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A Regulator's Introduction to the Insurance Industry A Regulator’s Introduction to the Insurance Industry Prepared for the National Association of Insurance Commissioners Robert W. Klein, Ph.D. A Regulator’s Introduction to the Insurance Industry 2nd Edition Robert W. Klein, Ph.D. Georgia State University © Copyright 2005 by National Association of Insurance Commissioners All rights reserved. National Association of Insurance Commissioners Insurance Products & Services Division 816-783-8300 Fax 816-460-7593 www.naic.org [email protected] Printed in the United States of America No part of this book may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any storage or retrieval system, without written permission from the NAIC. Executive Headquarters Securities Valuation Office Government Relations 2301 McGee Street 48 Wall Street Hall of States Bldg. Suite 800 6th Floor 444 North Capitol NW Kansas City, MO 64108 New York, NY 10005 Suite 701 816-842-3600 212-398-9000 Washington, DC 20001 202-624-7790 Acknowledgements The author expresses his deep appreciation to the National Association of Insurance Commissioners (NAIC) and Catherine J. Weatherford, Executive Vice President and CEO, for their support of the production of the second edition of this text. A number of NAIC staff members provided considerable assistance. Judy Lee, Chief Operations Officer, patiently coordinated the project from its inception through its completion. Eric Nordman, Trish Schoettger and Heidi Robertson reviewed the entire text, significantly improving its content and presentation. Various NAIC staff members provided valuable comments and corrections: Andrew J. Beal, Carolyn Johnson Speck, Tim Mullen, Jeff Johnston, David Vacca, Brett Palmer, Mary Beth Senkewicz, Chris Evangel, Joseph Prakash and Thomas Kindred. The author thanks all of these individuals for their efforts in helping ensure this book continues to be a valuable resource to regulators and others interested in the insurance industry and its supervision. The author and the NAIC express their appreciation to George E. Rejda and Addison-Wesley Educational Publishers, Inc., for their permission to use a portion of the glossary contained in the Principles of Risk Management and Insurance, 6th ed., by George E. Rejda. (Reading, Mass.: Addison-Wesley, 1998). The Rejda book served as the primary reference for the chapters on insurance principles and institutions in this text. Any remaining errors and omissions are the sole responsibility of the author of this text. Table of Contents Chapter 1: Introduction A. Context ............................................................................................1 B. Approach and Organization of Text ................................................4 Chapter 2: Important Insurance Concepts A. Risk and Uncertainty ......................................................................6 B. Pooling and Diversification of Risk through Insurance ..................6 C. Efficiency and Equity ......................................................................8 D. Conditions for Insurability ..............................................................9 E. Asymmetric Information Problems ................................................10 1. Adverse Selection......................................................................10 2. Moral Hazard ............................................................................11 F. Principles of Indemnity and Insurable Interest ..............................13 Chapter 3: Functions Performed by Insurers and Intermediaries A. Product Design ..............................................................................18 B. Pricing ............................................................................................19 1. Property-Liability and Accident-Health ..................................21 2. Life Insurance and Annuities....................................................24 C. Production and Distribution ..........................................................25 D. Underwriting ..................................................................................27 E. Loss Settlement ..............................................................................28 F. Investment ......................................................................................29 G. Reinsurance ....................................................................................30 Chapter 4: Insurance Lines and Products A. Property-Liability ..........................................................................38 1. Fire and Homeowners Multi-Peril Insurance ..........................38 2. Marine Insurance ......................................................................40 3. Casualty Insurance ..................................................................41 a. Automobile Insurance ........................................................41 b. Workers’ Compensation Insurance ....................................43 c. Medical Malpractice Insurance ..........................................44 d. Commercial Multi-peril Insurance ....................................44 e. Other Liability Coverages ..................................................45 4. Surety, Financial Guaranty and Title Insurance ......................45 B. Life Insurance and Annuities ........................................................46 1. Term Life ..................................................................................46 2. Whole Life ................................................................................47 3. Interest-Sensitive Life Insurance Policies ................................48 4. Endowment Policies ................................................................49 5. Annuities ..................................................................................49 C. Disability and Health Insurance ....................................................50 1. Disability Income ....................................................................51 2. Medical Expense Insurance ......................................................51 3. Medicare, Medicare Supplement and Long-Term Care Insurance ........................................................................53 Chapter 5: Insurer Organizational Forms and Distribution Systems A. Stock Insurers ................................................................................58 B. Mutual Insurers ..............................................................................60 C. Reciprocal Insurers ........................................................................61 D. Lloyd’s Associations ......................................................................61 E. Health Expense Associations ........................................................63 F. Risk-Retention Groups and Purchasing Groups ............................64 G. Captives ..........................................................................................65 Chapter 6: Conceptual Framework for Analyzing Insurance Markets A. The Structure-Conduct-Performance Framework ........................68 B. Supply of and Demand for Insurance ............................................70 C. Competition and Alternative Market Structures ............................73 1. Theory of Competition ............................................................73 2. Workable Competition ............................................................75 3. Alternative Market Structures ..................................................76 4. Cyclical and Excessive Competition ........................................77 Chapter 7: The Structure and Performance of the Insurance Industry A. Evolution of the U.S. Insurance Industry ......................................82 B. Property-Liability Insurance Markets ............................................87 1. Standard Market ......................................................................88 a. Market Structure ................................................................88 b. Market Performance ..........................................................92 2. Alternative Markets and Self-Insurance ..................................93 C. Accident-Health Insurance Markets ..............................................94 1. Standard Market ......................................................................94 a. Market Structure ................................................................94 b. Market Performance ..........................................................95 2. Alternative Health Insurance Entities ......................................96 D. Life Insurance and Annuities Markets ..........................................97 1. Market Structure ......................................................................99 2. Market Performance................................................................100 Chapter 8: Principles of Insurance Regulation A. Theories of Regulation ................................................................106 B. Regulation Defined ......................................................................107 C. Principles of Insurance Regulation ............................................107 1. Market Problems and Market Failures ..................................107 2. Regulatory Remedies for Insurance Market Failures ............109 D. Potential Effects of Insurance Regulation ..................................111 1. Solvency Regulation ..............................................................111
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