Insurance is a type of contract designed to provide protection from possible financial loss. For the contract to be recognized as an insurance contract, it must feature three elements: (1) risk-distribution; (2) substantial membership; and (3) an insurer engaged in the business of insurance.[1]
Risk distribution means that the insurance serves to distribute the risk of economic loss among as many people in similar sets of circumstances as possible. Individuals pay premiums into a general fund. Each person contributes towards compensating losses suffered by any one member of the group. Risk distribution is otherwise known as the broad sharing of risk. Substantial membership means that there must be “many” members of the group, though minimum levels to meet this threshold are highly fact-dependent. Note that some common products such as warranties and pre-paid service contracts are often confused with insurance but are not considered insurance contracts.[2]
In an insurance contract, the insured is the party covered by the insurance contract, the insurer is the company providing the insurance and the beneficiary is the individual eligible to receive payment.[3] The contract of insurance is the agreement in which the insurer, in exchange for a premium paid by the insured, assumes the risk and distributes it across members of a similarly situated group. Note that while the insured and beneficiary are often the same person, they need not be. For example, Jane could purchase life insurance on her own life from First Mutual with her husband John as the beneficiary. Or, Jane could purchase health insurance from First Health that promises to reimburse her for medical expenses. In both cases, Jane is the insured, but John is the beneficiary in the first case and Jane is in the second. State statutes define the term insurance contract for purposes of state law, but in a 1939 federal case, Jordan v. Group Health Association,[4] the federal appellate court for the District of Columbia Circuit laid out the “principal object purpose test,” which is a starting point in determining whether there is an insurance contract.
In Jordan, the issue before the court was whether the state insurance laws were applicable to certain group health associations wherein medical services were provided as needed in exchange for monthly fees. The court held the association was not engaged in the business of insurance. The plans were merely service contracts. The court held that the determination looks not only at whether there is risk involved, but at the nature of the contract to determine whether spreading the risk is the principal object and purpose of the arrangement. That there is some amount of risk distribution in the arrangement is insufficient to bring a contract into the regulatory sphere of insurance contracts.
Federal Regulation and the McCarran Ferguson Act
Insurance law has three areas of focus. There is the business of regulating insurance, or how insurance companies are required to conduct business to comply with state laws. The second focus is the content of the insurance policies, or the language of the policies and how they dictate coverage. Finally, insurance law focuses on how insurance companies handle the claims process. We will begin with regulation of the insurance business.
About the time states began to enact legislation governing corporations, they also began to enact legislation governing the establishment of insurance companies. By the 1900’s most states had some kind of licensing procedure for companies and agents. By the 1930’s, state insurance departments were given greater authority to collect information and were charged with the responsibility of ensuring insurers remained solvent. In 1944, in United States v. South-Eastern Underwriters Association,[5]the Supreme Court held that insurance transactions were subject to federal regulation under the Constitution’s “commerce” clause. Over industry objections, Congress passed the McCarran Ferguson Act after several court cases had limited the authorities of states to govern the insurance industry.[6] In Section 1 of the Act, Congress supported the abilities of the states to regulate and tax insurance Companies.[7]
Section 2 of the Act provides that insurance “shall be subject to the laws of the . . . states” and that no federal act “shall be construed to invalidate, impair or supersede any law enacted by any state for the purpose of regulating the business of insurance, or which imposes a fee or tax upon such business….”[8] In other words, to the extent that the states regulate insurance, the federal government will not do so in most cases. The McCarran-Ferguson Act gives supremacy to state regulation. However, due to ambiguities in the Act, it does not establish a clear demarcation between state and federal authority. Some of these ambiguities include:
– The Act fails to define the “business of insurance,” leaving case law to do so. If an agreement is deemed not within the business of insurance, it is not exempt from federal legislation.
– The Act requires federal law regulating insurance to assert that it “specifically relates” to the business of insurance. What constitutes “specific,” is also open for interpretation. Note that if the federal and state law can be interpreted to co-exist, both laws can operate side by side.
– It is unclear whether the mere existence of a state statute overrides federal law or whether there must be meaningful enforcement- showing the state is regulating that area- to preempt federal legislation.
Note that under the McCarran Act’s terms, if the Sherman Antitrust Act is being applied to the challenged activity involving an “agreement to boycott, coerce, or intimidate” competition, the Act allows the Sherman Act or federal antitrust legislation to prevail even over contrary state law.[9]
How States Regulate Insurance
Now that we’ve looked at the source of states’ unique abilities to control insurance based on federal law’s unusual grant of power, let’s look at how states, in fact, govern insurance. State legislatures govern insurance in a variety of ways. States regulate insurance by: (1) establishing and overseeing state insurance departments; (2) regularly reviewing and revising state insurance law and (3) investigating the financials of insurance companies. State regulation generally exists to protect consumers against the possible bankruptcy of an insurer, which would cause hardships for insureds and beneficiaries. State statutes offer distinct areas of protection which include company licensing, producer licensing, product regulation, market conduct and financial regulation.
All states establish what are usually called “Departments of Insurance,” each headed by an “insurance commissioner.” In most states, the Commissioner is appointed by the governor. The Commissioner’s primary responsibility is to protect the public. The National Association of Insurance Commissioners is the trade association that consists of the fifty state commissioners. It can coordinate influence on the regulation of insurance by, for example, helping state insurance departments prepare the forms on which insurers file their annual statements. Commissioners use the NAIC to bring together resources, discuss issues of common concern and align their oversight of the industry.
Another important organization is the National Conference of Insurance Legislators, which is a legislative organization working to preserve state jurisdiction over insurance as established by the McCarran-Ferguson Act.[10] States usually require insurance companies to be licensed to sell their products. States also require agents and brokers or producers to be licensed to sell insurance products. In addition, states regulate the product or the policy by making sure provisions are reasonable, fair and without major gaps in coverage.
States also regulate insurance rates or premium amounts. Rate regulation varies by state and by type of insurance.[11] By 1951, almost all states had adopted rate regulation legislation allowing for concerted ratemaking under the supervision of the state’s insurance department. Most states followed a prior approval approach, allowing certain types of insurance rates to become effective after being filed with the state insurance department unless disapproved.[12] In the 1960s, however, many states began to abandon the prior approval approach allowing for an open competition system.[13] In the 1960s and 1970s, states also began to adopt unfair trade practice statutes to prevent deceptive or unfair business practices. The National Association of Insurance Commissioners addressed unfair trade practices by issuing guidelines. They defined the following practices as unfair in the insurance industry:
– Misrepresenting the benefits, advantages, conditions or terms of any policy;
– Misrepresenting the dividends or share of the surplus to be received on any policy;
– Making false or misleading statements as to the dividends or share of surplus
previously paid on any policy;
– Making false or misleading statements as to the financial condition of any insurer or as to the legal server system upon which any life insurer operates;
– Using any name or title of any policy or class of polices that misrepresents the true nature of the policy;
– Intentionally misquoting premium rates for the purpose of inducing the purchase, lapse, forfeiture, exchange, conversion or surrender of any policy;
– Making a misrepresentation for the purpose of effecting a pledge or assignment of or effecting a loan against any policy; or
– Misrepresenting any policy as being shares of stock.[14]
State consumer protection agencies review complaints from consumers or other parties regarding sales or handling of claims. If practices are not in compliance with state law, companies may be subject to license suspension or revocation. State law or agencies can also require that insurance companies change certain business practices.
For example, insurance companies have generally used consumer credit scores to determine the level of risk before selling auto or home insurance policies. Sometimes, credit scores or information are also used to determine the premiums. Insurance companies often believe there is a direct correlation between credit information and the risk of filing an insurance claim. In response to this practice, more than a half a dozen states have enacted state legislation prohibiting or otherwise restricting the use of credit information or credit scores to determine insurance premiums.[15]
Ensuring Financial Viability and Regulating Coverage
States also are involved in overseeing the financial viability of insurance companies.[16] States conduct financial investigations in the forms of scheduled, usually routine, examinations. States investigate a company’s accounting methods and financial statements to ascertain whether the company is in good financial standing. If an investigation shows the company to be impaired, the state can take control of the company to protect its insureds.[17] States also regulate the finances of insurance companies by: (1) eliminating or limiting certain activities insurance companies can engage in, because of their financial risks; (2) overseeing or auditing insurance companies to determine if an insurance company is at risk for insolvency; and (3) establishing backup funds.[18] Regulators generally require conservative valuation in financial statements and limit certain investment options for insurance companies. Thus, insurance companies are not free to manage and invest their capital without oversight.[19]
States also impose capital requirements on insurance companies, which require companies to maintain minimum levels of available capital to continue to do business. Companies are required to file annual and quarterly statements allowing regulators to assess the company’s financial condition.[20] States have regulatory backups with risk-based capital requirements, which supplement the minimum capital requirements for insurance companies. In other words, if insurance companies are unable to pay claims, a state guaranty fund will pay, within certain limits.[21]
Finally, federal bankruptcy law excludes insurers from eligibility for bankruptcy relief under Chapter 7 (liquidation).[22] Most states also have statutes in place that provide for the management and distribution of the assets of an insolvent insurer. Generally, if this happens, all policies are terminated, and the insureds become unsecured creditors to the extent of the reserve value of their policies. In some cases, the insolvent insurer’s assets are transferred to another insurer, which assumes all liability under existing policies and continues the insolvent insurer’s business.[23]
Regulating Coverage
States can also regulate the coverage provided by insurance companies. For example, all states have statutes requiring car owners to have auto insurance to ensure that adequate funds are available to reimburse people who may suffer physical or economic losses from automobile accidents. As another example, some state statutes require people to provide health insurance for dependents, especially in the case of divorce or separation, where it is common for parents to be ordered to maintain health insurance for their minor children.[24]
States sometimes even mandate the language and terms for insurance contracts. For example, since 1943, the New York Standard Fire Insurance Policy has set forth the statutorily required form for fire insurance policies in some states. Variations to the policy language can only be accomplished through written endorsements added to the policy. This has created standardization in this type of policy.[25]
Other Forms of Regulation
In 2002, the National Association of Insurance Commissioners put together a working group to develop compact legislation with the purpose of modernizing state insurance legislation. They sought to develop a more effective system that would provide a single paradigm of filing for insurance companies and reviewing by states as well as national standards for insurance products. The Interstate Insurance Compact was created when the first two states, Colorado and Utah, adopted the compact legislation. In May of 2006, the Interstate Insurance Product Regulation Commission was born. It is a multi-state, public entity which services its member states. It adopted the first Uniform Standards for insurance products later that year. Now, the Commission has over one hundred uniform standards and 45 member states.
The Compact promotes consistency among state legislation by requiring uniform insurance product standards. The Compact is a central point of electronic filing for life insurance, annuities, disability and long-term care insurance policies, which are reviewed for compliance pursuant to uniform product standards adopted by the member states. The member states participate in the development and implementation of uniform standards.[26]
Judicial Regulation
Courts, on a case by case basis, interpret policy language and state statutes. They also perform regulatory functions. When a court interprets the contract language of an insurance policy to settle a coverage question, it is affecting the conduct of insurance companies and individuals even aside from the parties before it. By demonstrating how statutory and contractual insurance language will be interpreted, the court indirectly regulates the business of insurance.
Attorneys, paralegals and other legal professionals working in the realm of insurance compliance are called upon when their companies are being investigated for non-compliance. They are often asked to investigate the facts surrounding the non-compliance, to be familiar with the relevant laws and to respond to state regulators.[27] But in a more proactive sense, legal professionals are often asked to ensure that their companies are in compliance long before a lawsuit is filed, or regulatory agencies get involved.
In our next module, we’ll turn to the contractual rules and interpretation that form the bread and butter of insurance law. We’ll also look at several cases that indicate how insurance contracts are interpreted and enforced.
[1] John F. Dobbyn, Insurance Law in a Nut Shell 2 (Thomson West, 1981).
[2] Id. at 2-4.
[3] Glossary of Insurance Terms, National Association of Insurance Commissioners, https://www.naic.org/consumer_glossary.htm (last visited Nov. 9, 2018).
[4] Jordan v. Group Health Ass’n,107 F.2d 239, 248 (D.C. Cir.1939).
[5] United States v. South-Eastern Underwriters Association,322 U.S. 533, 553 (1944).
[6] Robert H. Jerry II and Douglas R. Richmond, Understanding Insurance Law (Carolina Academic Press, 2018); “McCarran-Ferguson Act,” National Association of Insurance Commissioners, https://www.naic.org/cipr_topics/topic_mccarran_ferguson_act.htm, (last updated May 1, 2018).
[7] 15 U.S.C. § 1011.
[8] 15 U.S.C. § 1012.
[9] Robert H. Jerry II, Douglas R. Richmond, Understanding Insurance Law 67-77 (Carolina Academic Press 2018); Michael G. Cowie, “Health Insurance and Federal Antitrust Law: An Analysis of Recent Congressional Action,” American Bar Association, (Dec. 2009),https://www.americanbar.org/content/dam/aba/publishing/antitrust_source/Dec09_Cowie12_17f.authcheckdam.pdf.
[10] Robert H. Jerry II, Douglas R. Richmond, Understanding Insurance Law 86 (Carolina Academic Press 2018); History & Purpose, National Council of Insurance Legislators, http://ncoil.org/history-purpose/ (last visited Nov. 9, 2018).
[11] State Insurance Regulation, National Association of Insurance Commissioners, https://www.naic.org/documents/topics_white_paper_hist_ins_reg.pdf
[12] Id.
[13] Robert H. Jerry II and Douglas R. Richmond, Understanding Insurance Law (Carolina Academic Press 2018).
[14] Unfair Trade Practices Act, National Association of Insurance Commissioners, https://www.naic.org/store/free/MDL-880.pdf (last visited Nov. 9, 2018).
[15] Use of Credit Information In Insurance 2016 Legislation, National Association of Insurance Commissioners, http://www.ncsl.org/research/financial-services-and-commerce/use-of-credit-information-in-insurance-2016-legislation.aspx (last visited Nov. 9, 2018).
[16] John F. Dobbyn, Insurance Law in a Nut Shell 474 (Thomas West, 1981).
[17] State Insurance Regulation, National Association of Insurance Commissioners, https://www.naic.org/documents/topics_white_paper_hist_ins_reg.pdf (last visited Nov. 9, 2018).
[18] Kris DeFrain, “U.S. Insurance Financial Regulatory Oversight and the Role of Capital Requirements,” National Association of Insurance Commissioners & The Center for Insurance Policy and Research, (Jan. 2012), https://www.naic.org/cipr_newsletter_archive/vol2_oversight.htm.
[19] Id.
[20] Id.
[21] Id.
[22] 11 U.S.C. § 109(b)(2).
[23] John F. Dobbyn, Insurance Law in a Nut Shell 484 (Thomson West, 1981).
[24] Robert H. Jerry II and Douglas R. Richmond, Understanding Insurance Law (Carolina Academic Press 2018).
[25] John F. Dobbyn, Insurance Law in a Nut Shell 483 (Thomson West, 1981); Edward Eshoo, “Holding the line: The Standard Fire Policy remains a useful floor,” United Policyholders, (Dec. 1, 2015),https://www.uphelp.org/blog/holding-line-standard-fire-policy-remains-useful-floor-guest-blog.
[26] About the Compact, Interstate Insurance Product Regulation Commission, https://www.insurancecompact.org/ (last visited Nov. 9, 2018).
[27] Practicing Insurance Law, LexisNexis, https://www.lexisnexis.com/legalnewsroom/lexis-hub/b/commentary/posts/practicing-insurance-law (last visited Nov. 9, 2018).