Principles for Insurance Regulation

The recent financial crisis and its cascading effects on the global economy have drawn increased attention to the regulation of financial institutions including insurance companies.

While many observers would argue that insurance companies were not significant contributors to the crisis, they did feel its effects, particularly in the life sector.1,2 A number of life insurers were stressed because of their investments in mortgage-backed securities and other real estate-related assets.

As the crisis triggered a severe economic recession and a precipitous fall in stock prices, both life and non-life insurers suffered further asset losses. Some took advantage of government programmes to bolster their capital.

Fortunately, these developments did not trigger a wave of insurer insolvencies. Nonetheless, the role of insurance companies in the financial economy and their potential vulnerability to systemic risk have become matters of considerable interest to policy-makers and regulators.

In this context, this paper examines the basic economic principles that should govern the regulation of insurance, and employs these principles in assessing current regulatory practices and potential reforms.

This assessment is particularly timely as policy-makers review and restructure the framework for the regulation of financial institutions. It should be noted that insurance regulatory reform has been an ongoing process with initiatives that began before 2008.

Still, the recent financial crisis has created a heightened sense of urgency regarding reform and added new issues for policy-makers to consider. Various stakeholders have a vested interest in this process and reasons to advocate for reforms that are economically sound and that will promote viable and efficient insurance markets.

This paper reviews fundamental principles of insurance regulation that should be applicable in various jurisdictions and assesses current practices and potential reforms in light of these principles. The paper is organised as follows.

The section “Economic principles for insurance regulation” outlines the basic rationale for the regulation of insurance and the economic principles that can be derived from this rationale. Several key areas of insurance regulation are addressed including solvency, prices and market conduct, with particular emphasis on financial (i.e., solvency) regulation.

The section “Evaluation of current practices and potential reforms” then applies these principles in assessing the soundness and efficiency of current regulatory practices and considering how these practices might be improved.

This assessment focuses primarily on insurance regulation in the United States with some extension to the European Union (EU) and other countries. The final section summarises and concludes.

1. Economic principles for insurance regulation

a. Why insurance should be regulated

The economic foundation for regulation is based on the presence of market failures. These market failures are judged against the social welfare maximising conditions for perfect competition.

Perfect competition requires numerous buyers and sellers in a market, the lack of barriers to entry and exit, perfect information, and a homogenous product. Under these conditions, the joint surplus or gains from trade of producers and consumers is maximised.

Of course, few if any markets satisfy the conditions for perfect competition in the real world. Hence, in assessing the need for and benefits of regulation in an imperfect world, markets are often judged against a standard of “workable competition” that reasonably approximates the conditions for perfect competition to the degree that government intervention cannot improve social welfare.

This standard of workable competition has the desirable attribute of focusing attention on the presence of market failures wherein government remedies can improve market efficiency and enhance social welfare.

Potential market failures in insurance include severe asymmetric information problems and principal-agent conflicts that could lead some insurance companies to incur excessive financial risk and/or engage in abusive market practices that harm consumers.

Insurance consumers, particularly individuals and households, face significant challenges in judging the financial risk of insurers and properly understanding the terms of insurance contracts.

There is also the possibility that insurers could acquire sufficient market power to restrict competition, resulting in barriers to entry, higher prices and excess profits. The issue of systemic risk has garnered considerable attention due to the recent financial crisis.

Systemic risk could be defined as the risk that a market or financial system could experience severe instability, potentially catastrophic, caused by idiosyncratic events or conditions in financial intermediaries.

It arises from the links between firms in a system or market in which the failure of one or more firms can have cascading effects that could potentially bring down an entire system or market. Arguably, this is a kind of market failure that can arise from excessive risk-taking by financial institutions whose failure can lead to the failure of other firms in a market or system.

In contrast to market failures, there are a set of circumstances that could be termed “market problems”. These are not failures in the economic sense but constitute “undesirable” market outcomes, for example high prices, the unavailability of insurance coverage, etc., that result from conditions affecting the cost of risk, rather than violations of the conditions for perfect or workable competition.

For example, in some markets insurance may be expensive because claim costs are high. One would expect the price of insurance to be commensurate with expected claim costs. While this may cause hardships for consumers, it is a natural result of properly functioning market forces and not a condition that can be remedied by regulation per se.

This kind of situation can be contrasted with true market failures in which there is a significant violation of the conditions for workable competition. The rationale for government intervention when market failures occur is based on promoting or restoring economic efficiency.

For example, an insurer may take on too much financial risk because its owners would not be required to pay the full costs of its insolvency due to limited liability of the corporate form of the organisation.

In many industries, the creditors of firms may be able to sufficiently judge the firms’ financial risk and take steps to protect their interests. However, the circumstances for certain financial institutions such as banks and insurance companies are arguably more problematic for creditors.

One could make the case that the costs of monitoring are so high for consumers that it is cheaper for the government to undertake this task and take action against insurers that incur excessive financial risk. If it is more efficient for the government to perform this monitoring and employ other compliance/enforcement measures, then regulatory intervention could increase social welfare.

Similarly, if there is collusion among insurers due to market power resulting from the presence of a small number of firms and entry/exit barriers in a particular market, then the government could remedy this market failure through antitrust measures or regulating prices.

The assumption here is that the government would ensure that the prices charged would be same as those that would be set in a competitive market. This is an efficiency-based argument that implies that the regulator would attempt to enforce prices equal to marginal costs.

If, in contrast, high insurance prices are due to high levels of risk (and not collusion among insurers) then regulation cannot enforce lower prices without causing market distortions. This distinction is important because regulatory intervention and policies often can be motivated by the desire to “fix” or ameliorate market problems rather than remedy legitimate market failures.

Optimal regulation is based upon an ideal set of policies that attempt to replicate the conditions of a competitive market and maximise social welfare. This theoretical model of regulation is based on the premise that regulators seek to remedy market failures and not market problems caused by other external factors.

This may include failures that would otherwise cause insurers to incur an excessive risk of insolvency and/or engage in abusive trade practices, for example, misrepresenting insurance products, refusing to pay legitimate claims, etc.

This assumes that regulators have perfect information and can determine and implement the correct market solutions, an assumption that may not be valid under some circumstances.

Hence, not all market failures can necessarily be remedied by regulation, and the desirability of any particular regulatory intervention must be assessed in terms of regulators’ ability to remedy a specified market failure and any deadweight costs associated with regulatory intervention that may exceed the benefits from intervention.

Further, this line of reasoning presumes that regulators will employ “best practices” and the most efficient measures to address market failures.

b. Solvency regulation

The social welfare argument for the regulation of insurer solvency derives from inefficiencies created by costly information and principal-agent problems.7,8 Owners of insurance companies have diminished incentives to maintain a high level of safety to the extent that their personal assets are not at risk for unfunded obligations to policy-holders that would arise from insolvency.

The argument is that it is costly for consumers to properly assess an insurer’s financial strength in relation to its prices and quality of service.

Insurers also can increase their risk after policy-holders have purchased a policy and paid premiums—a “principal-agent” problem that may be very costly and difficult for policy-holders to control. There are other aspects of excessive insolvency risk that may motivate regulatory intervention.

Financial regulators are also concerned about “contagion” and the possibility that a spike in insurer insolvencies could induce a “crisis of confidence” that may have negative effects on the industry.

Further, there may be negative externalities associated with excessive insurer insolvency risk as the costs of unpaid claims may be shifted beyond policy-holders to their creditors.

Hence, it is common for the regulation of financial institutions to be coupled with some form of insolvency guarantees (e.g., deposit insurance, insurance guaranty associations, etc.) that cover at least a portion of the obligations of bankrupt firms.

Note, this phenomenon does not constitute systemic risk as defined above but does reflect the negative externalities associated with the failure of one or more insurance companies. Arguably, the goal of optimal insurance solvency regulation should not be to minimise insolvencies as the costs of achieving such a goal would likely exceed the perceived benefits.

A more reasonable goal would be to minimise or limit the social cost of insurer insolvency within acceptable parameters. The social cost is more than the lost equity of the insurer as it includes the effects on policy-holders and third parties who may be creditors of insurers.

Regulators can potentially limit insolvency risk by requiring insurers to meet a set of financial standards and taking appropriate actions if an insurer assumes excessive default risk or experiences financial distress.

c. Price regulation

There are two potential rationales for regulation of insurance prices. The traditional explanation for regulation of insurance prices involves costly information and solvency concerns. According to this explanation, insurers’ incentive to incur excessive financial risk and even engage in “go-for-broke” strategies may result in inadequate prices.

Some consumers might buy insurance from carriers charging inadequate prices without properly considering the greater financial risk involved.

In this scenario, poor incentives for solvency safety could induce a wave of “destructive competition” in which all insurers are forced to cut their prices below costs to retain their market positions. In the United States, the solution offered was uniform prices developed by industry-rating organisations subject to regulatory oversight to prevent excessive prices.

This view essentially governed the regulation of property-casualty insurance prices in the United States until the 1960s, when states began to disapprove or reduce price increases in lines such as personal auto and workers’ compensation insurance.

The rationale that some might offer for government restrictions on insurance price increases is that consumer search costs impede competition and lead to excessive prices and profits.

It also might be argued that it is costly for insurers to ascertain consumers’ risk characteristics accurately, giving an informational advantage to insurers already entrenched in a market and creating barriers to entry that diminish competition.

According to this view, the objective of regulation is to enforce a ceiling that will prevent prices from rising above a competitive level and enabling insurers to earn excess profits.

In addition, the public may express a preference for regulatory policies to lower or cap insurance prices consistent with social norms or objectives.

This may not justify insurance price regulation based on the principles asserted above but, nonetheless, explains why insurance prices are regulated in some circumstances when a pure economic justification is not apparent.

These circumstances may include government mandates that compel consumers or firms to secure certain types of insurance. However, the empirical evidence does not tend to support a case for the regulation of insurance prices in most markets in developed countries where the insurance industry is relatively mature.

For example, studies of insurance markets in the United States indicate that they are highly competitive in terms of their structure and performance. Entry barriers tend to be low and concentration levels rarely approach a point that would raise concerns about insurers’ market power.

Further support for this assertion is provided by Table 1, which shows the number of insurers and concentration levels in major lines of business in the non-life sector in the United States in 2006.

In excess of 1,270 insurer groups (including stand-alone companies) sold property-casualty insurance in 2006, with several hundred insurers competing in each major line.

The principal measures of market concentration, the ten-firm concentration ratio (CR10), which is the market share of the top ten insurers, and the Herfindahl-Hirschman Index (HHI), which is the sum of the squared market shares of all insurers, also indicate competitive market structures in these lines.

The top ten insurers accounted for less than 65 per cent of the premiums written in any given line and 40–50 per cent in many lines. Similarly, HHI values ranged from 255 to 784, with most lines falling between 300 and 500.

These levels of concentration are considerably below levels that most economists consider necessary for firms to begin acquiring market power. Further, profits in both the life and non-life sectors in the United Sectors tend to be in line with or below the rates of return earned in other industries as shown in Figure 1.

Over the last 50 years, the enforcement of uniform rates has eroded in the United States and industry organisations have moved to the promulgation of “advisory” rates or loss costs. This has caused insurer pricing to be much more independent and differentiated.

Hence, it is not surprising that studies of the effects of the regulation of insurance rates have not uncovered significant benefits to consumers from such regulation. In the United States, prices/premiums for life insurance and annuity products have generally not been subject to direct regulation.

Price regulation in the life sector is imposed indirectly through the regulation of life insurance and annuity products. In approving such products, regulators consider whether the premiums charged according to these contracts are commensurate with the benefits offered.

In health insurance, almost all the states impose some form of rating constraints in the small group market but only 19 states impose rating constraints in the individual market.

d. Market conduct regulation

A stronger case can be made for regulating certain insurer market practices, such as product design, marketing and claims adjustment.

Constraints on consumer choice and unequal bargaining power between insurers and consumers, combined with inadequate consumer information, can make some consumers vulnerable to abusive marketing and claims practices of insurers and their agents.

In the United States, there have been numerous instances in which insurance products have been misrepresented and insurers or their agents have been found guilty of sales abuses.

For example, a number of life insurers settled legal suits in the late 1980s and early 1990s for agent practices that took customers out of safe policies and put them in inappropriate (high risk) policies.

Although several prominent insurers were involved in some of these cases, the greater threat probably lies with firms or agents that are not highly motivated to establish and maintain a strong reputation for fair dealings with consumers.

Hence, regulators need to be especially vigilant for “bad actors” who seek gains from abusive or fraudulent transactions. The industry has taken steps to mitigate market conduct problems through self-compliance measures and the establishment of a voluntary self-regulatory organisation (SRO). At the same time, regulators have promulgated new rules and bolstered their monitoring mechanisms.

e. An optimal regulatory framework

In sum, optimal regulation should be designed to minimise the cost of insurer insolvencies, promote the pricing of insurance at marginal cost, promote reasonable trade practices, provide appropriate incentives for insurers to police their own practices and those of their agents, and provide the optimal amount of insurance.

However, optimal regulation depends upon more than just the approach to regulation. It also depends upon where regulatory authority resides or how it is apportioned among different regulatory jurisdictions and coordinated among those jurisdictions.

The United States is somewhat unique in that insurance regulation has been primarily delegated to the states.

In most countries, insurance is regulated at the national level and in a few (e.g., Canada and Australia) regulatory responsibilities are divided between the states/provinces and the national government.

In the United States, the National Association of Insurance Commissioners (NAIC) serves as the primarily vehicle for coordinating regulatory policies among the states.

The EU constitutes a special case in which there is a formal legal framework designed to establish a common set of standards and harmonise the insurance regulations of its member countries.

At an international level, there are advisory organisations (such as the International Association of Insurance Supervisors) that seek to harmonise insurance regulation at a global level through the promulgation of core standards and principles.

The state-based system of insurance regulation in the United States has come under heavy criticism because of the inefficiencies it creates and the additional costs it imposes on insurance transactions across state borders.

Large insurers have pushed for the creation of an optional federal charter (OFC) that would allow insurers and agents to choose to be subject to federal regulation and exempt from state regulation.

Despite strong opposition from the states and small insurers, the OFC proposal received serious consideration by the Congress until the recent financial crisis refocused its attention on federal regulation of other financial institutions.

The Congress is likely to remain preoccupied with reforming the overall structure for the regulation of financial institutions and essentially leave insurance “on hold” for some period of time with some limited exceptions.

However, it is reasonable to expect that policy-makers will revisit proposals for the federal insurance regulation as issues concerning the regulation of other financial institutions are resolved and a new financial regulatory framework is established.

Location: Indonesia