Jedziniak – Fall 2017
What is Insurance?
Insurance is about risk and risk is uncertainty. The risk is that you won’t have enough money when you need it.
4 ways to Deal with Risk:
Avoid the risk – Don’t build the beach house on an Island; Don’t get in the car.
Mitigate the risk – you can find a way to reduce your potential for loss.
Retain the risk – I have 2 million dollars so it doesn’t matter.
Every country claims they invented insurance.
The two earliest forms come from:
Spreading the risk
The guilds in Europe did this for injured workers. After a worker is injured, they collect $$ from every worker. It was an after-the-fact assessment. What’s the problem with the after-the-fact assessment? They are only as good as long as people are willing to pay.
This concept spread to fire insurance in London. But, in 1666, everyone’s house burned down. No one could pay the assessment
Lloyd’s coffeehouse of London. Rich people would bet on everything. A lot of terms we have “slip” “underwriter” came from this gambling house. Ship owners would come in and bet against themselves. “bet” that their ship wouldn’t make it to around Africa.
Nicholas Barbon helped pioneer fire insurance. Society that you joined, if your house caught fire, they would put it out. Special logo on a house if you were a member. Paid to be a member.
Charleston developed a form of this. The problem was this after-the-fact idea. If they didn’t make it to the house in time, they assessed all the members.
If they didn’t make it to the house in time, they assessed all the members.
Came up with the idea for the first insurance company.
Franklin liked Barbon’s idea, but without the after-the-fact assessment.
He wanted to figure out ahead of time, how much would it cost if it burned?
(A before-the-fact assessment) aka a Premium. You paid a premium in return a promise to pay. — Franklin would inspect the property before he wrote the policy. You had to pay the premium to be part of the company, an up-front assessment. The people wanted in it writing, wanted a contract. This was the invention of the policy.
Only had people with law-risks paying the premiums, so the insurance co. made a lot of money.
He had standards that you had to follow to build a house if you wanted to be a member.
Franklin = Mutual Insurance Co.
Risk is the potential for loss; the risk that you won’t have enough $$ when you need it.
Franklin est. 4 things an Insurance Co. Looks at to Determine Your Risk
Physical – In Ben Franklin’s case (trees, occupants etc…). For health insurance companies, it’s obvious (smokers, obesity). Higher premiums for higher risk. Insurance companies base their premiums on this stuff. Car insurance companies might not offer you a policy at all if you have had 4 DUI’s and 3 suspensions. For homeowners insurance, think coastal property (very high premiums).
Moral – Right and wrong. people that go to jail, criminal record. Don’t want to write policies for criminals
Morale – are you a responsible person? Look at your credit score. Credit score measures your management skills and responsibility.
Legal – what the legal system can do to the amount of risk/loss you present. Look at the statutory laws, see if its plaintiff friendly. Premiums are higher in certain states.
Two types of underwriting:
“Front Door” or subjective underwriting. This is done by the agent at the front door of the office. Takes a look at you and sees what he thinks getting to know you a little bit.
Objective – done in the back office. Don’t look at the individual personally. They have to make objective decisions.
Core Principles for Insurance Companies
Spread the risk (transferring)
Premiums (membership/annual fess)
Pay claims Fairly
Franklin promised a fair payment, and promised to pay.
Predict Risk & Underwriting (use 4 factors above; Physical, Moral, Morale, Legal)
Policy (Put the promise to pay in writing)
Franklin did policyholder education, but this doesn’t happen anymore
Aka, a pot of money for investment potential; A reserve to protect policyholders.
Types of Insurance Companies
Mutual – owned and operated for the benefit of its policyholders. And the policyholders are “members,” it’s a membership organization. Everyone who has a policy owns a piece of the company. The company is operated and owned for the benefit of the members. You have a right to vote on the leadership. State Farm and Nationwide are examples. Farm bureau. Their ultimate goal is not to generate a profit, but generate enough money to put it back into the
company and provide better benefits, better coverage, cheaper coverage etc… your policy represents your share or right of ownership in that company.
One problem with mutual companies is raising capital. the only way to raise capital is to add more members really.
Stock – These companies are for-profit entities. No problem raising capital because you have a bunch of money from investors to start. You still charge premiums. Since its your $$, you get to make profits. Just like a regular corporation.
Fraternal – you don’t see to many of these. The policyholders are all members of a particular trade or profession. Its run by the members for the benefit of the members of the trade. Its not all assessment based, they pay some premiums. If the company gets in a hole, then they assess the members. Woodmen’s of the world is an example.
Benevolent – Good-will societies. Operates like a fraternal, except that its built around public service. Providence hospital, the Catholic Church owns it. The Catholic Benevolent Society covers priests. Its built around public service. — Its very much like a fraternal, but its regulated differently, so its called something different.
Reciprocal – Most confusing. Lloyds of London is an example. The bookies were called “underwriters.” The bookie holds all the money in a pot and he decides how to pay that money out.
You have a group of bettors. “Reciprocal inter-insurance exchange” – these are the bettors. They give all the $$ to an attorney-in-fact (AIF) (this is the bookie). If there is a loss, the AIF gets to decide when and if and how much to pay out.
The AIF can have a # of exchanges. You have turned over the rights to that money to the AIF.
What’s the benefit of this? when a company or business decides to pull out of the exchange, they get to take their money with them and any profits. This is good where the severity of loss is high, but the probability of loss is low. If you put your money in here, and you don’t have any losses, the money just grows.
There’s a whole bunch of flaws with this. regulators don’t like these. There are huge pots of money that they don’t get to tax until someone pulls the $$ out. Its costly also. Finally, once you give the $$ to the AIF, you have little control over it.
The Business of Insurance
“The Business of Insurance” is a term of art used by the Supreme Court to determine whether the state or the feds have authority to regulate. These same acts that Franklin created fall within the business of insurance.
So, what is insurance?
K under which one party (insurer) agrees to pay another party (insured) a specified amount upon determinable contingency (risk).
The definition of insurance in every state reads like that. Both statutes and cases.
(25) – “Insurance” means a contract where one undertakes to indemnify another or pay a specified amount upon determinable contingencies. The term “insurance” included annuities.
(45) – “Policy” means a contract of insurance.
(46) – “Premium” means payment given in consideration of a contract of insurance
Dept. of Insurance is a State Agency; has a commissioner or director in each state. In SC, we have a director of insurance. The governor picks the director. Directors are usually experience people from the insurance industry. – If it’s a com
United States v. Southeastern Underwriters Association, 322 U.S. 533 –Comm. Clause & Anti-Trust
Facts: The case involved as indictment of a “rating bureau” and its member companies for violating the Sherman Act by agreeing to fix premium rates and boycott non-members.
Rating Bureau is supposed to help companies. Instead they are undercutting prices and forcing companies to abide by their rules.
Held: Insurance is commerce (overruling Paul), so Congress has the power to regulate it under the Commerce Clause. Therefore, Sherman Anti-Trust Act applies to insurance. (Overturned by the Fed. McCarran-Ferguson Act)
3-Part Test for Commerce Clause (Paul):
Is insurance a channel of commerce?
–Yes, business can’t function w/o insurance; economy depends on it.
Is it an instrumentality?
–It is more than a contract. It is something, which drives commerce.
–This is the big one. Court looks at insurance receipts and such to show how much $$ is in it and how it affects the U.S. economy.
Dormant Commerce Clause – if Congress regulates it, states can’t regulate it. This would mean that state regulation goes away.
Aftermath: The insurance industry promptly supported legislation that would return regulatory authority to the states — known as the McCarran-Ferguson Act
Prof. loves Jackson’s dissent — He says of course insurance is commerce. However, if we say its commerce, we throw out state regulation. There are no federal laws on the book. No established federal regulatory agency. We are going to lose all the state precedent and we are going to have a ton of federal litigation. States will lose a ton of money. Experts say don’t do this.
Federal McCarran-Ferguson Act (1945)
Restore back to the States, the broad authority to tax and regulate the insurance industry. – Congress says that insurance is commerce, but we can’t regulate it, that’s the states job.
Now, the Federal Anti-Trust laws will not apply to insurance, as long as the state regulates in that area… but Fed. Anti-Trust laws will apply in cases of boycott, coercion, and intimidation.
Says that Congress, under the Commerce Clause, has to power over the “business of insurance” but that silence by Congress will allow the state to enact laws for the purpose of regulating and taxing the business of insurance. – Interpreted broadly to allow state regulation.
In order for an Act of Congress to regulate insurance, the act must say “this act is specifically introduced to regulate the business of insurance, contrary to McCarron-Ferguson.” You also need to state why – i.e., the states are doing a crappy job.
As long as the act is the business of insurance, it can be regulated and taxed by the States. “Business of insurance” is a term of art. It goes to the Ben Franklin factors.
State law pre-empts Fed. Law, unless the Fed. Statute specifically says, “we are regulating the business of insurance.”
– Fed. Gvmt does this sometimes when the states aren’t doing a good job. (Obama did this with healthcare law).