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In most lines of insurance, including life insurance, policy forms used by insurers are subjected to some degree of regulation to protect policyholders, insureds and beneficiaries against unfair and deceptive provisions and practices.
Standard Provisions
The extent of control over the content of an insurance policy form has varied over time and varies by the type of insurance. For example, state law has prescribed the exact wording of a fire insurance policy. The forms for some other types of insurance are subject to little or no mandates as to policy content. The regulation of individual life insurance policy forms falls somewhere in between.
Although there are no statutory standard life insurance policies, standard benefits or standard coverage provisions, as an outgrowth of the 1905 Armstrong investigation, states now require life insurance contracts to contain either certain specified standard provisions as set forth in the statute or provisions whose effect is the same "in substance" as those in the statute. However, provisions more favorable to the insured than those required by statute may be used. As a result, the prescribed standard provisions used by different insurers may vary somewhat.
These requirements arose from the fact that life insurance contracts had become overgrown with numerous conditions. Many of the conditions were confusing and uncertain as to meaning and some were unreasonable and unfair, especially since policies often were unread and/or not understood by the ordinary policyholder. States enacted laws reflecting a compromise between unrestrained liberty of contract and rigid restrictions imposed by prescribed standard policies. The legislatively imposed standard provisions are those considered necessary to safeguard the interests of the inured. Other provisions are excluded as being unfairly prejudicial to those interests.
Generally the standard provisions, as recommended by the NAIC and mandated by the states, include those providing (a) the entire contract clause, (b) the incontestable clause, (c) a grace period, (d) reinstatement, (e) nonforfeiture values, (f) policy loans, (g) annual apportionment of dividends, (h) misstatement of age provision and (i) settlement options. Individual states impose other requirements as to policy terms such as prohibiting any exclusion from liability for death other than specified limited exclusions such as a war clauses, a suicide clause limited to 2 years, an aviation exclusion and hazardous occupation and/or residence exclusions for 2 years.
Since it is expensive to develop and maintain different policy forms for use in different states, usually an insurer will attempt to draft a form which meets the requirements of all states in which it does business. Consequently, the requirements of one state tend to affect an insurer’s policies issued in other states. However, when conflicting state requirements occur, the insurer may be compelled to use a special policy form or modification in a particular state.
Surrender (Nonforfeiture) Provisions
Level premium life insurance involves charging more premiums than necessary for protection in the early years of the policy to accumulate monies, as reflected by insurer policy reserves, sufficiently large 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. Since the insurer’s future liability under the policy ceases, it no longer needs the assets standing behind the policy for the purpose originally intended. Few, if any, would deem it fair in these circumstances to compel the policyholder to forfeit the entire reserve value of the policy. Thus, life insurers came to grant a surrender value to a policyholder who discontinues a policy.
Although the practice of giving a surrender value is an old one, for many years whether to do so was optional with the insurers. Some did so voluntarily and some did not. Through the mid-1850s, forfeiture of accumulated values was still prevalent. However, commencing with Massachusetts in 1861, states began to enact "nonforfeiture" laws defining the minimum amount which must be returned upon surrender of a policy to prevent the forfeiture of equities accumulated in level premium policies. Traditionally, the values required to be returned have been referred to as nonforfeiture values and the form in which they must be returned has been referred to as nonforfeiture options. Over time, however, the terms surrender value and surrender options have more commonly been used.
Although nonforfeiture laws have been around since the first one was enacted in Massachusetts, updating and standardization were achieved in the 1940s with the NAIC adoption of the Standard Nonforfeiture Law for Life Insurance and its subsequent enactment in virtually all states. The Model Act has been subsequently amended on several occasions up through and into the 1980s.
Under the Standard Nonforfeiture Law for Life Insurance, no life insurance policy may be issued in the state, after the operative date of the Law, unless it contains in substance the provisions specified in the Law or corresponding provisions which, in the opinion of the commissioner, are at least as favorable to the defaulting or surrendering policyholder. The Law does not require specific surrender or nonforfeiture values. But rather, it requires that the nonforfeiture values be at least as large as those generated by the method which the law prescribes.
Today, many insurers provide surrender values in excess of the minimum legal requirements. Some may return cash surrender value equal to the full reserve on the policy. But commonly, in the early years of the policy, the surrender value is less than the full reserve to reflect costs which, in the absence of a surrender charge, would have to be borne by continuing policyholders.
Under the Standard Nonforfeiture Law, the minimum values are established in a manner to reflect two important principles: (1) surrender values should be established independently of policy reserves and (2) surrender values should reflect approximate asset shares accumulated under the policies. The technique used to accomplish these objectives is termed the adjusted premium method. This method reflects the philosophy that each group of policies issued on the same plan at the same age should pay its own way including the acquisition costs. This recognizes that expenses are heavily concentrated in the first year and that the first-year loading in the premium is insufficient to offset these expenses. The adjusted premium method gets its name due to the manner in which the surrender values reflect the unamortized acquisition costs.
The minimum nonforfeiture value at any policy duration is the present value, at that time, 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.
Pursuant to the Standard Nonforfeiture Law, states require life policies to contain three nonforfeiture (surrender) provisions which the policyholder may select at his or her option. First, a cash value is required after premiums have been paid for 3 years. The policy may be surrendered for cash payment in an amount equal to its cash value. If this option is elected, the protection terminates and the insurer has no further obligation. The cash value must be at least equal to the prescribed minimum standard as calculated by the adjusted premium method. Second, the insured must be afforded the option to acquire reduced paid up insurance even if the policy has been in force for less than 3 years. Under this option, the insured takes a reduced amount of paid-up whole life insurance payable on the same conditions as the original policy. The amount of the paid-up insurance is the amount which can be purchased at the insured’s attained age by the net cash value (that is, cash value minus policy indebtedness plus any dividend accumulations) applied as a net single premium. Third, the policy must also provide the option of paid-up term insurance in an amount equal to the original face amount of the policy (increased by any dividend additions or deposits and decreased by any policy indebtedness). The duration of coverage is that term which can be purchased at the insured’s attained age by the net cash value applied as a net single premium. The policy must contain a provision making available the optional surrender benefits in lieu of cash values and stating which optional benefit will take effect automatically (that is, reduced paid-up insurance or extended term insurance) if the insured fails to elect which option to take.
Furthermore, the policy must state the mortality table, the interest rate and the method to be used in calculating the amount of the nonforfeiture values. And the policy must contain a table showing the cash values and other nonforfeiture options for each of the first 20 years in the life of the policy.
Although not a protection against forfeitures, the policy must also contain a provision granting the insurer the right to defer payment of any cash value for 6 months. To avoid situations like "runs on banks" during the Great Depression, this provision is designed to protect life insurers from widespread policyholder withdrawals of funds at a time when investments might have to be liquidated in adverse circumstances. As a device to prevent unnecessary insolvencies, this provision can also be viewed as a means to protect policyholders as a whole.
As a consequence of the widespread adoption of nonforfeiture laws, most of which are based upon the NAIC standard law, life insurance policies are required to contain provisions protecting policyholders from unreasonable forfeitures of equities which they have built up in their policies. By doing so, insurance regulation has fundamentally enhanced the reasonableness and fairness of insurer conduct towards their policyholders.
Readability
To reduce the potential for successful deception or misunderstanding by insureds, a number of states have enacted "readable contract" laws and/or regulations. In essence, these 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 one with a high school education. The laws usually require use of some test which seeks to predict the difficulty that readers will experience with the text of the policy based upon such measures as average sentence length and syllable density.
With respect to life insurance, the NAIC developed and adopted the Life and Health Insurance Policy Language Simplification Model Act to establish minimum standards for language used in polices, contracts and certificates of life, health and credit insurance to facilitate the ability of the insured to read and understand the coverages provided. A majority of the states have adopted the Model Act or something similar thereto. (Several other states have implemented related regulatory controls.) With specified exceptions (such as variable policies deemed to be a security under federal jurisdiction), no policy shall be approved for use in the state unless (a) the text achieves a specified minimum score on a sanctioned test designed to measure the ease of reading, (b) the type meets minimum size requirements, (c) the style and appearance of the policy give no undue prominence to any portion of the text and (d) the policy, if it exceeds a specified size, contains a table of contents or index. To counter concerns that simplified language requirements would erode essential technical terms and established judicial precedents which have sought to define legal and technical terms used in insurance contracts, the Model Act makes provision to sanction the use of words of art and other terminology which are difficult to restate because there are no suitable alternatives.
Unfair Discrimination
Standard provisions and readability requirements constitute policy form and content regulation in the form of mandates as to what an insurer must include in its policies. Insurance regulation also has concerns as to what should not be contained in policies. As a prime example, the NAIC Model Unfair Trade Practices Act, which has been promulgated in some form in every state, prohibits unfair discrimination between individuals of the same class and equal expectation of life 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, among other things, 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.
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 commissioner. Typically, the commissioner is empowered to disapprove polices or provisions which fail to meet the statutorily prescribed provisions or are deemed to be unfair, deceptive or in some other statutorily specified way objectionable (such as lack of readability). The commissioner may approve provisions which, in his or her opinion, are more favorable to the policyholders than the provisions prescribed by the statute.
In short, states have sought to foster the regulatory goal of reasonableness of the insurance marketplace through regulatory controls over the substantive content of policies and enhancement of consumer understanding of policies with enforcement of such controls achieved through the policy form filing and approval mechanism.
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