Regulation Modernization


APRIL 2015

Insurance is regulated by the individual states. The move to modernize insurance regulation is being driven in part by the globalization of insurance services. Some large U.S. companies that operate in other countries support the concept of a federal system that provides one-stop regulatory approval while others believe the merits of a state system outweigh the virtues of a single national regulator. As a result of discussions about the merits of each system, states are making it easier for insurers to respond quickly to market forces.

States monitor insurance company solvency. One important function related to this is overseeing rate changes. Rate making is the process of calculating a price to cover the future cost of insurance claims and expenses, including a margin for profit. To establish rates, insurers look at past trends and changes in the current environment that may affect potential losses in the future. Rates are not the same as premiums. A rate is the price of a given unit of insurance—$2.50 per $1,000 of earthquake coverage, for example. The premium represents the total cost of many units. If the price to rebuild a house is $150,000, the premium would be 150 x $2.50. Rates vary according to the likelihood and potential size of loss. Using the example of earthquake insurance, rates would be higher near a fault line and for a brick house, which is more susceptible to damage, than a frame one.

While the regulatory processes in each state vary, three principles guide every state’s rate regulation system: that rates be adequate (to maintain insurance company solvency), but not excessive (not so high as to lead to exorbitant profits), nor unfairly discriminatory (price differences must reflect expected claim and expense differences). Recently, in auto and home insurance, the twin issues of availability and affordability, which are not explicitly included in the guiding principles, have been assuming greater importance in regulatory decisions.

In line with these principles, states have adopted various methods of regulating insurance rates, which fall roughly into two categories: "prior approval" and "competitive." This does not mean there is no competition in states using a prior approval system. Most approved rates in prior approval states are the rates used, but in some cases, particularly in commercial coverages, companies compete at rates below these approved ceilings.

Increasingly, even in the most regulated states, officials are relying on competition among insurance companies to keep rates down and are modernizing and streamlining the rate setting process.


Congress and Federal Matters

  • The Federal Insurance Office (FIO), an entity within the U.S. Department of the Treasury that was created as a result of the 2010 Dodd-Frank financial services reform law to report to Congress and the President on the insurance industry, is expected to release a report on how to improve and modernize insurance regulation in the United States. The report was mandated by the Dodd-Frank legislation. In developing the report, the FIO sought public comments from a wide variety of sources, including policyholders, academic experts, consumer groups, state insurance regulators, insurance industry representatives and other interested parties. The request asked for comments in 12 major areas, including federal regulation of some types of insurance. The report, due at the beginning of 2012, has not yet been published.
  • Speaking at an industry forum in January 2012, Michael McGraith, the first director of the FIO and a former Illinois insurance regulator, said the first report would set out how the FIO intended to monitor access to affordable insurance for underserved communities, a key responsibility. He also said that one immediate priority for the FIO was to ensure regulatory systems in other countries, such as Solvency ll , see Issues Update report, and proposals for new international accounting systems, do not put U.S. insurers at a disadvantage.
  • Insurance will continue to be regulated by the states, but the act includes a narrow preemption of state insurance laws in areas where the FIO determines that the state law is inconsistent with a negotiated international agreement and treats a non-U.S. insurer less favorably than a U.S. insurer. The FIO has the authority to monitor the insurance industry, identify regulatory gaps or systemic risk, deal with international insurance matters and monitor the extent to which underserved communities have access to affordable insurance products. The FIO covers insurers, including reinsurers, but not health insurance. Recently, the FIO has been trying to resolve differences between European and U.S. regulatory schemes, particularly with regard to rules for reinsurers wishing to enter the U.S. market.
  • In testimony before a subcommittee of the House Financial Services Committee in October 2011, McGraith said his goal was to work with state regulators to ”establish customs and practices that best serve the United States, our economy, the insurance industry and consumers.” The FIO is responsible for setting up the Federal Advisory Committee on Insurance, authorized by the Treasury to provide guidance on matters related to the office, he said. The committee will have 15 members, about half of whom will be state insurance regulators.
  • The 2010 reform bill addressed a number of concerns about insurance: lack of an entity at the federal level that could represent insurance interests, particularly in the discussion of international issues and the need to streamline the regulation of reinsurers and surplus lines insurers.
  • Among other things, the FIO must submit an annual report to Congress on the insurance industry. In gathering information, the FIO may require insurers, with the exception of small insurers, which are exempt, to submit data. The FIO is empowered to issue subpoenas but it must obtain data from state and federal regulatory agencies, where possible, before requiring insurers to submit them. The FIO oversees the federal terrorism insurance program.
  • Responding to the events that helped precipitate the financial crisis, the legislation also calls for systemic risk regulation. Under the bill, the federal government has authority to seize and dismantle large financial firms whose insolvency could destabilize the financial system. The bill creates a liquidation fund for this purpose to which large insurers might be required to contribute, even though insurance companies do not usually pose a systemic risk and the industry already has a funding system (state guaranty funds) to pay for the unwinding of failed companies. When assessing insurers for the cost of liquidations, contributions to these guaranty funds must be taken into account.
  • In addition, the reform package creates a separate Consumer Financial Protection Agency to address some of the practices that are believed to have contributed to the crisis. Property/casualty insurance is excluded from the agency’s jurisdiction. Individual states oversee market conduct as well as solvency.
  • In addition, the Dodd-Frank bill allows surplus lines (nonadmitted) insurance and reinsurance companies to be regulated by a single state and establishes national standards for how states regulate reinsurance and the surplus lines market, among other things. Nonadmitted insurers are companies that sell insurance to riskier entities whose business traditional insurance companies are unwilling to accept.
  • From the beginning of discussions, the property/casualty insurance industry has been concerned that bank-centric regulatory provisions would be imposed on the industry. Insurers have pointed out that property/casualty insurance companies are unlikely to pose a systemic risk to the financial system. They are generally low-leveraged businesses with more conservative investment portfolios than other financial services segments and have more predictable cash outflows tied to insurance claims rather than on-demand access to assets. In addition, as mentioned above, the insurance industry already has a mechanism to deal with failing companies and to protect policyholders in the event of an insolvency. Insurers are monitoring the rule-making aspect of the legislation.

State Regulation Reform

  • North Carolina: Two legislative committees have been working on modernizing the state’s auto and property insurance regulatory systems to improve availability and affordability but both suggested that specific legislative proposals be put off until the 2013 legislative session.
  • The property insurance committee made a number of recommendations, among them a review of territorial boundaries to ensure that policyholders in beach and coastal areas are being charged a premium that is actuarially appropriate and greater opportunities for public comment. A study by Milliman Inc. suggested additional ways to improve on the positive effects of the 2009 Beach Plan legislation, including a flex rating system, adjustments to the Beach Plan’s current territorial pricing and explicit recognition of the cost of reinsurance when developing rates.
  • The auto insurance committee suggested changes to the rate setting methodology used for high-risk pool drivers, including eliminating the surcharge paid by all drivers to support the pool but delayed decisions on other issues.
  • Florida: Florida has a new no-fault law designed to lower rates by combating fraud and abuse of the system, see No-Fault Auto Insurance report. Insurers are expected to file for lower rates as the law takes effect. On October 1, 2012 insurers were required to submit a rate filing to state regulators that showed at least a 10 percent rate reduction or documentation for why they cannot. Most major insurers are requesting decreases in personal injury (PIP) coverage. The PIP portion makes up about 20 percent of the premium, according to the Office of Insurance Regulation. Rates must be rolled back further, by an overall 25 percent, by January 1, 2014.
  • Most observers agree that Florida’s auto insurance system was riddled with outright fraud and blatant abuse. Data from Chief Financial Officer Jeff Atwater’s office shows that while the number of drivers in Florida has held steady and the accident rate even declined, going from 1.76 per 100 licensed drivers in 2005 to 1.52 in 2010, insurance costs dramatically increased, resulting in what some call a “fraud tax.”
  • The law called for an independent actuarial study of the savings that can be expected from the new provisions. The study, conducted by Pinnacle Actuarial Resources and made public in August 2012, suggests potential savings could be between12 percent and 20 percent of the PIP portion of an auto insurance policy. Regulators and insurers, however, point out that these are just preliminary calculations, a starting point to begin evaluating the impact of the reform provisions. The new law in some cases may not actually lower total premiums but instead reduce the size of a PIP rate increase.
  • In May 2011 Florida’s Governor Rick Scott signed SB 408, a wide-ranging property insurance reform measure known as the “cost driver bill” because it addresses many of weaknesses in the current system that have been pushing up costs. Insurers hope that the law will stabilize or reduce premiums and attract new insurers to the property insurance marketplace.
  • Among other things, the bill sets parameters on what constitutes a sinkhole loss, a major cause of rising costs, and limits coverage to the primary building, thus excluding cracks in driveways, swimming pools and separate structures. It also sets a two-year statute of limitation on the filing of sinkhole claims and a three-year limitation on the filing of hurricane and windstorm claims to prevent the filing of dubious claims long after the disaster. Another provision allows insurers to make a partial payment to the policyholder on a claim for structural damage and, once a contractor is hired, to pay the contractor for the remaining work, a practice that is the norm in most other states but was prohibited in Florida in 2007 when Charlie Crist was governor. Insurers had to pay the entire claim amount up front. This created an incentive for people to file claims but to use the claim payment for other purposes.
  • Other provisions increase the reserves insurers are required to keep on hand, raising the minimum to $15 million starting in 2011 for new companies and in 2021 for existing ones. A similar requirement was included in the property bill that Gov. Christ vetoed in 2010. SB 408 also allows insurers to pass on to policyholders up to 15 percent of reinsurance-related costs.
  • Massachusetts: Data from the National Association of Insurance Commissioners show that between 2007 and 2009, the period when the auto insurance system was changing over from state set rates to “managed competition,” the average premium in the state fell 12.7 percent, from $1,056.91 to $923.11, a $133.80 decrease compared with a 1.4 percent drop nationwide. The managed competition system, which also replaced a complex and unique residual market mechanism with an assigned risk plan, see report on Residual Markets, attracted  many new auto insurers to the state, including three large national companies.
  • Michigan: Michigan is unique among auto insurance no-fault states in that its no-fault law offers unlimited medical care under its PIP coverage and in that it does not use medical fee schedules (maximum fees that can be charged for common types of medical treatment for auto accidents, similar to the fees set under the state’s workers compensation system.) Legislators are considering various proposals intended to reduce costs and offer consumers more choice, including a low-cost plan for individuals who meet certain eligibility requirements.
  • New York: In New York, the regulation of all financial services entities is now the responsibility of a single regulator, Benjamin Lawsky. The deputy superintendent is the former superintendent of insurance, James Wrynn. Lawsky said he hopes the new Department of Financial Services (DFS) will be the leanest, most efficient and most effective in the nation and that it will be a nimble regulator and not stifle innovation. Further, he said, addressing fraud would be a major priority for the DFS as would commercial lines modernization, an issue that was discussed during merger negotiations. The merger took effect in October 2011. Two months later Lawsky said that the new department was already on track to reduce spending by more than 10 percent.
  • New York has been looking into the possibility of reviving the New York Insurance Exchange, which opened in 1980 in the expectation that it would become something akin to a U.S. Lloyd’s of London, a centralized marketplace. It closed seven years later, with many of its syndicates insolvent. State officials believe that new interest on the part of capital markets, advances in technology and the ability to make deals more transparent could revive the exchange. The legal and statutory structure for an exchange to function is still intact, according to New York’s former superintendent of insurance Eric Dinallo. Supporters of a revived exchange see it as a place for large-scale transactions and complex reinsurance deals and believe lower costs and regulatory efficiencies together with one-stop access to the 50-state marketplace provide significant advantages. Progress on the exchange was slowed during the merger of financial services departments.

Flex Rating

  • Connecticut: A flex rating band of 6 percent was approved for personal lines coverage for two more years in June 2011, continuing the system that was first implemented in 2006.
  • New York: The state adopted a permanent rule relating to flex rating, effective January 2010. The measure allows auto insurers to adjust their rates up or down within a 5 percent band without seeking approval from the state’s insurance commissioner. Insurers will still need prior approval from the insurance department for overall rate increases exceeding 5 percent in any 12-month period.
  • Tennessee: Effective July 2011, auto and homeowners insurers will be able to increase or decrease rates by up to 15 percent without prior approval by the insurance department.

Commercial Lines Deregulation

  • Connecticut: A flex rating band of 6 percent was approved for personal lines coverage for two more years in June 2011, continuing the system that was first implemented in 2006.
  • New York: The state adopted a permanent rule relating to flex rating, effective January 2010. The measure allows auto insurers to adjust their rates up or down within a 5 percent band without seeking approval from the state’s insurance commissioner. Insurers will still need prior approval from the insurance department for overall rate increases exceeding 5 percent in any 12-month period.
  • Tennessee: Effective July 2011, auto and homeowners insurers will be able to increase or decrease rates by up to 15 percent without prior approval by the insurance department.


Prior Approval: The insurer must file rates, rules, etc. with state regulators. Depending on the statute, the filing becomes effective when a specified waiting period elapses (if the state regulator does not take specific action on the filing, it is deemed approved automatically) or the state regulator formally approves the filing. A state regulator may disapprove a filing at any time if it is not in compliance with the law. The state regulator normally must hold a hearing to establish noncompliance.

Modified Prior Approval: This is a hybrid of "prior approval" and "file and use" laws. If the rate revision is based solely on a change in loss experience then "file and use" may apply. However, if the rate revision is based on a change in expense relationships or rate classifications, then "prior approval" may apply. A state regulator may disapprove a filing at any time if it is not in compliance with the law. The state regulator normally must hold a hearing to establish noncompliance.

Flex Rating: The insurer may increase or decrease a rate within a "flex band," or range, without approval of the state regulator. Generally, either "file and use" or "use and file" provisions apply. Generally, the insurer must file rate increases or decreases that fall outside the established "flex band" with the state regulator for approval. Typically, "prior approval" provisions apply. The "flex band" is set either by statute or by the state regulator. A state regulator may disapprove a filing at any time if it is not in compliance with the law. The state regulator normally must hold a hearing to establish noncompliance.

File and Use: The insurer must file rates, rules, etc. with the state regulator. The filing becomes effective immediately or on a future date specified by the filer. A state regulator may disapprove a filing at any time if it is not in compliance with the law. The state regulator normally must hold a hearing to establish noncompliance.

Use and File: The filing becomes effective when used. The insurer must file rates, rules, etc. with the state regulator within a specified time period after first use. A state regulator may disapprove a filing at any time if it is not in compliance with the law. The state regulator normally must hold a hearing to establish noncompliance.

State-Prescribed: The state regulator determines and promulgates the rates, classifications, forms, etc. to which all insurers must adhere. Insurers are usually permitted to deviate from state prescribed rates, classifications, forms, etc., with the approval of the state regulator.

No File/Record Maintenance: The insurer need not file rates, rules, etc. with the state regulator. Rates, rules, etc. become effective when used. The state regulator may periodically examine insurer(s) to ensure compliance with the law.

Generally, there are record maintenance requirements under which insurers must make their rating systems available to the state regulator for examination. A state regulator may order discontinuance of the use of the material at any time if it is not in compliance with the law. The state regulator normally must hold a hearing to establish noncompliance.


Insurance as a State-Regulated Business: Insurance regulation began in an era when states regulated railroads, utilities and almost all other domestic commerce with minimal federal involvement. At the time, small mutual companies insuring property risks were the norm and the vast majority of insurance was sold by companies that operated in a single state, or at most a very small region. Gradually, large interstate life and property/casualty insurance stock companies came to dominate the market. States with a large insurance presence put together regulatory systems. Connecticut and New York were pre-eminent in developing insurance law and regulatory procedures because many large insurers were incorporated there.

In 1871 the National Convention of Insurance Commissioners (now known as the National Association of Insurance Commissioners or NAIC) was founded to coordinate the work of state insurance commissioners. Over the years the group has become a strong force in strengthening solvency regulation. It developed an accreditation program that required state insurance departments to meet certain prescribed standards. It also established minimum capital requirements for insurers, based on the riskiness of their business.

The first law permitting an insurance commissioner to review rates to assure that they were not "excessive, inadequate, or unfairly discriminatory with regards to individuals" was passed in Kansas in 1909. Earlier, toward the end of the 19th century, price wars and a scramble for short-term revenues at the expense of more conservative actuarially based policies had caused many insolvencies, leaving policyholders without coverage. In the wake of these insolvencies, the insurance industry formed compacts designed to promote "correct pricing practices," but the compacts proved unpopular and were abandoned. State control of rates was seen as a better solution to the problem of potentially destructive price wars than a system of compacts largely beyond public control.

In 1914, the U.S. Supreme Court (German Alliance Ins. Co. v. Lewis, 233 U.S.389) articulated the rationale for closely regulating the business of insurance. In the Court’s opinion, insurance was a business "affected with a public interest," first because insurance is often a legal or contractual prerequisite for other market activity and second because the complexity of the insurance contract places the average consumer at a comparative disadvantage in the marketplace. This ruling served as the justification and impetus for increased state regulation.

In 1921, the NAIC adopted the "1921 Standard Profit Formula", which acted as a guide to regulators in determining the "proper" balance between rates that are sufficient to assure solvency yet low enough to prevent excessive profits. This formula, the first attempt by regulators to specifically define the meaning of "adequate but not excessive" rates, called for a 5 percent underwriting margin (investment income was not to be taken into account).

Throughout the first half of the 20th century the adoption of rate regulatory statutes in the United States continued to grow. By 1944, all but three states had statutes designed to control insurance rates. In 33 of these states, a formal mechanism was in place, which, at a minimum, provided for routine review of rates by the commissioner.

Following the passage of the McCarran-Ferguson Act in 1945, which explicitly provided for state regulation of the business of insurance, the NAIC adopted the "All-Industry" model statutes, which explicitly set out the principles that guide every state’s system of rate regulation. These statutes called for a bureau-rate prior approval system and by 1955 most states had adopted such statutes. There was one significant exception to this trend. California never adopted the "All-Industry" model statute. It adopted a "no filing" system, a strongly competitive system of rate regulation which would prove to be a testing ground for the subsequent use of competitive systems in other states. Later, Illinois, which had originally enacted a prior approval law, subsequently (1971) allowed it to sunset in the belief that the best system of rate regulation is the marketplace.

The Illinois system of open competition appears to be working well. Data on auto insurance nationwide consistently show that auto insurance expenditures in Illinois are close to the nationwide average. While not subject to approval or disapproval of the insurance commissioner, rates in Illinois for auto insurance, homeowners insurance and a few other insurance coverages must be filed for informational purposes. Rates for medical malpractice and workers compensation are regulated under a use and file rule.

The general trend toward deregulation in the United States during the 1960s and 1970s extended to the insurance industry and the California experience was often cited as an example of the effectiveness of competitive rate regulation. In 1980, the NAIC adopted its first model statute for a competitive rating system and by 1984 varying forms of competitive rating were operative in 25 states. This constituted a major shift in the way the business of insurance was regulated in the United States.

Now, the insurance industry is on the cusp of much broader regulatory change that has the potential to alter the structure of insurance regulation again. The impetus for this change comes in part from the globalization of financial services, which is the driving force behind international efforts to create greater uniformity in many areas including accounting and solvency. Europe’s Solvency ll, regulatory requirements designed to facilitate the creation of a single market for insurance services in the European Union, is part of this trend. In addition, the crisis in financial services is pushing legislators and regulators to reexamine the entire financial services regulatory system, including optional federal regulation.

State vs. Federal Regulation: The issue of federal regulation has surfaced before, but in response to different circumstances. In the 1980s, the issue stemmed from perceptions about the effectiveness of state solvency regulations after several major bankruptcies. These insolvencies and the fallout from the savings and loan crisis prompted a Congressional study, which culminated in the February 1990 report, "Failed Promises: Insurance Company Insolvencies." Known as the Dingell report after the chairman of the committee that investigated the insolvency cases, Rep. John Dingell (D-MI), the study looked at the insolvencies of Mission Insurance Co. and Transit Casualty Co., both with headquarters in California, although Transit Casualty was chartered in Missouri; Integrity Insurance Co. of New Jersey; and Anglo-American Insurance Co. of Texas and found what it called "disturbing" parallels between the mismanagement and fraudulent activity that led to the four insurer insolvencies and the factors that precipitated the savings and loan crisis. Specifically, it attributed the insurance company failures to rapid expansion, unsupervised delegation of authority, extensive and complex reinsurance arrangements, underpricing, reserve problems, false reports, reckless management, incompetence, fraud, greed and self-dealing. Debate over the failings of the companies gave rise to proposals for a federal regulatory system.

Regulatory Modernization: All insurers, regardless of their specialty or size, are in favor of modernization. They want a system that responds faster so that they can bring new products to the marketplace in a more timely fashion. However, insurers are sharply divided over the kind of regulatory system that should be in place to implement these changes.  Some argue for the continuation of a purely state system which they believe fosters experimentation that may benefit other states and enables regulators to better respond to the concerns and needs of local consumers. Others, particularly many life insurers and a number of large property/casualty insurers that write commercial coverages, believe an optional federal charter will best allow them to compete with other financial services firms, here and abroad. Insurance industry observers say it can take as long as two years for a new life insurance product to be approved by all 51 jurisdictions.

The passage of the federal Gramm-Leach-Bliley financial services reform law in 1999, which allows insurance companies and banks to engage in a broad range of financial services, in one sense preserved the status quo. The legislation said that insurance activities—whether conducted by banks, broker-dealers, or insurers—are functionally regulated by the states. It specifically protects 13 areas of state insurance regulation from federal preemption. These areas, known as safe harbors, protect states from federal interference in state laws and practices if they remain within boundaries that protect against discrimination.

However, the Act also put the U.S. financial services industry as a whole more on a par with that of other developed countries and moved insurance agents toward an era of greater regulatory standardization. Under the Act, if within three years (2002) a majority of states had not enacted uniform insurance agent licensing laws or reciprocity measures, a private national licensing organization would be created. This National Association of Registered Agents and Brokers would function as a self-regulating organization much like the National Association of Securities Dealers. The states met that goal.

In September 2003 the NAIC issued "A Reinforced Commitment: Insurance Regulatory Modernization Action Plan," emphasizing the renewed commitment of state regulators to continue modernizing the state-based system of insurance regulation, including the implementation of its Interstate Insurance Product Regulation Compact plan to create uniform product standards across state lines for life insurers.

Rate Regulation Systems

Currently, there are seven different types of rate regulation systems, with "no filing/record maintenance" being the most competitive, see chart “STATE REGULATION OF RATES”  and explanation of the various systems above. The rate regulation process may vary for different kinds of insurance within the same jurisdiction, and states may change the method used to oversee rates for a given kind of insurance if market conditions appear to warrant such a move.

The commissioner generally reserves the right to disallow rate filings within a certain period of time if they are deemed inconsistent with the principles of rate regulation. In the event that a rate change is disallowed, the new rate must be discontinued and adjustments made in policyholders' premiums to reflect the difference between the new and old filings, unless filings are not required.

Maintaining a Proper Balance: Traditionally, regulators have been guided by the general goals of insurance regulation set out in state statutes that charge them with two duties: 1) preserving the long-term solvency of insurance companies and 2) protecting insurance consumers from unfair and inequitable treatment. This precept would include protection against excessive rates and unfair rate discrimination (where the difference in premiums between groups of policyholders is not commensurate with cost differences).

Maintaining a balance between two seemingly conflicting concerns, adequacy and fairness, is beneficial to both consumers and insurers.

Consumers benefit from rate adequacy to the extent that they are protected from the loss of value that a policy suffers when an insurer’s financial ability to pay future claims is in doubt. They also benefit from rates that are not excessive. Insurance companies benefit from rate adequacy in that revenues will be sufficient to assure long-term solvency. Excessive rates would also be to insurers’ detriment in that consumers would increasingly choose alternatives, such as self-insurance. Regulators seek to achieve this balance differently under different regulatory systems. Competitive systems, which rely on market forces to set rates, implicitly assume that the insurance industry is sufficiently competitive that no firm will charge excessive rates, lest it lose market share, or inadequate rates, lest it jeopardize its financial health. Prior approval systems, on the other hand, assume the state must intervene to ensure a balance between adequate and excessive rates.

Under an active price control system, such as prior approval, this balance may be difficult, if not impossible to maintain. For example, political pressures to provide low-cost insurance may lead to a tendency toward inadequacy, leading insurers to withdraw from the marketplace, which in turn leads to affordability and availability problems. Regulatory lag, the extra time required for prior approval to react to changes in supply and demand, has been shown to affect the balance issue since it causes inadequate rates in times of high inflation and excessive rates during deflation periods.

Affordability and Availability: Though not explicitly set out in statutes, regulation has become increasingly concerned with issues of affordability and availability of insurance. These goals are difficult to pursue since what is considered affordable is a value judgment based upon lifestyle as well as income. In addition, the pursuit of these two goals may jeopardize achievement of the two others: adequacy and fairness.

States have addressed concerns that insurance be affordable and available in many different ways. These include rate caps and creation of cross-subsidies between different risk classes through limitations on rating variables, such as territory in the case of auto insurance.

One of the most common methods of dealing with insurance availability problems in lines such as auto, property, workers compensation and medical malpractice, has been the use of state-created “residual risk pools.” These mechanisms, which are complex and vary greatly from state to state and by line of insurance, are intended to be an insurer of last resort for those who have been rejected by standard market insurers (these individuals are known as “residual risks”). Although the specific operating structure of each pool may differ, all are based on a common concept: any insurer providing that particular line of insurance must share the profits or losses of insuring residual risks.

The size of residual risk pools is typically considered an indicator of the degree of rate inadequacy in the voluntary market. Since insurance companies generally will accept applicants for whom rates are commensurate with the risk to be assumed, the greater the inadequacy the greater the likelihood that the applicant will be rejected for coverage. Applicants rejected by the voluntary market may apply to the residual market where acceptance is usually contingent upon proof of inability to obtain coverage in the voluntary market, with some pools requiring evidence of rejection from two or three companies.

In the 1980s, losses in some of these residual markets systems reached exceedingly high levels. This led states to consider making such risk pools more self-sufficient by charging higher rates to those who impose high costs on the system. This trend highlights the fact that inadequate rates are not sustainable in the long run. An additional problem in workers compensation is that the burden of the residual market assessments can push up rates in the voluntary market, encouraging large employers with the financial resources to self-insure to do so. The number of policyholders insured in residual markets has been steadily dropping in most states for most types of insurance as prices have risen to more closely reflect losses and other changes in its system bring more high-risk policyholders into the voluntary markets.

Also in the 1980s, to further the regulatory goal of affordability, some states enacted excess profit laws that limit the amount of profit a company can make in a particular line of business. Seven states now have excess profit laws in their books. These statutes vary widely regarding the lines of insurance to which the law applies and the way excess profits are computed. In South Carolina, for example, the statutes apply to all lines of property/casualty insurance. In Michigan and Rhode Island, they apply only to workers compensation and in California, New Jersey and New York only to personal auto insurance. In Florida, they apply to both workers compensation and auto insurance. The formula for computing excess profits generally takes into account the three most recent calendar years but the "trigger" for determining whether profits are excessive varies among states and by line. In one state, the law may be activated when operating income, which includes investment income, exceeds a certain percentage of earned premium. In another, the trigger may be underwriting income. In some states, insurance companies are required to refund to policyholders any amounts deemed "excessive." In 2003, New Jersey extended the time period for calculating excess profits from three to seven years.

Deregulation of Commercial Insurance for Large Policyholders: Over the past decade, brokers and insurers that handle the insurance needs of large commercial entities have pushed for a simpler regulatory system that would reduce the inefficiencies inherent in dealing with the rules and regulations of 51 jurisdictions. Initially, they favored federal regulation. However, states are now more receptive to the idea of rate deregulation for large industrial corporations, which, unlike many individual consumers, have the expertise to compare complex contracts and pricing schemes. Brokers maintain that the cost of complying with multistate laws is pushing these companies to seek coverage offshore in places such as Bermuda where there is far less regulation.

In March 2002, the National Association of Insurance Commissioners approved a model law to minimize oversight of commercial insurers’ rate changes. Under the model, regulation of commercial lines rates falls under the use and file classification, meaning that insurers can begin to use new rates 30 days after filing with regulators.

Many states have gone further. Since the deregulation movement began, more than half of the states have passed laws that deregulate commercial insurance policy forms and/or rates. The changes are designed to allow traditional insurers to better compete with captives and others in the alternative market as well as insurers abroad and to offer customized, innovative products to an individual commercial client. This has been difficult to do since up to now most states have required companies to file products with their state insurance department and market the products in all states in which they do business.

States differ greatly on the extent of deregulation. In most states, to come under the large commercial risk umbrella, commercial entities must meet at least two of a list of criteria that establish their size and sophistication as insurance buyers, but the range in size varies from state to state.

In Arkansas, for example, the state no longer oversees any commercial property/casualty insurance rates, with the exception of workers compensation, and employers and professional liability insurance. Large commercial firms—defined as those that pay premiums of $250,000 or more—can negotiate the details of the policies they purchase. To qualify as a "large commercial risk" in Arkansas, in addition to the $250,000 premium level, a firm must also have at least 25 employees and a full-time certified risk manager. (A risk manager is a specialist who is responsible for identifying and reducing the firm's likelihood of accidental loss and for buying insurance.) Some states, such as Pennsylvania, put the premium threshold at $25,000; in Oklahoma it is $10,000, among the lowest for states that have set premium thresholds.

Proposition 103: Proposition 103, the 1988 California ballot initiative which passed by a small margin of 51 to 49 percent, called for all insurance rates to be rolled back by 20 percent below November 1987 levels. It also changed the state's long standing competitive rating law to prior approval, granted an additional 20 percent discount to good drivers (drivers with no more than one conviction for a moving violation) and changed the basis for computing auto insurance premiums, placing greater reliance on driving records than on geographical location.

On May 4, 1989, the California Supreme Court, responding to a suit filed by leading insurers and insurance organizations, upheld most sections of Proposition 103, including the rate rollback. However, it found the insolvency standard, which granted relief from the rate rollback only if an insurer was "substantially threatened with insolvency," violated the due process clauses of both state and federal constitutions. The court ruled that insurers are entitled to a "fair and reasonable" return, a concept that was subject to much judicial and regulatory scrutiny over the years as the appropriate standard for rate rollback refunds was fought out in the courts.

On August 18, 1994, after many legal battles, the California State Supreme Court affirmed the authority of John Garamendi, the insurance commissioner at the time, to apply a single industrywide, public utility-type standard in calculating how much each company’s rebate to consumers under Proposition 103 should be. The rate rollback standard was based on a 10 percent maximum rate of return, the industrywide average during the 1980s, as measured against a "reasonable" cost of providing insurance.

In its opinion, the court said that the commissioner’s ratemaking formula could not be deemed arbitrary, discriminatory or confiscatory as applied in general or specifically to 20th Century, the insurance company that had challenged the commissioner’s formula. Citing public utility cases, the court said that for the formula to be confiscatory it would "require deep financial hardship," meaning the inability of the regulated firm to operate successfully. As a result, it said, the rollback regulations do not violate the Fifth Amendment to the U.S. Constitution, which prohibits the taking of private property without just compensation—in this case, taking by the government through price controls. Furthermore, said Justice Mosk, who wrote the court’s opinion and also added one of his own, insurers could have withdrawn from the market after the initiative was passed, and some did. Since those who stayed voluntarily subjected themselves to price regulation, "there can be no taking," he said.

The passage of Proposition 103 marked the first time that changes in the rate setting process have been dictated by a voter initiative. Proposition 103 was brought about in part by the high cost of auto insurance in some parts of the state and an affordability problem in some inner city areas. It followed many unsuccessful attempts by legislators to enact legislation that would have lowered the cost of auto insurance.

Rating Factors: Auto Insurance: Under current federal and most state laws, insurance companies are permitted to set rates according to factors that are actuarially validated predictors of risk. Among the many traditional variables considered in setting auto insurance rates are gender, age and the geographical location of the vehicle to be insured. However, since the 1970s various groups have been challenging these rate setting practices on the basis of unfair discrimination and social equity. The first factors to be challenged were those outside the control of individual policyholders: age, sex and marital status. Rate classifications based on age and gender are prohibited by law in Hawaii, North Carolina and Massachusetts. Laws that reduce reliance on gender and ban age consideration have been passed in California. Michigan and Montana prohibit the use of rate classifications based on sex and marital status and Pennsylvania prohibits the use of gender. Bills that would ban gender-based rating have been considered and rejected in a number of other states.

More recently, rating by geographical area, or "territory," has come under attack, largely because many low-income drivers live in central city areas, which, due to traffic and road conditions, tend to have high accident rates and therefore higher than average auto insurance rates. In California, for example, auto insurance rate regulations now require territory to be assigned a relatively low weight relative to its actual importance as a risk determinant.

Territorial rating is used in every state in the development of auto insurance rates. Territories must be approved by the state’s insurance department prior to their use in rating. In collecting data to set rates for a territory, claim data is aggregated using the "principal" garage rule, under which all losses are tagged geographically according to where the driver’s car is garaged.

Critics of traditional auto insurance rating factors argue that rates should reflect driving habits over which each policyholder has some control. In their drive to eliminate age, sex and territory as rating factors, critics have tended to ignore the fact that premiums already are based in large part on individual driving habits—driving experience, traffic violations, at-fault accidents and the number of miles a vehicle is driven each year. Studies have shown that individual rating factors have the greatest effect on a driver’s premium.

Premiums can be made to reflect driving history to a greater degree by incorporating credits and debits into premium calculations over a longer period of time, thus increasing incentives to drive safely. A system in Massachusetts, set up in 1990, is based on this concept, which is widely used in European auto insurance systems. To provide greater rewards for safe driving, the state devised a system that will ultimately grant premium credits for each accident-free year and impose surcharges for accidents, over a 15-year period.

While some lawmakers are responding to the problem of high auto insurance rates by placing a greater emphasis on individual driving records, others have attempted to make insurance more affordable by flattening out rates so that those in the highest rate categories are subsidized by those in lowest. There are problems with both approaches. The first will increase the already high rates of drivers with poor driving records, to the point where some will drive without insurance, thus forcing others to bear the cost their accidents. The second creates market disruptions as insurers that are required to sell insurance below cost seek to deal with the effects of such regulations. Neither deals with the problem of how to stabilize the underlying costs that push insurance premiums up or with issues related to mandatory insurance, such as the amount and what type of coverage, if any, should be compulsory.

Territorial Rating: Insurance prices are based on the expectation of loss. Insurance company data showing auto accident losses by geographic location are used to establish rating territories. These are areas ranging in size from a few square miles to a portion of a state, where losses are basically the same. The territorial rating system helps set equitable rates.

Rates for auto insurance tend to be higher in urban areas because there is more traffic congestion in cities, and in older cities the roads may not have been laid out with the automobile in mind. Crime may also be higher in urban centers, raising comprehensive coverage prices. Because low-income drivers tend to be concentrated in cities, over time various states have experimented with programs that effectively subsidized auto insurance for drivers living in such areas. Thus, people living outside the cities paid more than they should, based on their territory, while people living in urban areas paid less. This can lead to a competitive disadvantage for insurers with large numbers of urban policyholders whose policies are subsidized by its non-urban business. Insurers with fewer urban customers may be able to offer lower prices.

Actuarial studies have found that territory is the most predictive of risk and driving record among the least because the average driver has so few claims in his or her lifetime. In Connecticut, for example, studies conducted for the Insurance Association of Connecticut show the average policyholder has only one bodily injury claim every 77 years, one property damage liability claim every 24 years, one comprehensive claim every 13 years and one collision claim every 15 years. Costs vary by territory. There is a more than two-to-one difference in liability and physical damage losses per insured car between New Haven, a high-risk territory, and the lowest risk territories, such as New London. The state already requires some subsidization of urban drivers’ rates due to an administrative ruling that limits the impact of territorial rating.

In California, territorial rating was banned for a while. However, in December 2000, a state appeals court overturned a lower court decision that insurers may not use ZIP codes to set auto insurance rates. The ruling was based on the court’s interpretation of Proposition 103, the 1988 ballot initiative. Proposition 103 provisions require that insurers first consider three factors. They are: the policyholder’s driving record; the number of miles driven each year; and the extent of that individual’s driving experience. The insurance department added 14 optional factors that insurers may consider, including gender and marital status but not age. The appellate court characterized the initiative as contradictory, saying that the law requires the insurance commissioner to protect drivers from arbitrary rates but, at the same time, requires rates to be based on a person’s driving history. Safety record, miles driven and driving experience are not as critical in assessing potential losses as where the driver lives, the court said. Thus, any agency implementing the law must attempt to reconcile these conflicting demands. However, in 2006, largely in response to a petition filed by the cities of Los Angeles, Oakland and San Francisco, an auto insurance rating system went into effect that relied less on territory and thus reduced rates for urban drivers.

Rating Factors: Property Insurance: Territorial rating also is used in property insurance. In California, for example, communities vulnerable to brush fires pay more for fire insurance than people in identical homes in less fire-prone parts of the state. Homeowners and business owners in inner city areas where the risk of fire and burglary is higher than average, also pay a higher rate. In states with regions that are vulnerable to weather-related disasters, such as hail and windstorms, territorial rating helps ensure that insurers actively compete for business in all parts of the state, not just in the areas with the lowest risk of storm or hail damage. All states have provisions in their rate regulation laws or in their fair trade practice acts that prohibit unfair discrimination, often called redlining, in setting rates and making insurance available.

The Use of Credit Reports: A federal law, the Fair Credit Reporting Act of 1970, allows for the use of credit reports in five situations, one of which is insurance underwriting. While the law itself does not define underwriting, the Federal Trade commission interprets underwriting to include an applicant’s eligibility for insurance. The law was reauthorized by passage in 2003 of the Fair and Accurate Credit Transactions Act.

Insurers have historically believed that there is a direct relationship between financial stability and risk. Credit reports, which show how a company or individual handles debt, have been used for years in commercial underwriting since firms that are in financial trouble are more likely than financially sound companies to skimp on maintenance and safety and to commit fraud. A few years ago, insurers began to use insurance scores based on credit reports to underwrite new auto insurance policies. Generally insurers do not receive a policyholder’s credit report. They purchase an insurance scoring product from a vendor. These are used for personal auto and homeowners underwriting on the grounds that a good credit history implies a responsible attitude and that such people tend to be more careful, see report on Credit Scoring. Research has shown that elements in a person’s credit history provides a strong indication of the likelihood of insurance loss.

Pay-As-You-Drive (Usage-Based) Auto Insurance Rates: Some insurers are experimenting with mileage-based and usage-based auto insurance policies. Environmentalists and municipalities see such policies as a means to reduce the amount of driving and pollution. Others see such programs where mileage and driving behavior are monitored as a method to make rates charged more reflective of the actual risk. California has implemented a specific optional miles-driven program. Other states allow insurers to market usage-based policies. Increasingly, states and insurers are examining how auto insurance rates can be made more reflective of a driver’s actual driving performance, see report on Pay-As-You-Drive Auto Insurance.

Rate Making Organizations: Reacting to pressure to limit insurer’s antitrust exemptions, rate-making organizations such as the Insurance Services Office (ISO), are providing participating insurance companies with advisory average prospective loss costs rather than advisory rates as they once did. Advisory average prospective loss costs are estimates of future claim payments, including such costs as claims handling and legal defense. Advisory rates contain provisions for various expenses, contingencies and a profit. The National Council on Compensation Insurance has also adopted a loss cost approach to filing rates for workers compensation. In addition, the ISO Board of Directors is now controlled by individuals who are associated with the insurance industry but are not members of major insurance companies.

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