommended by the NAIC and mandated by the states, include the following: an entire contract clause, an incontestable clause, a grace period, reinstatement, nonforfeiture values, policy loans, annual apportionment of dividends, a misstatement of age provision, and settlement options. Individual states impose other requirements on policy terms (for example, prohibiting any exclusion from liability for death other than specified limited exclusions, such as a war clause, a suicide clause limited to 2 years, an aviation exclusion, and a hazardous occupation and/or a residence exclusion for 2 years).

Nonforfeiture Provisions. Level premium life insurance involves charging more premiums than necessary for protection in the policy�s early years in order to accumulate monies, as reflected by insurer policy reserves, to fund the higher cost of protection as the insured grows older. The question arises as to what should be done with the accumulated funds if the insured fails to pay the premium or wishes to terminate the policy.

Starting with Massachusetts in 1861, states began to enact nonforfeiture laws defining the minimum amount that must be returned upon surrender of a policy to prevent forfeiting equities accumulated in level premium policies. Updating and standardization were achieved in the 1940s with NAIC adoption of the Standard Nonforfeiture Law for Life Insurance and its subsequent enactment in virtually all states. The model law has been amended on several occasions through the 1980s. No life insurance policy may be issued in a state unless it contains, in substance, the provisions specified in the law or corresponding provisions that, in the opinion of the commissioner, are at least as favorable to the defaulting or surrendering policyowner.

The minimum nonforfeiture value at any policy duration is the present value of the guaranteed future benefits under the policy, minus the present value of future adjusted premiums and the amount of any policy indebtedness. The adjusted premiums reflect the high first-year expenses associated with putting the policy on the books. The law sets forth the method of calculating the adjusted premiums, including the mortality table and the maximum interest rate to be used, both of which have been updated over time.

The values that have to be returned to the policyowner are referred to as nonforfeiture values, and the alternative forms that the policyowner can select are referred to as nonforfeiture options. The Standard Nonforfeiture Law requires policies to contain three nonforfeiture options: cash surrender value, reduced paid-up insurance, and extended term insurance. (The nature of these options is discussed in chapter 19.)

Readability. To reduce the potential for deception of or misunderstanding by insureds, several states have adopted readable contract laws or regulations such as the NAIC Life and Health Insurance Policy Language Simplification Model Act, whose purpose is to establish minimum standards for policy readability. (As of 1992, a majority of the states had adopted the model or something similar to it.) In essence, these regulations require that insurance contracts be written in simplified language, using a minimum number of technical or legal phrases and employing a basic vocabulary readable by someone with a high school education. The laws must usually pass a test that predicts the difficulty that readers will experience with the policy�s text, based on such measures as average sentence length and syllable density.

Unfair Discrimination. Standard provisions and readability requirements regulate policy form and content by mandating what an insurer must include in its policies. Insurance regulation deals with what should not be contained in policies. As a prime example, the NAIC Model Unfair Trade Practices Act prohibits unfair discrimination between individuals of the same class and life expectancy in the benefits payable and in the terms and conditions of a life insurance policy or annuity contract. If a commissioner finds unfairly discriminatory provisions, he or she may disapprove the policy.

Substantive Content of Special Types of Policies. The policy form and content requirements noted above have general applicability to different types of life insurance policies. In addition, certain types of policies are subject to more comprehensive treatment by regulations designed for their particular nature (for example, variable annuities, variable life insurance, market-value adjustment contracts, index policies, and universal life insurance). (Regulation of these policies is considered in chapter 27.)

Filing Policy Forms. State law provides that a policy form may not be used in the state until it is filed with and approved (or not disapproved within a specified number of days) by the insurance commissioner. Typically, the commissioner is empowered to disapprove policies or provisions that do not contain statutorily prescribed provisions or are deemed to be unfair, deceptive, or objectionable in some other statutorily specified way.

It is beyond the scope here to trace the long, complex, and convoluted history of rate regulation of property and liability insurance. Suffice to say that the basic statutory standards have been that rates cannot be excessive, inadequate, or unfairly discriminatory. These standards have been administered through a variety of detailed rate regulatory laws involving filing and approving rates. Although life insurance and annuity rates cause the same basic regulatory concerns as property and liability insurance, the regulatory response has been significantly different because life and annuity rates are not generally subject to commissioner approval.

The regulatory approach to excessive life insurance rates has been at least twofold. First, with several hundreds of life insurance companies competing for business, traditionally competition has been relied on as being sufficient to curb rate excessiveness. The promulgation of life insurance price disclosure regulations (discussed later in this chapter) to assist potential buyers in making an intelligent choice among competing products further enhances the competitiveness of the life insurance marketplace. Second, as a result of the Armstrong Investigation, New York enacted a complex expense limitation law to curb the amount of expenses that can be incurred in producing new business and continuing existing business. Although such provisions have not been enacted on a widespread basis, their impact extends beyond New York state since even out-of-state insurers doing business in New York must comply with the requirements.

The adequacy of premiums is indirectly regulated by the imposition of policyowner reserve liability requirements. Under the Standard Valuation Law, states mandate the establishment of minimum reserves. When an insurer is compelled to establish reserves at a higher level than it would have done in the absence of the minimum requirements, greater assets are needed to offset the higher reserves. This, in turn, should lead the insurer to charge adequate premium rates.

To deter unfairly discriminatory rates, state statutory provisions aimed at unfair trade practices, as mentioned earlier, include prohibitions against making or permitting any unfair discrimination between individuals of the same class and equal expectation of life in the rates charged for any life insurance policy or annuity.

In addition to overseeing insurer operations as to the products sold (controls of policy forms and content) and the prices charged, state insurance regulation is also directed at insurer treatment of the insurance-consuming public in terms of market conduct.

Unfair Trade Practices Act. States have long exercised regulatory control over certain unfair trade practices, such as misrepresentation, rebating, and discrimination. In response to the McCarran Act�s invitation (pursuant to the "regulated by the state law" proviso) to oust federal insurance regulation, the NAIC developed�and virtually all states enacted�the model Unfair Trade Practices Act, which is at the heart of regulatory efforts to ensure appropriate market conduct. Since then the act has been amended several times, most recently in 1992, and the amendments have been widely adopted to broaden the scope of prohibited conduct, to expand enforcement authority, and to establish commissioner rule-making authority.

The act�s basic prohibition is that it is an unfair trade practice for an insurer or agent to commit a defined practice if such practice is committed flagrantly and in conscious disregard of the act or any rule promulgated thereunder, or such practice is committed with such frequency to indicate a general business practice. The act then defines prohibited conduct in the following areas: misrepresentation and false advertising of insurance policies; false information and advertising generally; defamation; boycott, coercion, and intimidation; false financial statements and entries; stock operations and advisory board contracts; unfair discrimination; rebates; prohibited group enrollments; failure to maintain marketing and performance records; failure to maintain complaint-handling procedures; misrepresentations in insurance applications; and unfair financial planning practices. In addition, the act contains a separate section directly aimed at prohibiting coercion in credit insurance. Moreover, after a notice and hearing, the commissioner may promulgate rules and regulations to identify specific methods of competition or practices that are generally prohibited in the above areas.

The commissioner is empowered to examine and investigate the affairs of an insurer or agent to determine whether such person(s) has been or is engaging in proscribed unfair practices. Whenever there is reason to believe that an unfair practice has occurred, after an appropriate hearing, the commissioner may issue a cease-and-desist order and may, at his or her discretion, order monetary penalties specified in the act or suspend or revoke the person�s license if that person knew or should have known that such conduct was in violation of the act. Violations of cease-and-desist orders incur further monetary penalties. Furthermore, not only does failure to maintain marketing and performance records or complaint-handling procedures constitute an unfair trade practice, but, to aid enforcement, state insurance departments (both individually and collectively through the NAIC) can also perform market-conduct examinations separate from but similar to examinations for financial solidity.

Business-generating Activity. Insurance regulators exercise a substantial measure of control over the methods by which insurers and their agents obtain business.

Misrepresentation in Getting Business: Solicitation and Advertising in General. Misrepresentation for the purpose of inducing the payment of an insurance premium was adjudged more than 100 years ago to be a crime in Massachusetts. During the present century, legislation has been enacted to penalize such conduct. The Unfair Trade Practice Act, which reflects the current widely adopted approach, contains provisions to combat the use of misrepresentations in efforts to acquire business. First, the act defines as an illegal unfair practice the making, issuing, or circulating (or causing to be made, issued, or circulated) of any estimate, illustration, statement, sales presentation, omission, or comparison that misrepresents the benefits, advantages, conditions or terms of any insurance policy or the dividends to be received. Second, the act also defines as an unfair practice the making, publishing, disseminating, circulating, or placing before the public in a newspaper or magazine or on radio or television an untrue, deceptive, or misleading advertisement about the business of insurance or about an insurer in the conduct of its insurance business. Third, the model act contains an antidefamation provision defining as a prohibited unfair trade practice the making of or aiding in oral or written statements that are false or maliciously critical of the financial condition of any insurer and that are calculated to injure such person.

As insurers and agents solicit business through a variety of business-generating activities, they are subject to these general constraints. Violation of these constraints can result in not only an order to stop but also monetary fines and possible license revocation.

Although the insurance regulator can exert control over advertising practices utilizing the general provisions contained in the Unfair Trade Practices Act, to gain more specificity and to better provide guidance to insurers and agents, the NAIC developed Model Rules Governing the Advertising of Life Insurance in 1975. These rules regulate the form and content of advertisements, establish minimum disclosure requirements in advertising life and annuity contracts, and provide enforcement procedures. As of 1992, 18 states had adopted either the NAIC model rules or comparable rules, and another 11 states had put their own independent set of related rules into place.

Policyowner Dividends. The model act explicitly proscribes statements, sales presentations, illustrations, comparisons, or omissions that misrepresent policyowner dividends or share of surplus to be received on an insurance policy or that make any false or misleading statements about dividends or share of surplus previously paid on any insurance policy. The advertising rules further specify that an advertisement (the word advertisement is used in the broad sense) must not state or imply that either the payment or the amount of dividends is guaranteed. Dividend illustrations must be based on the insurer�s current dividend scale and must contain a statement that they are not guaranteed and not estimates of future dividends.

Unfair Financial Planning Practices. Amendments to the Unfair Trade Practices Act in the 1980s defined certain of an insurance producer�s financial-planning activities as unfair trade practices. It is unlawful for an agent to hold himself or herself out as a financial planner, investment adviser, or other specialist engaged in the business of giving financial planning or investment advice when that person is, in fact, engaged only in the sale of insurance policies. Even if the person is engaged in the business of financial planning, he or she must disclose that he or she is also an insurance salesperson and that a commission for the sale of an insurance product will be received in addition to any fee the prospect pays for the financial planning service. An insurance producer may not charge a fee for financial planning unless it is based on a written agreement.

Price Disclosure. Several factors enter into rational decision making when purchasing a life insurance policy, including the suitability of the policy to what the buyer wants and needs, the quality of the policy, the solidity of the insurer, the service to be provided by the agent and/or insurer, and of course, the cost. Other things being equal, policyowner interest is better served by purchasing at lower rather than higher prices. If the other factors are unequal, the prospective purchaser needs to weigh price differentials against the differences in other factors that are important to him or her. Therefore meaningful information is an essential element in insurance consumer protection.

Furthermore, insurance regulation relies on competition as the primary means to prevent excessive rates. Effective price competition is predicated on buyer willingness and ability to purchase insurance from lower-cost companies. This, in turn, requires that buyers be able to compare prices of policies issued by different insurers. Adequate disclosure of life insurance pricing information is fundamental not only to serving the prospective policyowner in his or her individual purchase decision, but also to maintaining an effective competitive marketplace, which benefits life insurance consumers as a whole by tending to keep prices overall at reasonable levels.

Increased consumer education and price awareness in the early 1970s demanded improved cost-comparison methods. Consequently, the NAIC developed, adopted, and has frequently amended the NAIC Model Life Insurance Disclosure Regulation, which mandates general disclosure requirements and price comparison information. Over 30 states have adopted or closely followed some version of the NAIC model regulation, and additional states have implemented somewhat different cost disclosure requirements.

The 1992 version of the NAIC model regulation seeks to improve the quality of information offered to prospective life insurance buyers to better enable them to select the plan most suitable to their individual circumstances, to improve their understanding of the basic features of the policy to be purchased, and to enhance their ability to evaluate relative costs of similar types of policies. To achieve these purposes insurers are required to give the prospective purchaser a buyer�s guide containing a clear explanation of products and how to shop for them and a policy summary containing essential information pertaining to the particular policy being considered. In general, the insurer must give both of them to the prospective policyowner before accepting the applicant�s initial premium unless either the policy or the policy summary contains a 10-day (or longer) unconditional refund provision. If so, the guide and summary may be delivered with or prior to the policy.

Among the elements the policy summary is required to disclose are two interest-adjusted cost indexes for the policy. These indexes reflect the time value of money by recognizing that money is paid and received at different times and that costs can be better compared by using a specified interest assumption. The Net Payment Cost Comparison Index is useful when the main concern is that benefits are to be paid at death. This index helps to compare costs at some future point in time, such as 10 or 20 years, if premiums continue to be paid and cash values are not withdrawn. The calculations reflect the time value of money, assuming a specified rate of 5 percent. The index is derived from an estimate of the average annual net premium outlay the policyowner incurs (premiums less dividends) adjusted by interest (5 percent) to reflect the point in time when the premiums are paid in and the dividends paid out during a 10- or 20-year period.

The Surrender Cost Comparison Index is useful when the main concern is the level of the cash values. This index compares the costs of surrendering the policy and withdrawing the cash value at some future point in time, such as 10 or 20 years. The surrender cost index is the payment index less the annualized equivalent of the cash value available to the policyowner at the end of the 10- or 20-year period, adjusted for interest. The result is the average amount of each annual premium that is not returned if the policy is surrendered for its cash value. Although the use of these cost indexes is subject to caveats�including the fact that they do not reflect actual net costs to the individual policyowner�the prospective cost estimates can be valuable in giving the applicant a relative sense of which similar policies are high or low in cost. Over time, as circumstances change and different products evolve, changes in the information provided and the comparative cost measures are to be expected. Nevertheless, despite the current limitations in the NAIC cost-disclosure approach, the mandate that insurers furnish buyer guides and policy summaries marks a major advancement in enhancing informed life insurance buyer decision making.

Replacement. Replacement is a transaction in which a new life insurance or annuity contract is to be purchased and it is known, or should be known, by the proposing agent that, because of such transaction, an existing life insurance or annuity has been or will be terminated, converted, or otherwise reduced in value. An existing insurance policy may be replaced by another policy from the same insurer or by a policy issued by a different insurer. When a policyowner is induced to discontinue and replace a policy through agent or insurer distortion or misrepresentation of the facts, it is referred to as "twisting." However, replacement is broader than twisting since it may occur in the absence of any misrepresentation.

The replacing agent�s motives may be laudable or less so. If an agent accurately discloses the facts and the replacement works to the policyowner�s benefit, regulatory concern is served. However, because of high first-year commissions on new policies, agents have financial incentives not only to take business away from another insurer but also to replace a policy in their own company and thereby generate another first-year commission. Furthermore, insurers seeking new business may not be adverse to taking it away from a competitor even though doing so may not benefit the policyowner.

Traditionally, most replacements were considered to be detrimental to the policyowner since he or she had already incurred the high first-year expenses, since the premiums under the new policy might be higher because of the policyowner�s increased age, and since the suicide and incontestable provisions might expire sooner (if they have not already done so) under the existing policy. However, in more recent years, with changing conditions (including higher interest rates and improved mortality experience), a policyowner may substantially improve his or her situation by replacing an existing policy in either the same or a different company.

To protect policyowners� interests regulators must balance the need to preserve the opportunity to replace a policy when it benefits the policyowner and the need to reduce potential injury to policyowners from unprofessional agents and insurers. As a starting point, the Unfair Trade Practices Act contains prohibitions against misrepresentation, including misrepresentations to induce the lapse, forfeiture, exchange, conversion, or surrender of any insurance policy. In 1969�followed by significant revisions in 1978 and 1984�the NAIC adopted what is now called the Replacement of Life Insurance and Annuities Model Regulation. Whereas the original version established minimum standards of conduct, the 1978 version shifted the focus to providing the buyer with full disclosure of information in a fair and accurate manner, including ample time to review the information before making a final decision. Approximately 40 states have promulgated regulations governing life insurance replacement, most based on either the original or revised versions of the NAIC model.

When an agent submits an application for life insurance or an annuity to his or her insurer, it must include a statement about whether or not the policy is a replacement. If it is, the agent must give the applicant a prescribed notice alerting the applicant to the need to compare the existing and the proposed benefits carefully and to seek information from the agent or insurer from whom he or she purchased the original policy. The replacing insurer must advise the other insurer of the proposed replacement and provide information on the replacing policy or contract, as required in the Model Life Insurance Disclosure Regulation (or the Model Annuity and Deposit Fund Disclosure Regulation). The replacing insurer must also give the applicant a 20-day free look at the replacement policy, during which he or she has an unconditional right to a full refund of all premiums paid if he or she decides not to retain the policy. The existing insurer or agent has 20 days to furnish the policyowner with policy information on the existing policy, prepared in accordance with the disclosure regulation, containing premium, cash values, death benefits, and dividends computed from the current policy year. Both insurers and agents are responsible for the accuracy of the information submitted to the existing policyowner.

Free Look. Although the life insurance transaction is long term, a significant number of policies lapse within 2 years of purchase. Since early cash values tend to be very small in comparison to the premium paid because of heavy acquisition costs and other expenses, the failure to continue a life insurance policy can be quite costly to the policyowner. Thus the decision to do so reflects serious dissatisfaction with the original decision to buy.

To give policyowners enough time for sober, unpressured reflection on such a substantial long-term financial commitment, a majority of states have enacted a "free look" law, which gives the policyowner 10 or 20 days to reconsider the decision to replace a policy. If he or she determines that the purchase was unwise for any reason, the insurer is required to rescind the replacement policy and refund monies paid. Versions of the free look requirement are included in the life insurance disclosure and replacement regulations.

Rebates. Rebating is reducing the premium or giving some other valuable consideration not specified in the policy to the buyer as an inducement to purchase insurance. The classic rebate situation involves an agent who agrees to give a portion of his or her commission to the buyer as a reduction of the first premium to induce the prospect to insure.

Between 1885 and 1905, as a part of a larger package of abusive practices to acquire business at any price, rebating became commonplace in the fierce competition between agents. Antirebate laws were enacted to prevent excessive and ruinous competition. Ultimately, prohibition against rebating was incorporated into the NAIC Unfair Trade Practices Act in 1947.

The proponents of maintaining the antirebate laws include the life insurance industry (which does not want legislative changes that would make it more expensive and difficult to attract and retain an agency force) and the national and local life insurance agent trade associations (viewing rebates as unwarranted pressure on their compensation). The arguments against rebating include the following: (1) Rebating results in varying first-year charges to similarly situated policyowners, which is inequitable discrimination against consumers who lack the economic leverage to demand rebates or the knowledge to do so. (2) Permitting rebates can lead to destructive rate cutting ("ruinous competition") that can adversely affect insurers� financial condition. First, replacements prevent insurers from recovering issue expenses normally amortized over several years. Second, insurers pressured to raise commission rates to enable agents to compete by rebating might be unable to raise premiums to recover the increased expenses. (3) Lured by a rebate, a policyowner can more easily be encouraged to replace his or her existing policy. (4) Many agents and agencies are not well positioned to offer significant rebates. (5) Permitting rebating encourages agent turnover and aggravates agent shortages. This lessens the number of agents available to service the public and to foster competition in the marketplace. Since life insurance tends to be sold rather than bought, the fewer the number of agents, the smaller the amount of life insurance sales, and the greater the underinsurance of the public. (6) Buyers may be more influenced by the size of the rebate�the deal they can make�than by the total long-range costs, the nature and suitability of the products, and the quality of agent counseling and service.

Despite these contentions, the 1980s witnessed increasing agitation to eliminate the ban against rebating. Antirebating critics argue as follows: (1) Antirebate laws needlessly shelter agents from competition, thereby contributing to excessive insurance rates. (2) Ruinous competition and the increased likelihood of insolvency are "sham arguments." The amount of an agent�s rebate does not affect the amount of the premium received by the insurer to fund its obligations. How an agent spends his or her money is irrelevant to insurer solvency. (3) The antidiscrimination rationale lacks substance. The life insurance business is replete with examples of discrimination (economies of size garner better rates, insurers discriminate in underwriting, agents discriminate in selecting their prospects, and so on). (4) In stifling competition between agents, the ban on rebates permits the less competent or inefficient agents to be compensated on a basis equivalent to the most knowledgeable and efficient agents.

In recent years, lawsuits have been brought in several states challenging the constitutionality of the antirebate provision. In 1986 the Florida Supreme Court overturned that state�s law prohibiting rebates as a violation of the Florida Constitution�s due process clause. For many persons, including courts in other states, the Florida Supreme Court�s due process analysis has proven unpersuasive. In 1990 Florida enacted a law regulating rebates but also permitting insurers to prohibit their agents from rebating commissions. The constitutionality of such a law is being challenged. In California, when voters adopted a broad referendum (commonly referred to as Proposition 103) covering a wide gamut of insurance issues, they repealed the ban on rebates in that state.

Elsewhere, the influence of proponents of continuing the ban on rebates have prevailed. To date, no other state supreme court has found the antirebate provision to be unconstitutional. Unless change is compelled at the federal level, it appears that the antirebate provision will remain the law in the vast majority of states for at least the immediate future. In the meantime, Florida and California are a testing ground that may reveal whether the fears of proponents of the ban or the claims of proponents of change are realistic or exaggerated.

Privacy. When underwriting, a life insurer typically investigates factors bearing on the applicant�s insurability, especially when the amount of insurance applied for is substantial. Several states require that the insurer obtain permission from the applicant to make this investigation. A central reporting agency, the Medical Information Bureau (MIB), receives and retains information about underwriting impairments of persons who have applied for insurance. Through this source, an insurer can often verify the accuracy of an applicant�s statements if he or she has previously applied for insurance.

In recent years privacy has become a sensitive issue (even more so with the proliferation of AIDS). Several states have imposed restrictions on the underwriting information an insurer may obtain, in part due to the concern that the information may be disclosed to others. In 1979 the NAIC adopted the Insurance Information and Privacy Protection Model Act (amended in 1981) to establish standards for the collection, use, and disclosure of information gathered by insurers, agents, or insurance support organizations. The act tries to achieve a balance between the need for information necessary to conduct the insurance business and the public�s interest in privacy. The commissioner is empowered under the act to examine insurers, agents, and support organizations to ascertain compliance with the Privacy Act, issue cease-and-desist orders, and issue reports. Violations are subject to monetary penalties and/or revocation of an insurer�s or agent�s license. Furthermore, any person whose rights are violated may seek damages through the judicial process. By mid-1992, approximately 15 states had adopted some form of privacy regulation, most of which is patterned after the NAIC model act.

Unfair Discrimination. All states have enacted laws or promulgated regulations, in substantial part based on NAIC models (especially the Unfair Trade Practices Act), proscribing unfair discrimination in a wide variety of contexts. Moreover, the commissioner has the authority to further define unfair trade practices and promulgate regulations.

The law prevents unfair discrimination, not simply discrimination. Some discrimination among policyowners is deemed appropriate since not all policyowners present the same degree of risk. In contrast, unfair discrimination refers to inequality of treatment among policyowners that is not justified by underwriting considerations or sound business practices or that is deemed unacceptable because of external public policy objectives. As an example of unacceptable discrimination, the model act defines refusing to insure, refusing to continue to insure, or limiting the amount of coverage available to an individual because of sex, marital status, race, religion, or national origin as an unfair trade practice. Here, no reference is made to unfair discrimination. Whether or not there are valid underwriting or actuarial reasons, these types of discrimination are banned as a matter of fundamental social policy.

As discussed earlier, among the specific prohibitions in the model act are making or permitting any unfair discrimination between individuals of the same class and life expectancy in the rates charged for life insurance or annuities, the dividends paid, other benefits paid, or in the contract�s terms and conditions. Furthermore, it is illegal discrimination to refuse to insure solely because another insurer has rejected granting a new policy or has canceled or failed to renew an existing policy. Insurers must base their decisions on sound underwriting, rather than on another insurer�s action.

To further define unfair trade practices the NAIC adopted a model regulation in 1979 proscribing as unfair discrimination any life and health insurer�s refusal to insure, refusal to continue to insure, or charging a different rate for the same coverage solely because of an applicant�s physical or mental impairment unless the rate differential is based on sound actuarial principles or is related to actual or reasonably anticipated experience. A 1978 model regulation (as amended in 1984) does the same with respect to blindness, except that there is no exception for actuarial experience. Nearly half of the states have adopted legislation or regulations pertaining to mental and physical impairments (10 of which are based on the NAIC model), and most states have done so pertaining to blindness (approximately 35 of which are based on the NAIC model).

In 1975 the NAIC adopted the Model Regulation to Eliminate Unfair Sex Discrimination, which prohibits denying benefits or availability of coverage on the basis of sex or marital status. As of 1992, over 15 states had adopted the model regulation (or something similar), and another nine states had effected related legislation or regulations. The model regulation refrained, however, from mandating the same rates for men and women. Women�s life expectancy is greater than men�s, generally resulting in lower life insurance rates and higher annuity rates for women. Traditionally, such rate discrimination has been deemed equitable and appropriate, rather than unfair, since the rates reflect actual cost experience.

However, in the 1980s there were demands for nondiscriminatory unisex or gender-neutral insurance rates, regardless of the actuarial soundness of such classifications. Although group contracts now have unisex rates, life insurance companies have generally resisted unisex rates for individual policies. (Gender-neutral rating laws are a good example of an external goal�s impact on the insurance industry, as discussed previously in this chapter.)

Policyowner Dividends. Nature and Distribution. Because of the long-term nature of a life insurer�s obligations and because of fixed premiums, charges for premiums need to be established on a conservative basis. Barring unusually adverse experience, conservative premiums should generate gains that increase the size of the insurer�s surplus. How this gain is allocated to surplus depends on whether the insurer writes participating or nonparticipating policies. (Nonparticipating policies guarantee the amount insured but do not entitle the insured to receive any benefits other than those explicitly set forth in the contract.) Most participating life insurance is written by mutual insurers; nonparticipating insurance is written by stock insurers.

The increase in surplus for mutual (participating) companies is normally greater since premiums are intentionally established more conservatively. The higher premium cost to the policyowners is adjusted by dividends paid to them. The extra margins built into conservative premiums and better-than-assumed mortality, interest, and expense experience the source of these dividends.

Mandated Annual Distribution. Although a life insurer�s management has considerable latitude in fashioning dividend policies, regulatory concerns have led to some limitations and mandates. An early source of regulatory concern arose out of the use of tontine and semitontine life insurance policies, which were very popular in the late 1800s. These policies enabled insurers to accumulate vast surpluses that were neither properly accounted for nor allocated to policyowners. Instead, management often squandered such funds in extravagance and corruption.

As a result of the Armstrong Investigation, New York enacted a statute requiring the annual apportionment and distribution of dividends to policyowners. Most states now require that an insurer make an annual apportionment of divisible surplus. Commissioners review insurer dividend formulas from time to time, often in conjunction with their examination of the insurance company. A few states limit the amount of aggregate surplus an insurer may accumulate to an amount not to exceed a specified percentage of the legal reserve.

Limits on Stockholders� Charge. The requirement for annual distribution of policyowner dividends is inapplicable to stock companies issuing nonparticipating policies. However, a potential conflict of interest arises in those stock companies issuing both participating and nonparticipating policies. In some states, as well as in Canada, there are laws or regulations limiting the amount of participating policies� unused margins that the company can allocate to the benefit of the stockholders (commonly referred to as the stockholders� charge). For example, in New York and Wisconsin, stockholders of insurers authorized to do business in the state are limited to 10 percent of the profits on participating business or $.50 per $1,000 of insurance in force, whichever is larger.

Unfair Discrimination. Although annual policyowner dividends are mandated and the dividend formulas are subject to periodic review by the insurance departments, insurers still have wide latitude in establishing dividend policy, as noted above. However, they are constrained by the Unfair Trade Practices Act, which defines as an unfair trade practice making or permitting any unfair discrimination in the policyowner dividends payable between individuals of the same class and life expectancy. Commissioner review and enforcement are the same here as they are for other unfair trade practices.

An insurance company�s basic function is to pay justified claims. Failure to administer the claims function to assure prompt and full payment of claims contravenes the basic regulatory goal of the insurance-consuming public�s fair treatment. The Unfair Trade Practices Act originally included a full section defining certain patterns of settlement practice conduct as unfair and subject to the commissioner�s full investigative and enforcement powers. However, in 1990, the NAIC opted to establish a free-standing act separate from the Unfair Trade Practices Act. The Model Unfair Claims Settlement Procedures Act sets forth standards for the investigation and disposition of claims arising under insurance policies. To supplement the act and further elaborate on insurer and agent obligations, the NAIC adopted the Unfair Claims Settlement Practices Model Regulation. It establishes minimum standards that relate to specific forms of misrepresentation, failure to acknowledge communications, failure to promptly investigate claims, and failure to effect prompt, fair, and equitable settlements. In addition, an insurer is required to maintain complete claim files that are subject to the commissioner�s examination. Several states have adopted the model regulation, and several others have similar or modified versions.

Whereas some aspects of insurance regulation aim at achieving either reliability of the insurance mechanism or reasonable, equitable, and fair treatment in the marketplace, other portions are concerned with both sets of insurance regulatory goals. In this context the following discussion relates to AIDS, fraud, management quality, and insurers in hazardous financial condition.

Impairing Financial Condition. The Acquired Immune Deficiency Syndrome, commonly referred to as AIDS, was first diagnosed in the early 1980s. The spread and the magnitude of this lethal disease has staggered the nation. In addition to the victim�s personal tragedies, there are the potential adverse effects on life and health insurers and their policyowners. The focus here is on life insurance.

The disease has reached near-epidemic proportions, promising a substantial increase in both the number of cases and the number of deaths in the years ahead. Life insurers anticipate significantly increased costs, with no compensating premiums, arising from AIDS-related deaths under existing policies that contain no exclusion for AIDS and were not underwritten for AIDS. Therefore to avert threats to their financial condition and widespread harm to their existing policyowners, life insurers try to underwrite prospective policyowners to avoid writing business on people who have or are likely to contract AIDS.

Traditionally, an insurer may ask an applicant various medical questions and require submission to a medical examination as a part of the underwriting process to determine whether or not to issue a policy and at what premium. Generally, medical underwriting and testing are lawful unless declared otherwise by statute or regulation. However, the emergence of AIDS as a social and political issue has complicated the insurer�s task. Public compassion for AIDS victims and their dependents has exerted pressure to make life insurance available to them at an affordable cost. Consequently, conflicts have emerged between the needs of AIDS victims and the adverse economic consequences to insurers and their policyowners in providing coverage to people with AIDS. Questions have arisen regarding an insurer�s right to ask (in the application for insurance or otherwise) whether the applicant has evidenced symptoms of AIDS or has been tested for the AIDS virus (and the results of the test), to test insurance applicants for exposure to the AIDS virus, and to deny insurance coverage based on test results. These questions, in turn, have led to issues pertaining to discrimination and privacy.

Discrimination. Clearly, people with AIDS (or the AIDS virus) present a much greater mortality risk than people who do not have the disease. As noted earlier, insurers are required by law to base premium rates on reasonable mortality assumptions and may not unfairly discriminate between applicants of equal life expectancy. Thus under general insurance unfair discrimination laws, insurers are permitted�perhaps even required�to treat AIDS victims differently from other classes of insureds.

However, discrimination can be viewed from another perspective. AIDS is concentrated more heavily within a few segments of the population�homosexuals, bisexuals, and intravenous drug users. While far from all persons in these segments contract AIDS, it is not unknown for insurers, in their efforts to reduce their exposure to insuring AIDS victims, to underwrite applicants on the basis of their sexual preference. This is argued to be unfair discrimination.

In 1986 the NAIC tried to deal with the issue by adopting underwriting guidelines. Although recognizing the fundamental importance of properly assigning risk classifications to determine coverage and establish a fair price, the guidelines prohibit as unfair discrimination determining insurability on the basis of sexual orientation. The guidelines prohibit questions intended to elicit an applicant�s sexual orientation, but insurers can continue to seek medical information, including information that enables the underwriter to assess the risk of the applicant�s having AIDS or the AIDS virus. The use of objective medical facts is not deemed to be a violation of the NAIC guidelines as long as the facts are not used to establish sexual preference that, in turn, becomes the basis for denying coverage. As of 1992, most states had adopted some requirement with respect to AIDS underwriting, with 17 states following the NAIC approach or something similar thereto.

Drafters of the NAIC guidelines were unable to achieve a consensus on the issue of AIDS testing. A few states have imposed restrictions on an insurer�s ability to screen out likely AIDS candidates by limiting or prohibiting the use of certain tests to reveal AIDS or the virus that can cause AIDS. However, there has been no successful movement to mandate insurers to make coverage available to AIDS victims. In states that permit testing, the insurer must obtain the written consent of an applicant who is requested to take an AIDS-related test, and the use of the test must be revealed.

Privacy. Critics assert that the underwriting process to discover the AIDS virus violates the applicant�s right to privacy�a major concern because of the possible economic, medical, and social consequences that could result from improper release of positive AIDS test results. Those against limitations on insurers� ability to underwrite stress that insurers have long maintained confidentiality of medical test results in such sensitive areas as chemical dependency, alcoholism, and syphilis. Furthermore, as discussed earlier, protections are afforded under state insurance privacy laws. The combination of state privacy laws and insurers� demonstrated ability to maintain confidentiality, they say, balances the applicant�s need for privacy with the insurer�s need for information.

As accumulators of substantial amounts of financial resources, insurance companies have sometimes been the scene of a variety of fraudulent or near fraudulent activities. An insurer can be victimized by fraud from at least three sources.

Insurance Claims against an Insurer. Policyowners, beneficiaries, or third-party claimants, either individually or as a part of a conspiracy, may seek to extract unwarranted funds from the insurer. Although this problem appears to be much more prevalent in other lines of insurance, life insurers have not been totally immune (for example, murder for life insurance claims). The primary deterrent is a state�s general criminal and civil laws against fraud. In addition, approximately half of the states have enacted specific laws against insurance fraud, some of which are based on the 1980 NAIC Model Insurance Fraud Statute. This statute specifically defines as a felony presenting any written or oral statements or documents to support a claim knowing that they are false, misleading, or incomplete concerning any fact material to the claim. A few states have established antifraud units within their insurance departments to investigate insurance claim fraud.

Business Relationships. An insurer might be the victim of unethical or fraudulent conduct perpetrated by those with whom it has entered into business relationships by providing insurance and insurance services. Two prime candidates emerge. First, fraudulent activities by agents or brokers can victimize insurers. For example, agents or brokers can obtain multiple commissions through layering arrangements, skim portions of premiums off the top before remitting them to the insurer, or write unauthorized business to generate additional commissions. If an agent is given authority to arrange for reinsurance on blocks of business he or she writes, the agent can formulate such arrangements to maximize compensation, rather than to effect real and sound reinsurance protection. Fraudulent activity significantly contributed to the financial impairment�even insolvency�of several insurers, especially property and liability insurers, in the early and mid-1980s. In addition to state and federal general criminal and civil laws against fraud as the main legal or regulatory defense against agent or broker conduct, the commissioner has the power to revoke an agent�s or broker�s license to do business.

Second, an insurer may be the victim of reinsurance fraud. The purchase of adequate reinsurance and the reinsurer�s willingness and ability to perform on its obligations are essential to an insurer�s financial well-being. However, since an insurer�s insolvency caused by its inability to collect on its reinsurance is much more of a factor in the property and liability industry, no further discussion of this problem is warranted here.

Internal Fraud. A third source of fraud or unethical conduct against an insurer is the insurer�s own management or the management of its parent company or affiliates in a holding company system. In the several insolvencies or near insolvencies in the past decade, some managements (or members thereof) embarked on activities to extract funds from the insurer for their own personal gain. For example, undue or excessive funds were drawn out of insurers to pay management and service fees to a parent holding company or an affiliate in which the insurer�s management had an economic interest. Insurers loaned funds to parents, affiliates, or individuals that were not repaid in whole or in part. Extravagant salaries and expense allowances, unearned bonuses, and questionable fringe benefits were authorized in several situations; questionable dividends were upstreamed to a parent holding company; unearned commissions were paid to agencies affiliated with management members.

The war against internal fraud is conducted in a variety of ways. First, to the extent that unethical individuals can be screened out of management or ownership positions beforehand, the likelihood of internal fraud is minimized at the outset. At the time of an insurance company�s formation and/or licensing, the commissioner is authorized to investigate the character and competence of incorporators, stockholders, and management and to withhold approval if his or her findings are negative. Similarly, under the holding company laws, when there is a change in an insurer�s control, a registration statement must be filed including biographical information about the persons controlling or managing the insurer. An acquisition can be disapproved if the commissioner is not satisfied with the competence, experience, and integrity of the people in control. In addition, establishing sufficiently high minimum capital and surplus requirements may indirectly screen out potential fraud.

A second approach to combat internal fraud is to regulate conduct to deter fraudulent activities. Along with general prohibitions against fraud that are applicable to all insurers, the insurance holding company laws establish standards for transactions between affiliates and require disclosure of material transactions. The ongoing evolvement of the model holding company law is, in part, a reflection of the concerted effort to strengthen the law as new abuses emerge.

Finally, industry sanctions deter fraud by removing unethical insurers from the scene. In general (and specifically with the insurance holding company laws), a commissioner has great power over an insurer. The commissioner may suspend or revoke an insurer�s license to do business or institute rehabilitation or liquidation proceedings if he or she deems further transaction of business to be hazardous to policyowners. The commissioner may also cause criminal proceedings for willful violation of the law to be instituted. In addition to state laws implicitly directed at insurance fraud and general state and federal criminal laws prohibiting fraudulent activities, as discussed previously, actions brought under the federal mail fraud statutes or the federal Racketeer Influenced and Corrupt Organization Act (RICO) have occasionally proven effective.

Management quality, experience, and integrity (or lack thereof) determine the nature of an individual insurer, the insurance industry as a whole, and most of the ensuing regulatory problems. As noted earlier, regulators have specific legal authority to consider management quality when, for example, an insurer is being formed, seeks a license or license renewal, or engages in activities within a holding company system. Also as noted before, in addition to taking direct action against individual management members by causing their removal or instituting civil penalties or criminal actions, a commissioner has the ultimate authority to suspend or revoke an insurer�s license to do business or even place the insurer in rehabilitation or liquidation.

Although broad, regulatory power over management quality is not without practical limitations. For example, in the absence of strong indications in a person�s background�a criminal record or a pattern of involvement with financially troubled insurers�competency and integrity are difficult to assess in advance of performance. Thorough background investigations of the thousands of ever-changing senior managers may be beyond insurance departments� physical capability. Furthermore, courts are reluctant to deprive a person of his or her career or to deprive a company of its ability to do business. Often it is difficult to build a case that is strong enough to overcome this judicial reluctance. Consequently, regulatory efforts may be unsuccessful or may not even be brought at all.

In 1985, the NAIC adopted the Model Regulation to Define Standards and Commissioner�s Authority for Companies Deemed to Be in Hazardous Financial Condition. As of 1992, this model act or something similar to it had been adopted in approximately half of the states; a few other states have adopted related legislation or regulations.

The purpose of the model regulation is to establish standards that a commissioner may use to find that an insurer is in a financial condition that renders its continued operation hazardous to the public or to its policyowners. It enumerates a litany of tests, inquiries, and events that might indicate that the insurer has serious problems. If the commissioner determines that transacting business is hazardous in light of these factors, he or she may order the insurer, subject to an appropriate hearing and judicial review, to take specific corrective actions. By specifically defining the standards of hazardous financial condition, both the regulators and the regulated have better guidelines, and the commissioner�s position is bolstered should his or her actions be subject to judicial challenge.

For Part 2 of this discussion on the regulation of life insurance, see chapter 27, which deals with state insurance regulation within the framework of federal controls.