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Insurance regulators exercise a substantial measure of control over the methods by which insurers and their agents obtain business. Such control seeks to enforce a higher standard of competition than that prevailing in other fields of endeavor and to protect the insurance consuming public against practices detrimental to their interest. State unfair trade practices acts and regulations promulgated thereunder constitute a major element in achieving these purposes.
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 commonly enacted to penalize such conduct. The NAIC Unfair Trade Practices Act, which reflects the current widely adopted approach, contains three provisions directly aimed at 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 the same) of any estimate, illustration, statement, sales presentation, omission or comparison which misrepresents the benefits, advantages, conditions or terms of any insurance policy or the dividends to be received. Second, the Act 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 concerning the business of insurance or concerning an insurer in the conduct of its insurance business which is untrue, deceptive or misleading. Third, the Act contains an antidefamation provision defining as a prohibited unfair trade practice the making or airing of oral or written statements which are false or maliciously critical of the financial condition of any insurer and which are calculated to injure such person. As insurers and agents solicit business through a variety of business-getting activities, they are subject to these general constraints, the violation of which can give rise not only to an order to stop but also to monetary fines and possible license revocation.
Advertising Rules. The regulators seek to exert control over advertising practices by utilizing the general provisions contained in their unfair trade practice laws. But to gain more specificity and better provide guidance to insurers and agents, in 1975, the NAIC developed model Rules Governing the Advertising of Life Insurance. These rules attempt to assure truthful and adequate disclosure by regulating the form and content of advertisements, establishing minimum disclosure requirements and providing enforcement procedures. As of 1992, 18 states have adopted either the NAIC model rules or comparable rules and another 11 states have put into place their own independent set of related rules.
The stated purpose of the NAIC model advertising rules is to establish minimum standards to assure full and truthful disclosure of all material and relevant information to the public in the advertising of life insurance policies and annuity contracts. The model rule defines the term advertisement in a very broad sense. Advertisements embrace those materials designed either to create public interest in life insurance, annuities, an insurer or an insurance producer, or to induce the public to purchase, increase, modify, reinstate or retain a policy. Consequently, these rules cover a very wide variety of materials used in a host of different contexts ranging from material used in broad media campaigns to solicitations by individual insurance agents.
The form and content of advertisements shall be sufficiently complete and clear to avoid deception of a person of average education or intelligence within the segment of the public to which the advertisement is directed. Specific words having the tendency to mislead are prohibited.
Numerous specific disclosures are required. For example, no advertisement shall omit material information if such omission has the capacity or tendency to mislead prospective purchasers as to the nature of any benefits payable, losses covered, premium payable or tax consequences. Rules are established with respect to such areas as nonmedical examination requirements, premiums, cash values, dividends, the use of testimonials or endorsements by third parties, introductory or special offers, and individual deferred annuity products or deposit funds. An advertisement shall not make unfair or incomplete comparisons with policies, benefits, dividends or rates of other insurers.
Every insurer is required to maintain a system of control over the content, form and method of disseminating of all advertisements of its policies. The insurer is responsible for the advertisements regardless of by whom created or presented. A complete file containing a specimen copy of every printed, published or prepared advertisement, along with notation indicating the manner and extent of distribution, shall be maintained. Such file is subject to examination by the insurance department. Also the insurer shall file annually a certificate of compliance stating its belief that advertisements disseminated by or on behalf of the insurer in the state during the year complied with the requirements of these rules.
Constitutional Limitations. The ability of the states to regulate advertising is somewhat confined by constitutional boundaries pertaining to free speech. The First Amendment provides that "Congress shall make no law . . . abridging the freedom of speech. . . ." By virtue of the Supreme Court’s interpretations of the Fourteenth Amendment, the First Amendment also applies to the states. Historically, the Court held to the view that advertisements of commercial products were not entitled to the same First Amendment protection as political, artistic and other noncommercial statements. Consequently, states have enjoyed considerable freedom in regulating advertising of businesses and professions including those persons in the insurance business.
States traditionally justify regulation of commercial speech on the basis that such activity protects the interest of their citizens by assuring truthful and legitimate commercial information to enable them to purchase, invest or otherwise act on an informed basis. However, regulation of commercial speech is not unlimited. Regulation going beyond the prohibition of false and misleading advertising and other unlawful activity is vulnerable to a judicial finding of "unwarranted commercial regulation."
For the first time, in 1976, the United States Supreme Court directly held that the First Amendment imposes limits on government regulation of commercial speech. However, the Court made clear that such limits do not extend to government efforts aimed at assuring that commercial information is not false or misleading. Subsequently the Court enunciated a four-part test in determining whether the regulation of commercial speech is constitutionally permissible. (1) Does the expression concern a lawful activity and is such expression not misleading? If the answer is no, the expression is not entitled to commercial speech protection. If yes, the inquiry continues. (2) Is the asserted governmental interest in imposing such restriction substantial? If the answer is no, the restriction is unconstitutional. If the answer is yes, the inquiry continues. (3) Does the regulation directly advance the governmental interest asserted? If no, the restriction is not permitted. (4) If the answer to (3) is yes, the final test is whether the regulation is more extensive than necessary to serve that interest. If the answer is no, the state-imposed restriction is constitutional. It has become established that the First Amendment protects an insurer’s right to advertise truthfully. However, advertisements which are misleading, false, or fraudulent are subject to state proscriptions.
The Model Act explicitly proscribes statements, sales presentations, illustrations, comparisons or omissions which misrepresent the policyholder dividends or share of surplus to be received on an insurance policy or which make any false or misleading statements as to dividends or share of surplus previously paid on any insurance policy. The advertising rules provide further specificity by making clear that an advertisement (with the word advertisement being used in the broad sense) shall not state or imply that either the payment of dividends or the amount of dividends is guaranteed. Any illustration of dividends must be based on the insurer’s current dividend scale and contain a statement that they are not guaranteed nor or are they estimates of future dividends. These proscriptions have been made widely applicable throughout the nation.
Life insurance policy illustrations have been used for many years in the sale of life insurance. Policy illustrations are projections of what might occur under a policy with respect to premiums, cash values, death benefits and dividends if actual experience mirrors the assumed factors (interest, mortality and expenses) used in calculating the illustration. When properly used and properly perceived, an illustration is not a prediction or a guarantee. But rather, it is a depiction of how a policy will perform over a period of years using an individual insurer’s current assumptions as to interest rates, mortality charges and expenses. Such illustrations serve to educate the potential buyer as to the nature and workings of the policy and, in the process, afford the agent an important sales tool.
As a general proposition, prior to the 1980s, policy illustrations did not give rise to substantial problems. Dividend scales were developed by the insurance companies and supplied to the agents. The dividend scales changed only infrequently. Agents used the illustrations provided to them. Not only was the practice simple, it also proved to be conservative. Following World War II, until 1981, interest rates steadily increased. Similarly, over a comparable period, mortality experience showed significant improvement. Expenses were kept under control, especially with the advent of new computer and other technology. Since the dividend scales were based upon an insurer’s previous actual experience and since subsequent actual experience improved over that used in constructing the illustrations, performance under the policies proved better than what had been illustrated and anticipated. With dividends being higher than those originally illustrated, there was general policyholder satisfaction rather than policyholder complaints.
Although life insurance policy illustrations have long been used in the selling of life insurance, they did not become a very common and integral part of the selling process until the arrival of universal life and interest sensitive policies in the competitive marketplace. In recent years changes in products, computer technology, and the economic and investment climate all contributed to new approaches in the design of, use of and emphasis on policy illustrations. Universal life and other unbundled products removed much of the mystery of dividend formulation and replaced it with specified interest credits, mortality charges and expense loads. With the enhanced visibility of these credits and charges, a clearer understanding of the policy as well as improved ability to compare one policy with another appeared possible. Furthermore, various illustrations can be shown for a range of charges and credits to illustrate what might happen under different assumptions and scenarios. The personal computer and supporting software enabled agents to perform "what if" testing. No longer are agents confined to insurer-supplied dividend projections. But rather, they can adjust interest and mortality assumptions. Illustrations can be tailored to the client’s situation. Increased flexibility and sophistication in the use of illustrations, when used correctly, can contribute significantly to buyer understanding. However, life insurance policy illustrations are also subject to problems and abuse.
Unfortunately many agents, companies, professional advisers and prospective policyholders have tended to focus on policy illustrations as being the product rather than upon the policy itself. Sales were made on the basis of the illustration. However, the performance illustrated is based upon the assumptions used today. The actual performance achieved occurs over time based upon the actual experience tomorrow. It is almost certain that the actual future numbers for premiums, cash values, dividends and death benefits will vary, and not improbably vary quite drastically, from those presented as part of the sales presentation. For example, interest rates and an insurer’s investment returns fluctuate over time, sometimes over a rather broad range. Yet, a small change in interest rates can dramatically affect a policy’s performance, especially with respect to the interest-sensitive policies. Similarly, inflation rates and insurer expenses may significantly increase over the assumptions contemplated in the illustrations. Policyholders’ tax rates can also fluctuate considerably over the life of the policy which can lead to significant variations between actual and projected performance under some types of illustrations. When buyers of life insurance perceive the illustrated results to be what they bought and when actual results emerge which are lower than those expected, there is a natural inclination to be quite upset. This is what has happened in recent years.
Commencing in the high interest rate environment of the 1980s, when competition was keen not only between different life insurance companies but also between life insurance and investment-oriented products of other financial institutions such as securities firms and banks, illustrations were predicated on high interest rate assumptions. However, as the 1980s progressed, interest rates markedly declined. Insurer investment portfolios were subject to losses from the stock market as well as the depression in the real estate market. (Furthermore, in the future, mortality experience may not improve as much as in the past due to factors such as AIDS.) Buffeted by these pressures, insurers were compelled to declare dividends and other nonguaranteed pricing elements less favorable to their customers vis-à-vis what had been projected in the illustrations used to sell the policies.
The failure of actual results to match those projected has left many policyholders disillusioned and angered. During the 1980s when both interest and inflation rates were in double-digit numbers, policy illustrations commonly projected interest of 12 percent to 15 percent or more for more than 30 years. Sales presentations using these projections created unrealistic expectations on the part of buyers. Many became irate when the magnitude of the shortfall between actual cash values and the optimistic projections made at the time of purchase became apparent. (Too often, policyholders believed the original illustration to be a minimum guarantee.) Similarly, policy illustrations projecting a vanishing premium (through the application of dividends to premium payments) led to unrealistic expectations as actual experience required the payment of premium for considerably longer periods than anticipated. Neither the agents selling the products nor the consumers buying them anticipated the rapid decline in insurer investment earnings when interest rates plummeted. Furthermore, they were unaware of the sensitivity of policy results to such changes. The ensuing ill will, charges of deceptive sales practices and the actual or potential initiation of litigations serve well neither the policyholders, agents nor insurers over the long run.
In attempting to address this problem, a 1992 study of policy illustrations by a task force of the Society of Actuaries found that, although policy illustrations work well in educating clients in the mechanics of how policies work, they are not an adequate tool in comparing costs of policies of different insurance companies. Policy illustrations do not result in accurate projections of future performance due to the differences in assumptions and the problems of estimating future parameters.
In the context of mounting consumer pressure, congressional criticism and insurance regulators’ own concerns, in late 1992 the NAIC formed a regulatory working group to specifically address the issues surrounding the use of policy illustrations. In a highly critical report, the group identified several problem areas in the marketing of life insurance including (1) inappropriate use of policy illustrations to estimate future policy performance and to compare different company policies; (2) absence of accountability of various parties to the sale (insurer, agent and applicant); (3) lack of a standardized format for life insurance policy illustrations; (4) lack of standard and consistent definitions, language, assumptions and methodologies; (5) inadequate description of policies; (6) failure to notify customers of changes in current assumptions; (7) insufficient penalties; and (8) out-of-date regulatory approaches. This NAIC working group concluded that a regulatory response to the illustration problem is called for. It anticipated recommending to the NAIC a broad enabling Model Act granting the insurance commissioner the authority to establish standards aimed at ensuring that policy illustrations will not be misleading or incomplete. The Model Act is to be supplemented by detailed regulations covering policy illustrations.
Initially, action on the recommendations developed was anticipated in the latter part of 1994. During the ensuing debate a variety of proposals have been advanced. Common elements embraced by most proposals included the following. (1) In the illustration guaranteed elements should be shown separately from nonguaranteed elements and a warning should be included highlighting that the actual results of values including nonguaranteed elements may be greater or less than those illustrated. (2) With respect to the problem of vanishing premiums, prospective buyers should be warned that the option to suspend premium payments at some point may be delayed because of future experience. (3) The illustrations should be signed by both the agent and the applicant. (4) The Actuarial Standards Board should develop a set of standards to be used by actuaries in the design and preparation of illustrations.
However, progress slowed when confronted by substantial controversy over a variety of issues, such as whether illustrations should be permitted only with respect to guaranteed benefits and past performance, whether insurers should be required to annually provide customers with updated illustrations, whether a certified actuary must certify that the illustrations meet the standards as to the measurement of past performance as established by the Actuarial Standards Board, etc. Progress was also slowed by the determination that any model illustration law development should be coordinated with the efforts of a separate NAIC task force working on developing a life insurance model nonforfeiture law. Furthermore, consideration has been given to permitting the commissioner to require insurers that illustrate benefits which are not supportable to pay benefits based upon the illustration most favorable to the policyholder which, in effect, would convert sales illustrations into guarantees.
In the fall of 1995, the NAIC Life Insurance Committee adopted the Life Illustrations Model Regulation, which provides illustration formats for life insurance policies and defines the standards to be followed when illustrations are used. The Model also specifies disclosures required in conjunction with the illustrations. The Model is to be considered for adoption by the NAIC as a whole at the NAIC Winter 1995 meeting. Depending upon what is finally adopted by the NAIC and implemented at the individual state level, the NAIC ultimate work product could have a significant impact upon the manner of future sales of life insurance.
Unfair Financial Planning Practices
1980s amendments to the Unfair Trade Practices Act defined certain activities of an insurance producer in the context of financial planning as constituting unfair trade practices. These requirements are considered later in the context of the regulation of financial planners under both state and federal law.
Disclosure of Price and Other Policy Information
Functions of Meaningful 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 or price. Other things being equal, the policyholder’s 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 vis-à-vis the differences in the other factors important to him or her. Consequently, meaningful information constitutes an essential element in insurance consumer protection.
Furthermore, insurance regulation relies on competition as the primary means to prevent excessive rates to assure reasonableness of rates in the marketplace. However, 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. Consequently, adequate disclosure of life insurance pricing information is fundamental not only to serving the prospective policyholder as he or she makes a purchase decision in his or her individual situation, but such disclosure is also essential to the maintenance of an effective competitive marketplace which benefits all life insurance consumers as a whole by tending to constrain prices on an overall basis to reasonable levels.
Traditional Net Cost Method
Traditionally, the most commonly used means of cost comparison was the net cost method. Its primary virtue is simplicity—it is simple to compute and easy to understand. This method totals the premiums to be paid over a period of years, usually 10 and 20 years, and subtracts therefrom both the cash value at the end of the period and the accumulated total of dividends for the period (as shown in the life insurer’s dividend illustration for the period). The results are then averaged over 10- and 20-year periods and are referred to as the 10 and 20 average annual surrender net cost.
Unfortunately, the simplicity of the traditional net cost method derives from some basic flaws. Although providing a simple means to compare costs of policies issued by different companies, the traditional net cost method has been subject to several criticisms. For example, the assumption that the insurer’s current dividend scale will be continued over the 10- and 20-year periods is questionable. The assumption that future changes in dividend scales will affect all insurers in roughly the same manner is questionable. The assumption that the policyholder will retain the policy for the 10- or 20-year periods and then surrender it is questionable. Most important, there is the failure to recognize the time value of money; that is, interest is ignored. Consequently, the traditional net cost method no longer remains an acceptable method of comparing the cost of life insurance policies whether they are the same or different types.
NAIC Model Regulation
With increasing interest in consumer education and an awareness that consumer price knowledge is a condition precedent for effective competition as the means to assure overall reasonable rate levels, the early 1970s witnessed demands for an improvement over the traditional net cost method as the common basis upon which to compare prices. Among the pressures for change were congressional critics and the Federal Trade Commission which conducted an extensive and critical investigation of cost disclosure in the sale of individual life insurance.
In response, commencing in the 1970s, the NAIC developed, adopted and frequently amended the NAIC Model Life Insurance Disclosure Regulation which mandates general disclosure requirements as well as price comparison information. Over 30 states adopted or closely follow some version of the NAIC Model Regulation. Additional states have implemented somewhat different cost disclosure requirements. The following discussion is based upon the 1992 version of the Model Regulation.
The NAIC Model Regulation applies to any solicitation or procurement of life insurance within the state subject to specified exceptions. Through the regulation, the regulators seek to improve the quality of information provided to prospective life insurance buyers to better enable them to select the most appropriate plan suitable for their individual circumstances, to improve buyer 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. These purposes are to be achieved by requiring that the prospective purchaser be given (1) a buyer’s guide containing a clear explanation of products and how to shop for them and (2) a policy summary containing essential information pertaining to the particular policy being considered. As a general proposition, the insurer must provide the prospective policyholder a buyer’s guide and a policy summary prior to accepting the applicant’s initial premium unless either the policy or the policy summary contains a 10-day or longer unconditional refund provision (that is, free-look provision) in which case the guide and summary may be delivered with or prior to the delivery of the policy.
Buyer’s Guide. The content and the language of the buyer’s guide are prescribed by the regulation. The guide sets forth questions which the purchaser should ask about buying life insurance, his or her present policies, how much insurance is needed and the right types of policies. The guide notes with brief descriptions different types of policies (such as term, whole life, endowment, universal life and variable life insurance). Once the type of coverage is determined, the guide urges the purchaser to compare similar policies from different insurers considering such factors as premiums (including whether they vary from year to year), cash values, extent to which premiums and/or benefits are not guaranteed and the effect of interest paid and/or received at different times during the course of the policy. The guide defines the cost indices used for price comparisons and how they are to be used, encourages the buyer to determine the amount and type of insurance he or she needs, and encourages the buyer to make cost comparisons.
Policy Summary. Although not specifying the exact language and format which must be used for the policy summary, the insurer must provide a written policy summary describing the elements of the policy including those set forth in the regulation. Such information includes the annual premium, the amount payable upon death, the cash surrender values at the end of the policy year, cash dividends if any, and endowment amounts payable if they are not included in the cash values. If the policy possesses a nonguaranteed factor, a statement must be included showing which cost factors are not guaranteed and that such cost factors are based upon the insurer’s current dividend scale or current rate schedule. The annual policy loan interest rate must be shown and, if there are to be dividends, such must be noted as based upon the current dividend scale and are not guaranteed. Furthermore, among the elements required to be disclosed are interest-adjusted life insurance cost indices.
Interest-Adjusted Cost Comparison Indices. The interest adjustment cost indices reflect the time value of money by recognizing the fact that money is paid and received at different times and that, by using a specified interest assumption, costs can be better compared. The NAIC Model Life Insurance Disclosure Regulation requires two interest-adjusted cost indices for a policy and mandates the use of an assumed 5 percent interest rate factor.
First, there is the life insurance Surrender Cost Comparison Index which is useful when the main concern is the level of the cash values. It aids in comparing costs if at some future point in time, such as 10 or 20 years, the policy were to be surrendered and the cash value withdrawn. To derive this index, in essence the interest-adjusted method treats the payments of premiums as if they were placed into interest bearing accounts to accumulate at interest for a given period of time. Similarly, dividend payments are treated as if they are deposited in an account earning interest for the same given period. Using the accumulated premium adjusted for the assumed 5 percent interest earned (that is, the future value of premiums) and the accumulated dividends adjusted for the assumed interest earned (that is, the future value of the dividends), the future value of the net surrender cost for the given period is determined by subtracting the policy cash value at the end of the given period and the interest-adjusted accumulated dividends from the interest-adjusted accumulated value of the premiums paid. Then, to obtain the level annual cost for the policy, the above derived future net cost is divided by the future value of an annuity due based upon a specified interest rate and the period of time being evaluated. The aggregate amount can then be converted to a per $1,000 amount by dividing the level annual cost by the number of thousands of dollars in the policy death benefit.
As a simple example, the characteristics of a fictional policy appear in the following table. In this example, premium payments are $15 per year over a 10- year period. No dividends are payable in the first year, $1.00 is payable in the second year, and payments increase by $1.00 per year until they reach $9.00 in the 10th policy year. The premiums and dividends are accumulated at an assumed interest rate of 5 percent, resulting in an accumulation of $198.10 of premiums and $54.14 of dividends at the end of 10 years. Subtracting the accumulated value of dividends from the accumulated value of premiums gives a future value of net premiums of $143.96. When the cash value of $120 at the end of 10 years is subtracted from the future value of net premiums, there results a future value of surrender net cost of $23.96. When this future net cost is divided by the present value of an annuity due for 10 years (13.2068), there results the surrender cost index of $1.814676. This result is the average amount of each annual premium not returned if the policy is surrendered for its cash value.
Second, the NAIC regulation also mandates the life insurance Net Payment Cost Comparison Index which is useful when the main concern is that benefits are to be paid at death; hence the level of cash values is of secondary importance. 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. Hereto the calculation of the index reflects the time value of money assuming a specified rate of 5 percent. The Net Payment Cost Comparison Index is derived from an estimate of the average annual net premium outlay incurred by the policyholder (that is, premiums less dividends) adjusted by interest (5 percent) to reflect the point in time when the premiums are paid in and the dividends are paid out during a 10- or 20-year period. In the above example, by ignoring the cash value, the Net Payment Comparison Cost Index becomes $10.90.
Interest Adjusted Cost Method
(Amounts are per $1,000 of coverage)
Surrender Cost Index
Payment Cost Index
Surrender Cost Index
Payment Cost Index
Future value of premiums
Minus future value of dividends
Future value of net premiums
Less net cash value
Divide by annuity factor
SURRENDER COST INDEX
Future value of net premiums
Divide by annuity factor
PAYMENT COST INDEX
Neither the net payment cost nor the surrender cost indices reflect actual net costs to the individual policyholder. The actual cost of a life insurance policy to an individual depends upon his or her own circumstances and the actual cash flows experienced under the policy. This cannot be ascertained until the contract expires by death, maturity or surrender and then only with some assumption as to the time value of money to the individual.
However, the cost comparison indices do serve to indicate the relative cost position of two or more similar policies. (Other things being equal, the policy with the smaller numerical value for the surrender cost and the payment cost indices is preferable to those having higher index values.) Furthermore, the current version of the Model Regulation provides surrender and net payment indices on both a guaranteed and an illustrated basis. However, the interest- adjusted method is not suitable for comparing dissimilar policies, for example, a whole life policy versus term insurance, nor is it well suited for evaluating policy replacements.
Although the use of the NAIC mandated interest-adjusted cost indices is subject to caveats, nevertheless, prospective cost estimates can be valuable in providing a good relative sense as to which policies are high and low cost. Over time, as circumstances change and different products evolve, changes in the information provided and in the comparative cost measures used 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 setting forth specified important information (including comparative cost information) pertaining to the particular policy under consideration marks a major advancement in enhancing informed life insurance buyer decision making. This not only contributes to a more competitive market which better assures reasonable prices for policyholders as a whole, but it also better enables the individual to purchase a suitable policy at a reasonable price for himself or herself. These are major insurance regulatory objectives.
An existing policy of insurance may be replaced by another policy of the same insurer or by a policy issued by a different insurer. When a policyholder is induced to discontinue and replace a policy through agent and/or insurer distortion or misrepresentation of the facts when proposing the replacement, such activity is referred to as "twisting." However, replacement is broader than twisting in that it can be achieved in the absence of misrepresentation.
Replacing agents’ motives may be laudable or otherwise. If the agent accurately discloses the facts and the replacement works to the policyholder’s benefit rather than detriment, regulatory concern is served. However, because of high first-year commissions on new policies, agents possess financial incentives not only to take away business from another insurer but also to replace a policy in their own company thereby generating another first-year commission instead of a lower renewal commission on the same policy. Furthermore, insurers seeking new business may not be adverse to taking it away from a competitor even though that may not benefit the policyholder. Thus, financial motives abound for replacement, regardless of policyholder interest. Such results may even be sought through twisting.
Evolution of Replacement
Replacement through twisting is not a new phenomenon. The practice of twisting business developed out of an era of intense competition for new business. It enjoyed its first real lease on life after 1880 when cash surrender values were first made available to retiring policyholders. The door was open for agents to induce individuals to replace one policy with another, often using the cash values in the existing policy to fund the purchase of the new policy. Commissions paid for new business were on the rise in the latter part of the 1800s when stiff competition for agents characterized the marketplace. By the time of the Armstrong investigation in 1905, twisting had been pointed to as a major cause of life insurance policy lapses. In the years following the Armstrong investigation, numerous states adopted laws against twisting. However, laws afforded little deterrent to replacements since twisting was often quite difficult to prove.
Confronted with increasing replacement activity which characterized the 1920s, the life insurance industry sought a more effective means to control the loss of business through replacements. In 1930 an industry replacement committee, comprised of both agents and insurers, was established to develop an approach to thwart improper replacement activities. The committee recommended the following set of procedures. (1) In the application for insurance there should be a question as to whether the purchase involved a replacement. The answer was to be signed by the applicant and the agent. (2) The replacing company should notify the original company of the replacement. (3) In situations of actual or suspected replacement, the issuance of a new contract should be delayed for 2 weeks to afford the existing company an opportunity to conserve its business. (4) Each insurer should maintain records to monitor the extent of the problem. And (5) the companies should educate their agency force and policyholders. Initially, 25 insurers agreed to abide by these recommended procedures. By 1943, 94 companies had joined and put the procedures into operation. This intercompany agreement proved quite effective as evidenced by the decrease in the number of replacements.
In 1938 Congress created the Temporary National Economic Committee (TNEC) to review the postdepression economy including the life insurance industry. The Committee’s report was published in 1940. Although overall the report was complimentary of the industry, it did note that the industry replacement agreement might serve to effectively restrict competition. However, at that time, the suggestion that the intercompany agreement might have been anti-competitive was not particularly troublesome since the federal antitrust laws had been held inapplicable to the insurance business because of the United States Supreme Court decision in Paul v. Virginia. But a few years later when the Court decided the South-Eastern Underwriters Association case in 1944 rendering the antitrust laws applicable, the suggestion that the intercompany agreement constituted anticompetitive behavior appeared much more ominous. Even with the enactment of the McCarran Act, the company signatories to the replacement agreement, being uncertain as to the implications of the law, permitted the agreement to expire.
With the enactment of the McCarran Act, regulation of insurance remained with the state. In response to the congressional invitation, the states adopted unfair trade practices acts based upon the NAIC Model. Twisting appeared in these acts as a prohibited practice. However, as before, such provisions proved ineffective because of the evidentiary problem. Commencing in the late 1950s, replacement reemerged as a major problem as some companies aggressively marketed minimum deposit insurance which served as an effective vehicle for replacements. During the next few years, some states adopted some form of replacement regulation. Enough shared the concern to lead to the adoption of a model regulation by the NAIC in 1970 which incorporated much of the machinery of the 1930 intercompany agreement.
Traditionally, most replacements were considered to be detrimental to the policyholder for several reasons. First, the policyholder has already incurred the high first year expenses associated with his or her existing policy. These expenses include agent compensation, which typically involves high first-year commissions, underwriting expenses and policy issuance costs. Replacement incurs such expenses a second time. As a result the cash values and dividends (if any) may grow more slowly, at least initially, since the insurer must absorb the cost of issuing a new policy including the payment of another first-year commission. Second, premiums under the new policy are likely to be higher because of the insured’s increased age. Third, under the replacing policy, the time of the applicability of the suicide and/or incontestable provisions starts anew unless waived by the replacing insurer. Other arguments against replacement involve a change in the insured’s health status, loss of favorable policy provisions and certain adverse tax consequences.
However, in more recent years, with changing conditions including higher interest rates, improved mortality experience and/or new types of policies, a policyholder may substantially improve his or her situation by replacing an existing policy in either the same or a different company. For example, non- participating policies, being tied to lower interest rates and higher mortality assumptions which gave rise to higher premiums and lower cash values than more recent policies, may be particularly vulnerable to replacement. Furthermore, the proposed replacing policy may be more suitable to the policyholder’s circumstances. For example, the existing policy may be a high premium-savings policy while the policyholder’s current needs may be better served by greater death benefits and more limited premiums. There can be a variety of other circumstances justifying a replacement.
Regulation of Replacement
To protect the interests of policyholders, the regulators are confronted with balancing the need to preserve the opportunity for replacement where to do so benefits the policyholder while at the same time reduce the potential for injury to policyholders arising from those agents and insurers possessing little concern for professional behavior. As a starting point, the Unfair Trade Practice Act contains prohibitions against misrepresentation including misrepresenting for the purpose of inducing the lapse, forfeiture, exchange, conversion or surrender of any insurance policy. In addition to being able to proceed under this general statutory standard under the Act, in 1970, followed by significant revisions in 1978 and 1984, through the NAIC, the regulators adopted the now named Replacement of Life Insurance and Annuities Model Regulation. The late 1970s version shifted the focus to providing the buyer full disclosure of information in a fair and accurate manner with ample time to review the information before making a final decision. The original replacement regulation arose at a time when life insurance replacements were perceived to be generally detrimental to consumers. The 1978 version was said to create a better balance between the duties of the existing and replacing insurers and agents. In the mid-1980s version, the regulation was amended to—among other things—remedy the absence of adequate disclosure requirements for annuities as well as improve other provisions. Approximately 40 states have promulgated regulations governing life insurance replacement, most based upon either the original or revised versions of the NAIC Model Regulation. In addition, a handful of states hew to their own approach.
The Model Regulation attempts to protect the interests of policyholders by establishing minimum standards of conduct to be observed in a proposed replacement of existing life insurance by (1) assuring that the policyholder receives information upon which he or she can make a decision in his or her best interest and (2) reducing the opportunity for misrepresentation and incomplete disclosure. Specific duties are imposed on the replacing and existing agents and the replacing and existing insurers.
Replacement is defined as a transaction in which a new life insurance policy 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 by use of nonforfeiture benefits or by being pledged as collateral.
When an agent submits an application for life insurance or an annuity to his or her insurer, it must include a statement as to whether a replacement situation is involved. If yes, the agent, not later than the time of taking the application, shall provide to the applicant a prescribed notice alerting the applicant to the need to carefully compare existing to proposed benefits and to seek information from the agent or insurer from whom he or she purchased the original policy. The agent must leave with the applicant a copy of written communications used in the presentation to him or her.
The replacing insurer shall advise the insurer of the existing policy of the proposed replacement as well as information on the replacing policy or contract. Such information is required in the Model Life Insurance Disclosure Regulation (or the Model Annuity and Deposit Fund Disclosure Regulation). The existing insurer or agent undertaking to conserve the business is afforded 20 days to furnish the policyholder with policy information on the existing policy prepared in accordance with the disclosure regulation with premium, cash values, death benefits and dividends computed from the current policy year. Such information shall also be provided to the replacing insurer upon request. Furthermore, the replacing insurer shall notify and provide the applicant with a 20-day free-look period 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. There are also provisions governing insurers replacing coverage through direct response sales rather than achieved through an agent.
If an agent or insurer recommends the replacement or conservation of an existing policy by use of substantially inaccurate presentations or comparisons of an existing contract’s premiums, benefits, dividends or values, such a recommendation constitutes a violation of the regulation. Both insurers and agents are responsible for the accuracy of the information which they submit to the existing policyholder.
To assist in efforts to assure compliance with the replacement requirements, the replacing insurer shall maintain for 3 years the materials used in connection with the replacement as evidence that requirements of the regulation have been met. Furthermore, the NAIC has included in its Examiners Handbook procedures to review insurer controls to assure agent compliance and to review the insurer’s files for evidence of compliance.
Through the procedures set forth in the Model Replacement Regulation, responsibilities are imposed on the replacing agents and insurers to provide applicants/existing policyholders with accurate and complete information upon which they can make an informed choice as to whether the replacement serves their best interest. The insurer of the existing policy, if different from the replacing insurer, has an opportunity to conserve its policy through the provision of information and the correction of errors which the replacer might have made concerning the existing policy. Through this mechanism, the regulators have sought to protect the policyholders by enabling them to render their own informed judgments as to what best serves their needs based upon full and accurate disclosure.
Although the life insurance transaction is long term in nature, a significant number of policies are lapsed within 2 years of purchase. Since early cash values tend to be very small in comparison to the premium paid, due to heavy acquisition and other expenses, the failure to continue a life insurance policy can be quite costly. Thus, the decision to do so reflects serious dissatisfaction with the original decision to buy.
To afford policyholders with an opportunity for additional time for sober, unpressured reflection on such a substantial long-term financial commitment, most if not all states have enacted a "free-look" law and/or adopted regulation which gives the policyholder typically 10 or 20 days to reconsider. If he or she determines that the purchase was unwise for any reason, the insurer is required to rescind the policy and refund all monies paid. Furthermore, as previously noted, versions of the free-look requirement are included in the life insurance disclosure and the replacement regulations.
Related to unfair discrimination but distinct therefrom is the practice of rebating. Rebating involves reducing the premium or giving some other valuable consideration not specified in the policy to the buyer as an inducement to purchase insurance. Whereas the prohibitions against unfair discrimination are directed towards benefits, terms, etc., contained within the policy, rebates involve practices external to the policy. The classic rebate situation involves an agent agreeing to give a portion of his or her commission as a reduction of the first premium to induce the prospect to insure.
Historical Development of the Statutory Bank
Rebating became commonplace in the chaotic period between 1885 and 1905 as part of a larger package of abusive practices in the life insurance business designed to acquire business at any price. Rapid growth and cutthroat competition in life insurance markets created an environment in which greed, theft and deceit flourished. Agents sought to increase sales, hence their profits, by giving up some of their commissions to some of their policyholders. Insurers sought to retain agents by offering them increasingly large commissions. Larger commissions enabled larger rebates. Insurers attempted to increase their market shares by competing for agents through the payment of higher commissions. In turn, the agents brought in the business. The cost of obtaining and keeping policyholders spiraled as agents used their high commissions to give rebates to policyholders of rival insurers to induce switching. Agents failing to match rebates of a competing agent lost customers and renewal commissions. Eventually, rebating came to be viewed as a national scandal as the wealthy demanded and obtained rebates while less advantaged persons lacked the knowledge and/or economic power to do so. As expenses mounted, both agents and companies called for reform.
In 1889, New York became the first state to enact legislation to prohibit rebates by prohibiting discrimination between individuals of the same actuarial class. In 1891 the NAIC passed a resolution calling for all states to prohibit the payment of rebates in an effort to prevent the perceived fierce excessive and ruinous competition between agents. Although within a few years several states had antirebate laws, the practice continued. The continuing problem with rebates contributed to the launching of the Armstrong investigation.
To curb life insurer abuses and excesses in efforts to acquire new business, in 1906, the Armstrong Committee recommended not only that limits be imposed on commissions and other costs of acquiring new business and that a maximum limit be placed on the amount of new business, but also that rebates continue to be prohibited. By the early 1900s every state enacted some form of unfair discrimination or antirebate law. In 1912, the NAIC adopted a Model Act prohibiting rebates.
Ultimately, in 1947, the prohibition against rebating was incorporated into the NAIC Unfair Trade Practices Act. The Model Act specifically defines a rebate as a prohibited unfair practice with respect to life insurance, annuity and accident and health contracts. The Act sets forth with some specificity different types of rebates. In addition, numerous state insurance department rulings have been promulgated to deal with a variety of practices suggestive of rebating since rebating can assume many forms other than simply an agent returning a portion of his or her commission to the policyholder. For example, rebating might involve such practices as giving the prospective insured a free gift, providing interest-free promissory notes for premiums, discharge of prior indebtedness, free counseling services, promises of loans not specified in the policy, and extensions of credit.
Laws prohibiting rebating rest upon the traditional public policy objectives of (1) assuring equitable treatment of all policyholders, that is, preventing unfair discrimination as between insureds similarly situated, (2) avoiding adverse impact on insurer financial condition (possibly leading to insolvency) through destructive rate cutting, and (3) protecting career agents from unfair competition by avocational or part-time agents who serve their relatives and friends at reduced prices. However, the 1980s witnessed increasing agitation for the elimination of the ban against rebating with respect to life insurance.
Pros and Cons of Rebating
The proponents of maintaining the antirebate provisions include most insurers and agents in the life insurance industry and their national and local trade associations. Although agents generally tend to view rebates as unwarranted pressure on their compensation, they also believe that widespread rebating would adversely affect the insurance consuming public and insurers in several ways including the following.
Unfair Discrimination. Rebating would result in varying first-year charges to similarly situated policyholders thereby fostering unfair discrimination against those consumers not possessing either economic leverage (that is, purchasers of small amounts of coverage) to demand rebates or simply lacking the knowledge to do so. If forced to make rebates in selected situations to meet the competition, agents would be forced to demand higher commissions from their insurers in order to make a living. Eventually such increased commissions would work their way back into the cost of the product resulting in higher premiums across the board for policyholders, many of whom would be unable to demand and obtain rebates.
Adverse Impact on Insurer Financial Condition. Permitting rebates could lead to the ruinous competition which led to the bans in the first place nearly 100 years ago. Intense competition through rebates may adversely impact the financial condition of insurers (perhaps to the point of insolvency). This could arise from increased early year lapse rates due to replacements, thereby preventing insurers from recovering issue expenses normally amortized over several years. Weakened financial condition also could emerge from the pressure on the insurer to raise commission rates to enable agents to compete even though the insurer might be unable to raise premiums to recover the increased expenses due to competition in the marketplace.
Replacements. Rebates afford an additional and powerful tool for those agents inclined to replace policies. Utilizing the lure of rebates, an agent can more easily encourage a policyholder to replace his or her existing policy, thereby incurring the expensive burden of another set of acquisition costs. In situations where replacement is not warranted in terms of policyholder interest, the availability of rebating exacerbates the replacement problem.
Agent Manpower Shortage and Adverse Public Effects Thereof. Larger agencies and more established agents tend to be better positioned to offer significant rebates. As a consequence, the removal of the ban on rebating would encourage the concentration of agency forces, would favor the more established agents, and would result in increased turnover of agents, especially new agents who already have a difficult time surviving long enough to develop a viable career. In turn, these impacts could aggravate agent manpower shortages in life insurance agencies, thereby reducing the number of agents available to service the public and limiting competition in the marketplace. Furthermore, in view of the generally held axiom that life insurance is sold rather than bought, the fewer the number of agents, the smaller the amount of life insurance sales and, in turn, the greater the underinsurance of this nation’s population.
Quality of Policyholder Decision Making. The availability of rebates detracts from the likelihood of prospective policyholders making the best decisions for themselves in purchasing long-term contracts of life insurance. Encouraging prospective buyers to focus on the size of the rebates in the first year (a very small portion of the total cost of insurance over the life of the policy) will tend to reduce the quality of buyer decision making in comparing prices. Perhaps the gravest danger posed by rebating is the all too real possibility that the buyers will be more influenced by the size of the rebate, that is, by the "deal" they can make, than by the merits of the insurance contract, the total long-range costs, the nature and suitability of the products, and the quality of agent counseling and service.
Despite these public policy arguments, the 1980s witnessed increasing agitation for the elimination of the ban against rebating. The critics of antirebate laws maintain the following.
Anticompetition. The rebate laws are anticompetitive by needlessly sheltering agents from competition, thereby contributing to excessive insurance costs. Consumer opportunity to negotiate between agents for a better price is barred. In contrast, the removal of the ban on rebates will focus on competition for the consumers’ business rather than insurers simply competing for agents to market their products. Permitting rebates would contribute to lower costs for at least some consumers.
Absence of Significant Impact on Insurer Financial Condition. Ruinous competition and increased likelihood of insolvency are viewed as very tenuous, if not sham, arguments. Rebating would have little impact on insurer solvency. The amount of money an agent gives back in the form of a rebate does not affect the amount of the premium received by the insurer to fund its obligations. How an agent chooses to spend his or her money is irrelevant to insurer financial condition.
Although rebates may have contributed to insolvencies nearly 100 years ago, circumstances have dramatically changed. Unlike the past when insurers’ financial condition was not closely scrutinized and regulated, such is no longer the case. As considered earlier, a host of legislation, regulation and monitoring procedures have been instituted to address the solvency issue. No longer do rebates play a significant, if any, role in the context of solvency maintenance. The problems of solvency regulation are addressed more effectively by direct regulation than by statutes and regulations governing rebating.
Lack of Inappropriate Discrimination. Rebating does not give rise to unfair discrimination. The life insurance business is replete with examples of discrimination. (Remember, it is only unfair discrimination which is prohibited.) Economies of size garner better rates. Insurers discriminate in underwriting by allocating policyholders to different rate classifications. Group insurance policyholders enjoy the lower costs associated with the absence of the high first-year agent commissions paid on individual policy sales. Agents discriminate in selecting their prospects. Similarly, buyers should be able to select among agents and vary their costs based upon the amount and quality of work performed by the agent. A knowledgeable buyer needing little prospecting, analysis or research should not be compelled to pay the same commission as a difficult customer who might utilize ten times as much of the agent’s time.
The Amount and Quality of Service. In stifling competition between agents, the ban on rebates permits the less competent or inefficient agents to be compensated on a basis equivalent to that of the most knowledgeable and efficient agents. The absence of competition reduces incentive for providing superior service. The essence of negotiated commissions is the ability of the consumer to purchase the amount and quality of services desired and needed. In contrast, under the fixed-commission system, the consumer may obtain a particular service only by paying for the full range of services offered by the agent. Whether the consumer wants, needs or actually utilizes the agent’s services does not affect the price paid.
It is not the function here to resolve the merits of the dispute over the continued appropriateness of the antirebate laws. However, a wider and better understanding of the pros and cons by those interested in the insurance business should contribute to a better resolution of the issue if and when it comes up for debate in a given state.
Current Status of the Regulation of Rebates
Recent years have witnessed some efforts to remove the ban against rebates. In 1977, a task force of the United States Department of Justice recommended that the determination of commission levels should evolve from the interplay of market forces. Four years later the Wisconsin Insurance Commissioner proposed legislation to repeal that state’s antirebate law. In the same year, legislation was introduced in Congress to override state antirebate laws. In 1985 the Consumers Union filed suit in California challenging the constitutionality (ultimately unsuccessfully) of the antirebate law of that state. Shortly thereafter, the efforts to eliminate such laws reached a high-water mark, first in Florida and then in California.
In 1986, the Florida Supreme Court overturned that state’s law prohibiting rebates as a violation of the Florida Constitution’s due process clause. In the Court’s view, the ban on rebating commissions has no legitimate state interest. It bears no reasonable relationship to the health, safety and welfare of the citizens of Florida. For many persons, including courts in other states, the Florida Supreme Court’s due process analysis has proven unpersuasive.
In 1990, the Florida legislature enacted a law imposing significant limitations on the availability of rebating. No agent shall rebate any portion of his or her commission except as follows. (1) The rebate shall be available to all insureds of the same actuarial class. (2) A rebate shall be in accordance with a rebating schedule filed by the agent with the insurer issuing the policy to which the rebate applies. (3) Such schedule shall be uniformly applied to all insureds who purchase the same policy through the same agent for the same amount of insurance. (4) Rebates shall not be given to a policy purchased from an insurer which prohibits its agents from rebating commissions. (5) The rebate schedule shall be prominently displayed in public view in the agent’s place of business and a copy shall be provided upon request to insureds at no charge. (6) The age, sex, residence, race, nationality, ethnic origin, marital status or occupation of the insured may not be used in determining either the availability or the amount of the rebate. Also the statute provides that no rebate may be withheld or limited based on factors which are unfairly discriminatory. Agent concerns over potential regulatory and/or private party judicial actions based on unfair discrimination if he or she should grant rebates selectively to some persons or groups, as well as the possibility of termination by his or her insurer, have tended to deter widespread rebating in Florida.
To date, no other state supreme court has determined that the antirebating law is unconstitutional.
However, despite judicial determination that the antirebate ban was constitutional, in November 1988, the California electorate voted in favor of a broad-ranging referendum (commonly referred to as Proposition 103) covering a wide gamut of insurance issues including the repeal of the ban on rebates in that state. Unlike Florida, California has not issued regulations to prohibit discriminatory or random rebating. If an agent rebates in some cases but not in others, the issue is posed whether he or she is subject to liability for unfair discrimination. The threat of civil actions by private parties (either as individuals or as part of class actions) or by regulators on the basis of discrimination has proven to be of considerable concern to agents inclined to rebate.
While acknowledging that rebating is now legal in California, several life insurers in California have taken the position that it is within their right to refuse to deal with agents who do rebate. The Department moved against insurers who fired an agent who offered his customers commission rebates. An administrative law judge concluded that it is not an unfair business practice for life insurers to do so. Although initially indicating that he would not accept the judge’s ruling, the insurance commissioner ultimately concluded that insurers may fire agents who rebate. Proposition 103 repealed the prohibition against rebates. It does not require insurers to do business with those agents who do rebate. Insurers may fire those agents who engage in such practices if doing so constitutes a violation of their agency contracts with the insurer.
Elsewhere, to date, the arguments and influence of the proponents of the ban against rebating have prevailed in both public policy forums and judicial challenges. Other than in Florida, judicial challenges to the antirebate laws have proven unsuccessful. Only in California has a comparable result been achieved by voter referendum. In the other 48 states, the antirebate laws remain intact. Unless change should be compelled at the federal level, it appears that the antirebate provision will remain the law in the vast majority of states at least for the immediate future. While rebating in Florida and California is legal, the legal climate remains hostile.
The State of Marketing Life Insurance: A Crisis in Ethics
Although the life insurance industry has been somewhat shaken in recent years by a few substantial insolvencies, that storm has apparently been weathered through both regulatory and industry action coupled with the adoption of additional regulatory safeguards to better deal with and deter such situations in the future. However, while fears as to the financial condition of the life industry as a whole have ebbed, a new crisis has emerged. Questionable market conduct and misleading sales practices on a widespread basis are emerging as a major issue, if not the major issue, for both life insurers and their agents in the mid-1990s. When combined with the recent financial difficulties of life insurers, public concern over the integrity and fairness of life insurance company market conduct assumes even greater significance as to the long-term prospects of the life insurance business.
The life insurance business involves millions of transactions, billions of dollars, intense competition both with other insurers and other financial institutions, and a largely autonomous sales force. As a result, the industry is vulnerable to various pressures and abuses by a wide range of agents and companies in their quest for business. Whereas in the past such conduct has been said to be the province of a few "rogue" agents, with the emergence of the scandal involving the Metropolitan Life Insurance Company (both a historical and current pillar and giant in the life insurance industry), no longer can this contention be accepted without question.
Central in the Metropolitan situation were widespread deceptive sales of whole life insurance policies sold as retirement plans rather than as life insurance. Instead of selling annuities to serve as a retirement, investment, or savings plan for a low (for example, 2 percent) first-year commission, agents were tempted to misrepresent whole life policies as such plans because of the high (for example, 55 percent) first-year commission. Thus, at the heart of the problem are the relatively high commission incentives for the sale of whole life insurance in a market where investment and retirement plans have more appeal to the consumer than life insurance policies. Within this incentive environment, Metropolitan agents, especially out of its Tampa office, made national mailings extolling their retirement plan without disclosing that what was really being sold was whole life insurance. Under Florida law, such sales practices are deemed deceptive.
Ultimately, the sales activities of both the company itself and its agents became subject to numerous investigations by several states individually. In addition, the NAIC established a committee to coordinate the investigative activity of numerous states. As a result of this activity, in early 1994, the Metropolitan agreed to pay up to $76 million in restitution to approximately 60,000 customers and $20 million in fines. In addition numerous Metropolitan agents around the country have been or are facing fines and license suspensions or revocations. Furthermore, Florida filed charges against nearly 90 agents alleging fraudulent sales practices, stating that this was not a situation where only a few agents sought to take advantage of potential customers. But rather, it was alleged that there was a concerted effort by many individuals to dupe customers into purchasing life insurance policies disguised as a retirement savings plan.
After conducting its own internal investigation, the insurer admitted that wrongdoing was not confined to a few agents. Among internal problem areas were the development and provision of misleading brochures in the home office and the failure of internal auditor reports to disclose abuses in agent offices. Investigators attributed the abuses primarily to the insurer’s "sales-at-all-cost" corporate culture, the insurer’s lack of supervision, tacit approval of questionable sales tactics, and ineffective company audits of marketing practices.
These events sparked a major overhaul of Metropolitan’s compliance procedures. The insurer established a corporate ethics and compliance department to monitor company practices throughout the country. This includes auditing personal insurance sales offices. Compliance deficiencies are to be reported to senior management to assure the correction of problem areas. As part of a new program, the Metropolitan put into place 41 ethics and compliance officers throughout the company. Thirty-seven lawyers (as compared to a previous three) have been assigned to compliance issues including the approval of sales literature.
Unfortunately, the Metropolitan situation does not appear to be unique. Other major life insurers have admitted that one or more of their agents have employed a virtually identical marketing scheme. The largest life insurer of all, the Prudential Insurance Company of America, has admitted to deceptive and misleading practices by some of their representatives. Investigations in various states are turning up more than a few isolated cases of agent misconduct including agents of various well-known major life insurers. Unsuitable replacements of policies, with the same policyholder often being the victim several times (sometimes referred to as churning), remain a persistent problem. Separate class action lawsuits were brought in early 1994 against both the Metropolitan and the Prudential alleging churning in that the insurers developed a scheme for marketing new life insurance policies to existing customers possessing high cash values in their policies by falsely saying that they could obtain new policies with more coverage at no additional cost by financing the new replacement policy with the accumulated equity in their existing policies. Also, inappropriate use of policy illustrations, giving rise to unfulfilled expectations, has been all too common throughout the life insurance industry as a whole. The latter cannot be laid solely at the feet of agents. Some actuarial practices have been described as "deplorable" as company actuaries have been pressured by management to make unrealistic predictions of future policy performance so that a company’s policy illustrations will appear more attractive competitively. And, there have been a number of agents, when moving from one insurer to another, who replace the policies of the company they left.
In this environment, is not surprising that plaintiff attorneys have turned to class actions against life insurers and have sought large punitive damage awards. For example, in a situation said to have involved $30,000 of economic damages, a jury awarded a $25.4 million settlement against the Prudential for failing to properly supervise or terminate its relationship with a particular agent who allegedly grossly misled numerous policyholders as to the amount of monthly benefits they could receive from the policies he sold to them. The judge concluded that the punitive damages were not excessive because of the potential harm to innocent insureds if the insurer’s inappropriate conduct is not deterred. This and other situations illustrate that life insurers are beginning to experience the punitive effects of both class action and/or punitive damage litigation which has more traditionally been the bane of property and liability insurers. While some may applaud, it must be recognized that the costs which result are not only passed on to other policyholders in the form of added premium costs and/or lower dividends, but also in some situations such result could even jeopardize the financial condition of the insurer. Furthermore, consumers in general suffer from excessive punitive damage awards since insurers will need to build the cost of potential litigation into their cost structure.
Many regulators believe that inappropriate market conduct is not limited to just a few companies. But rather, there is the sense that market conduct and misleading sales practices may be the major life insurance regulatory issue of the 1990s. Critics of the industry, as well as some supporters, perceive deception and fraud as being an integral part of the life insurance business which is not likely to be rooted out easily. And, as a product of developments such as these, the public’s attitude toward the life insurance industry has dramatically declined over time.
As the previous discussion makes clear, state insurance regulation has not been oblivious to abuses in the marketing of life insurance products. Currently the most detailed and widespread code for ethical market conduct is the NAIC Unfair Trade Practices Act, which has been amended from time to time to adjust to current circumstances. Furthermore, the Act has been supplemented by a variety of regulations governing such activities as advertising, disclosure, replacements, and so on. Both insurers and agents may be subject to fines, license suspension, or even license revocation for engaging in unfair trade practices.
In addition, states are more frequently using market conduct examinations to monitor insurer and agent activity. The NAIC has developed, and periodically updates, its Market Conduct Examiners Handbook. This handbook sets forth recommended standard procedures for state market conduct examiners to use when they review insurers to assure that consumers are treated fairly. The handbook covers such areas as company operations and management, underwriting, policyholder service, claims, marketing and sales, producers licensing, and complaint handling. The NAIC is also exploring means to better coordinate state regulation of market conduct through multistate market conduct examinations.
The Metropolitan situation has generated a more recent rash of activity by state regulators. In addition to state activity directed specifically at the Metropolitan and other companies engaging in similar practices (such as failing to identify life insurance as life insurance and churning policies to generate additional agent first-year commissions, often at the expense of leaving policyholders worse off than before), as discussed earlier, the NAIC is currently attempting to develop an approach to govern policy illustrations. Also, with the encouragement of the life insurance industry, the NAIC contemplates using its developing producer database, among other things, to address the problem of "rogue" agents jumping from company to company and state to state (whether voluntarily, after being fired, or after losing their license in the state for disciplinary reasons).
In addition, states are increasingly joining together to investigate possible improper marketing and sales practices of particular companies. In 1994, it was the Metropolitan situation. In early 1995, five states reached a multistate settlement with Capitol American Life Insurance Company, and later in the year several states combined in a multistate investigation of insurer churning. Joint efforts not only enable a pooling of regulatory resources and information, they also tend to lead to quicker results.
Furthermore, individual states have broadened their investigations to the industry as a whole. For example, in early 1994, the New York Superintendent of Insurance ordered the life insurance companies doing business in that state to conduct regular internal company investigations to uncover illegal marketing and sales practices. Those insurers failing to do so may be subject to fines and/or required to submit all advertising materials to the insurance department before using such materials. Companies must review all advertising files and practices to assure compliance with state regulations, review procedures for notifying the department as to the reasons for firing agents, examine company complaint files to ascertain patterns of abuse, and review procedures for evaluating compliance with regulations governing sales, advertising, product approval, and filing requirements. Also each insurer president is required to file specified compliance reports, signed under oath, with the insurance department stating that such reports constitute a fair and accurate statement of compliance by the insurer and its agents with all laws, regulations, internal controls, and operating procedures governing the sale and marketing of life insurance and annuity contracts.
Other states have initiated efforts on the same theme of requiring significantly more from insurers in the area of market conduct compliance with respect to those life insurers doing business therein. In addition, the possibility of expanding the interstate compact concept has been raised as a potential mechanism to regulate sales practices and/or agent-company licensing.
It has been said that efforts such as these, when viewed together, constitute one of the largest assaults on the conduct of the life insurance industry since the 1905 Armstrong investigation. Life insurers are not being prompted by the regulators alone to clean up their act; under the laws of most states, an insurance company is liable for fraud or other wrongdoing perpetuated by its agents in the course of their employment. Even when an agent’s carelessness or intentional misconduct is conducted solely on his or her own, the insurer may be liable if the agent was authorized to do business for the company since the company is deemed to be acting in the person of its agent. Courts are showing the tendency to expand insurer liability for the wrongful acts of agents.
Also lurking in the background are corporate criminal sentencing guidelines. In 1991, the National Sentencing Commission codified penalties imposed by federal courts against organizations in the form of punitive guidelines for organizational criminal offenses. Since it is impossible to put an organization in prison, penalties must take the form of fines and sanctions. Under the guidelines, an organization must undertake clear steps to prevent inappropriate conduct. These include establishing compliance standards and procedures, to be followed by employees and other agents, that are reasonably capable of reducing the likelihood of criminal conduct. Specific high-level individuals must be assigned responsibility to oversee compliance. Due care needs to be exercised to avoid the delegation of substantial discretionary authority to persons known (or who should have been known) to have the propensity to engage in illegal activities. The organization needs to communicate its standards and procedures and implement training programs. Monitoring and auditing systems should be in place to detect criminal conduct. Standards should be enforced through appropriate discipline. If a company has undertaken measures to prevent organizational criminal offenses, it may be found less culpable when defending against charges of misconduct.
Furthermore, market conduct of life insurers has aroused the interest of congressional and other proponents of federal regulation of the life insurance business. In fall 1994, for example, at the request of the then-chairperson of the House Energy and Commerce Subcommittee (which has jurisdiction over insurance), the General Accounting Office launched an investigation into life insurance marketing practices. This investigation is the first formal inquiry in many years into life insurance marketing practices by a congressional committee possessing jurisdiction over insurance. Thus, it has become quite evident that misleading sales illustrations and other market concerns have emerged as a prime issue in the wake of the Metropolitan and other highly visible adverse situations.
State insurance regulators are making it increasingly clear that the days of relying on agents to manage customer relationships with little or no effective company oversight are coming to an end. Companies and industries failing to achieve customer satisfaction and regulatory compliance can look forward to increasingly intrusive regulatory control. With the regulators and the courts imposing multimillion dollar fines on life insurers for less than forthright sales practices of some of their agents, with the potential of criminal sanctions, and with the ever-present federal interest, life insurers are feeling increased pressure. Further investigations, allegations, and penalties are almost sure to continue. But even more damaging than the monetary penalties is the damage to the reputations of not only individual insurance companies but to the industry as a whole. Given the nature of the insurance product, maintaining customer trust is critical.
In response to the mounting pressure, as well as a recognition of their responsibility for the conduct of their agents, several insurers and professional agent organizations have focused increased attention on better means of installing a system of values or ethical standards in the conduct of the life insurance business. The recently beefed up program at the Metropolitan is one example. Professional organizations, like the American Society of CLU & ChFC, have for some time required a pledge from their members to adhere to a code of ethical standards.
In 1994, the American Council of Life Insurance (ACLI), a major life insurance trade organization, formed a task force to address the issue of misleading sales practices. Later that year, the ACLI board of directors approved in principle a system of self-assessment by life insurers with indication by a third party as to whether the insurer meets a set of ethical standards and a code of conduct for the life insurance industry. The purpose of the assessment process is to improve market conduct in the life insurance industry by evaluating insurer conformity with the adopted Principles and Code of Conduct. A form of recognition would be accorded to conforming companies. While the precise form of the Principles and the Code of Conduct is still evolving, as is the nature of the assessment process, currently the six principles to which an insurer would commit in matters affecting the sale of life insurance and annuity products are
1. To conduct business according to high standards of honesty and fairness
2. To ensure competent and customer-focused sales and service
3. To engage in active and fair competition such that the public can obtain
needed services and products at reasonable prices
4. To provide advertising and sales materials that are clear as to purpose
and honest and fair as to content
5. To provide for fair and expeditious resolutions of customer complaints and disputes
6. To maintain a system of supervision and reviews that is designed to achieve compliance with these principles of ethical market conduct.
The Code of Conduct is intended to afford a more detailed expression as to how insurers and their agents should live up to the general principles.
An insurer seeking certification would conduct a self-assessment of its compliance with the Principles and Code of Conduct. Such self-assessment would then be submitted to a third party (perhaps an accounting firm) to review the report and conduct an independent assessment for consideration by the recognition body.
It is anticipated that companies participating in this program would seek independent reassessment periodically, perhaps every 3 years. The program is voluntary. It is envisioned that insurers would be able to use the fact that they have been recognized as complying with the Principles and the Code of Conduct in their marketing efforts. Although the program has been approved in principle, it is still a work in progress rather than an accomplished fact.
In short, to regain, maintain and/or improve public confidence in the market conduct activity of the life insurance business, which is essential to the long-term viability of the industry, it can be anticipated that life insurers, professional agent organizations, and regulators will all strive to remedy current abuses and deter future ones. Consequently, the regulation of market conduct activities will continue to evolve in efforts to achieve the fundamental regulatory objectives of the goals of reasonableness in the marketplace, which seeks to bar mistreatment of policyholders as individuals in such areas as claims practices, agent misrepresentations and service.