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Letter February 23, 2006:
The Honorable Michael G. Oxley:
Chairman:
Committee on Financial Services:
House of Representatives:
Subject: Definitions of Insurance and Related Information:
Dear Mr. Chairman:
This letter transmits to you our briefing slides concerning a variety
of issues related to identifying a universal definition of insurance
and the challenges associated with doing so. We briefed your committee
staff on the preliminary results of our work on June 24, 2005, and on
our final results on November 29, 2005. Specifically, we provided
information on (1) the elements that are commonly part of definitions
of insurance, (2) a few products not universally defined as insurance
or regulated across the states by their insurance departments, (3)
possible regulatory implications of developing separate definitions for
insurance products covering insurance risks in more than one category,
(4) current developments in statutory and financial accounting
communities in re-evaluating their guidelines for measuring risk
transfer in reinsurance contracts, and (5) certain circumstances when
finite risk contracts are used.
We focused on insurance and reinsurance in the private sector and
excluded federal insurance programs. We identified elements crucial to
defining or developing a definition of insurance, but we did not
attempt to compile an exhaustive list of all private sector products
that might be considered insurance. We reviewed relevant documents from
the National Association of Insurance Commissioners (NAIC), academic
sources, accounting boards, insurance companies, professional and
industry associations, state insurance regulators, federal securities
regulators, court cases, and general media. We also met with
knowledgeable staff at NAIC and other professional and industry
associations. We conducted our work from December 2004 through December
2005 in accordance with generally accepted government auditing
standards.
Definitions of Insurance:
We looked at a variety of sources to identify a definition of insurance
and found that, while most definitions differed because they were
developed for specific purposes or had changed over time, the
definitions shared key elements of risk transfer and risk spreading.
Definitions of insurance are developed for various purposes such as
different fields of study, categories of insurance, and state or
federal statutes.[Footnote 1]
While risk transfer and risk spreading are key elements, these
definitions often include other elements, or parameters, commonly found
in the definitions. These include:
* indemnification, which is the payment for losses actually incurred;
* the ability to make reasonable estimates of future losses;
* the ability to express losses in definite monetary amounts; and:
* the possibility of adverse, random events occurring outside the
control of the insured.
Further, while products may transfer various types of risks, a product
must transfer insurance risk to qualify as an insurance product.
Insurance risk is coverage for exposures that have the potential for
financial loss. It is defined by NAIC as equivalent to underwriting
risk. That is, for property-casualty insurers, it is the risk of
mispricing new business or the risk of underestimating needed reserves
for business already written. The accounting industry defines insurance
risk as those risks related to uncertainties resulting from both the
amount and timing of losses paid and other expenses.
Even when some losses lack certain elements of insurance, insurers have
sometimes found ways that allow coverage for such losses. For example,
nonpecuniary or noneconomic losses (e.g., the loss of well-being or
happiness) lack certain elements of insurance--there is no commonly
accepted method of expressing a definite monetary amount for
nonpecuniary losses and no measurable means to indemnify the insured.
For example, the loss of happiness upon the death of a loved one would
be difficult if not impossible to quantify in monetary terms; instead
of attempting to quantify such a loss, life insurers agree to pay a
predetermined amount of monetary benefits upon the death of the
insured, and they charge a premium based on both the amount of
insurance and the expected mortality risk of the insured.
In reviewing the various definitions of insurance, we also found that
court interpretations and state regulatory practices change definitions
over time. For example, courts have emphasized different elements of an
insurance contract such as its principal object and purpose as in
Jordan v. Group Health or have focused on the legal elements necessary
for an enforceable contract as in Griffin Systems v. Washburn.[Footnote
2] (See slides 5-8 and 13-15 for further discussion of various
definitions of insurance.)
How States Define and Regulate Insurance:
Generally, states define and regulate the same products as insurance.
While states rely on a variety of sources to provide a legal and
regulatory definition of insurance, these sources sometimes lead to
differences in how certain products are categorized--whether as
insurance or not. In an effort to reduce confusion, NAIC has attempted
to catalog products regulated by each of the state insurance regulators
in standardized lists known as Uniform Product Coding Matrices (UPCM)-
-one for property casualty products and another for
life/accident/health products. Insurers are to use the UPCM as a guide
for filings of insurance rates and policy forms. Most of the products
in the UPCM are recognized and regulated across all states as
insurance. However, some differences still exist. For example, prepaid
legal service plans are defined and regulated as insurance in Texas but
not in South Carolina.
Many states have a statutory definition that is stated generally and
may explicitly include and/or exclude specific insurance
products.[Footnote 3] A few states do not have a general definition.
For example, Illinois' statute lists classes of products subject to or
excluded from regulation. When a product is not listed in the statute,
Illinois regulators apply a functional definition consisting of the
elements articulated in Griffin Systems v. Washburn.
We identified some products either not included in the UPCM or subject
to differences in statutory or regulatory approaches among various
state insurance regulators. These include:
* products created and offered by noninsurers as substitutes for other
products underwritten by insurers (e.g., debt cancellation contracts
created by lenders as substitutes for credit insurance; see slide 18);
* products that are viewed sometimes as insurance and other times as
prepayment or discount payment plans for services (e.g., legal and
medical services plans; see slides 21-22);
* various annuity products sold by insurers because whether a
particular annuity product is insurance hinged on the level of
insurance risk and/or investment risk assumed by the insurer (e.g.,
variable annuities in which the insurer assumes no investment risk and
period certain annuities in which the insurer assumes no mortality
risk; see slides 27-28); and:
* insurance products regulated by state departments other than state
insurance departments because of their historical association with
particular industries or economic activities (e.g., title insurance
that, according to a state insurance department official, is
historically associated with the real estate market; see slide 31).
Products we identified with differences in regulatory approaches among
some state insurance regulators are listed and discussed on slides 18-
31.
Regulation of Products That Cover Insurance Risks in More Than One
Category:
Products that cover insurance risks in more than one category (life,
accident, health, property casualty) could face uncertain regulation if
separate insurance definitions were developed and used for each
category. Currently, insurance products are classified by regulators as
life, accident,[Footnote 4] health, or property casualty insurance,
even though some products cover insurance risks in more than one of
these categories.
Based on the product descriptions in NAIC's UPCM, we list and describe
eight insurance products we found that cover risks in more than one of
the categories (slides 33-34). Our list was not intended to be
exhaustive but to illustrate that some products could actually fit in
two or more categories even though each product is historically
associated with one particular category of insurance. The historical
associations have not affected insurance regulation because insurance
definitions generally apply across categories. However, if separate
statutory definitions of insurance were developed for each category, it
is unclear how products characterized by features from multiple
categories would be classified for regulatory purposes. As a result,
products that cover insurance risks in more than one category might be
regulated differently or might be regulated under multiple regimes. For
example, it is unclear whether accident insurance that also provides
death and health care benefits would be regulated solely as accident
insurance or also as both life and health insurance, and whether
regulation would differ across the three types of insurance. (See
slides 32-34 for additional information on this issue.)
Reinsurance:
Reinsurance is insurance for insurers. In contrast to insurance,
reinsurance is not sold as a standard product. Each contract is
separately negotiated. Two basic types of reinsurance contracts exist-
-treaty and facultative. The key difference between treaty and
facultative reinsurance contracts is how insurers select risks for
transfer. In a treaty reinsurance contract, the reinsurer and insurer
agree on which select class(es) of underlying policies of the insurer's
to underwrite. In a facultative reinsurance contract, the reinsurer and
insurer agree on individual underlying policies. In addition to the
method of selecting underlying policies, reinsurance contracts usually
contain features such as floors and caps that limit the amount of risks
underwritten.
The transfer of risk is the key element to defining reinsurance. While
reinsurance contracts can also transfer noninsurance risks, it is the
transfer of insurance risk that is the focus when evaluating the
validity of a reinsurance contract. Further, if sufficient insurance
risk is transferred, the entire contract can be defined as reinsurance
and qualify for reinsurance accounting--a type of accounting treatment
sought when beneficial to the insured's financial statements.[Footnote
5] Currently, the statutory and financial accounting communities are re-
evaluating methods used in determining whether a reinsurer's contract
covering property casualty insurance risks actually transfers insurance
risk. Both statutory and financial accounting standards establish the
necessary conditions of risk transfer for reinsurance contracts
including that the reinsurer assume significant insurance risk and face
a reasonable possibility of significant loss.[Footnote 6] Statutory and
financial accounting guidelines also clarify that while reinsurance
contracts may transfer other types of risks, such as investment risk,
only insurance risk is subject to the conditions for determining risk
transfer. Also, the guidelines require that determinations of risk
transfer should consider all features in a contract such as
cancellation provisions or payment schedules that delay the reinsurer's
timely reimbursement of claims; features like these may limit the
transfer of insurance risk. In addition, financial accounting
guidelines explain that determining the extent of risk transferred in
one reinsurance contract should be done in the context of all other
related contracts or agreements because they may potentially limit the
transfer of insurance risk. However, once the determination is made
that the contract transfers sufficient insurance risk, reinsurance
accounting can be applied to the entire contract, including any
noninsurance risks being transferred. (See slides 35-42 for further
information on reinsurance.)
Finite Risk Contracts:
No widely accepted definition exists for finite risk contracts. Finite
risk contracts can be used by both insurers (finite risk reinsurance)
and noninsurers (finite risk insurance). In general, such contracts
transfer less insurance risk than traditional reinsurance or insurance.
Instead, finite risk contracts tend to emphasize financing and
accounting benefits. Specifically, the contracts allow the insured to
transfer to a reinsurer or insurer both insurance risk and
uncertainties about the timing of certain cash flows and recognition of
certain income and expenses. Thus, an insured could use these contracts
to both reduce insurance risk and control or smooth the timing of cash
flows and the recognition of certain expenses and income. This could
favorably affect earnings, capital, and certain ratios that regulators,
rating agencies, and investment analysts might use to measure and
monitor a company's financial health.
Finite risk contracts must transfer sufficient insurance risk to
legitimately qualify for these financing and accounting benefits.
Although finite risk contracts can be legitimately structured to meet
these requirements, some companies that originally presented their
finite risk contracts as transferring sufficient insurance risk, and
thus qualifying for the financing and accounting benefits, were
discovered to have used mechanisms such as undisclosed side agreements
that resulted in little or no insurance risk actually being
transferred. Disguising such contracts to look like "real reinsurance"
or insurance can mislead regulators, policyholders, and investors about
the actual financial condition of the company. (See slides 43-47 for
further discussion of finite risk contracts.)
In summary, we found that there is no single, universal definition of
insurance. However, we identified certain key elements of risk transfer
or risk spreading that were common among the varying definitions.
Moreover, while statutory definitions of insurance sometimes differed
between states leading to differences in the regulation of certain
products, states generally define and regulate the same products as
insurance. Insurance products also are categorized by type of insurance
risk such as life, accident, health, and property casualty. However,
some products, while designated as belonging to one of the major
categories, have characteristics that fall into more than one category.
Therefore, if separate statutory definitions of insurance were
developed for products in each category of insurance risk, products
that transfer insurance risks in more than one category could face
uncertain regulation.
Concerning reinsurance and its accounting treatment, the amount of
insurance risk actually transferred is important because of the
benefits of reinsurance accounting to the ceding company. Specifically,
if insurance risk is transferred at sufficient levels, the entire
contract would qualify for reinsurance accounting, with resulting
positive effects on the ceding company's reserves and surplus. Another
type of contract--the finite risk contract--can receive reinsurance
accounting or other preferred accounting treatment but transfers less
risk at a lower premium than traditional insurance. Recently some
companies that had these contracts and used reinsurance accounting
treatment were found to have transferred insufficient insurance risk to
qualify for such treatment.
As agreed with your office, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 30 days
from the date of this report. At that time, we will send copies of this
report to the Chairman and Ranking Minority Member of the Senate
Committee on Banking, Housing, and Urban Affairs and the Ranking
Minority Member of the House Committee on Financial Services. We also
will make copies available to others upon request. In addition, the
report will be available at no charge on GAO's Web site at [Hyperlink,
http://www.gao.gov].
If you or your staff have questions regarding this report, please
contact me at (202) 512-5837 or [Hyperlink, williamso@gao.gov]. Contact
points for our Offices of Congressional Relations and Public Affairs
may be found on the last page of this report. Lawrence D. Cluff, Angela
Pun, Mel Thomas, Christine J. Kuduk, Nancy S. Barry, and Tania L.
Calhoun made key contributions to this report.
Sincerely yours,
Signed by:
Orice M. Williams:
Director, Financial Markets and Community Investment:
Enclosure: Definitions of Insurance:
Presentation For Committee on Financial Services:
U.S. House of Representatives:
Contents:
Scope and Methodology (slide 3):
Definitions of Insurance (slides 4-11):
How States Define and Regulate Insurance (slides 12-31):
Regulation of Products That Cover Insurance Risks in More Than One
Category (slides 32-34):
Reinsurance (slides 35-42):
Finite Risk Contracts (slides 43-47):
Summary (slide 48):
Scope and Methodology:
We focused on products sold by insurers or reinsurers in the private
sector and excluded federal insurance programs.
We did not attempt to compile an exhaustive list of all products in the
private sector that might be considered insurance.
We reviewed academic textbooks and journals; documents from National
Association of Insurance Commissioners (NAIC), state insurance
regulators, Securities and Exchange Commission, and National
Association of Securities Dealers; statutory and financial accounting
principles and standards; general media; and court cases.
We interviewed officials from NAIC, industry associations for life,
health, and property casualty insurance, as well as banking and other
professional associations. We also interviewed academicians and
officials with the Illinois insurance department.
Definitions of Insurance:
In our research, we found that:
* There is no universal agreement on a definition of insurance,
* Most definitions have common elements,
* The Gramm-Leach-Bliley Act provides one definition used by the
federal government,
* Nonpecuniary losses are usually not covered by insurance, and:
* Identity theft insurance pays only for actual expenses incurred by
the victim.
No Universal Agreement:
Insurance industry participants and state regulators develop
definitions for different purposes, such as
* Specific subject areas, such as accounting, actuarial science,
economics, and finance;
* Specific types of insurance, such as life or property casualty;
or;
* Statutes and regulations, which can vary across states.
These definitions are dynamic, sometimes caused by
* Evolution of thinking in subject areas;
* Product innovations; and:
* Changes in statutes, regulations, and court interpretations.
Key Elements:
Definitions of insurance have two key elements:
* Risk is transferred.
- An uncertain, possibly large, loss is transformed into a certain,
small cost or premium for the insured; and:
- An insured transfers risk to another entity.
* Risk is spread. That is, an insurer spreads risk over a large enough
group for the law of large numbers to predict both total losses and the
probability of a single loss with some accuracy.
Other Elements:
Other elements often considered to be conditions necessary for an
"insurable" risk are:
* Risks that are reasonably homogeneous and independent; and:
* Losses that meet certain conditions, including
- Chance occurrences,
- Low probability of loss,
- Occur at a definite time and place, and can be expressed as a
definite monetary amount, and
- Are not catastrophic, i.e., do not affect a large number of insureds
at the same time.
Gramm-Leach-Bliley Definition:
Section 302(c) defines insurance as:
Any product regulated as insurance as of Jan. 1, 1999, in accordance
with the relevant state insurance law, in the state in which the
product is provided; and:
Any product first offered after Jan. 1, 1999, which:
* A state insurance regulator determines shall be regulated as
insurance in the state in which the product is provided because the
product insures, guarantees, or indemnifies against liability, loss of
life, loss of health, or loss through damage to or destruction of
property, including, but not limited to, surety bonds, life insurance,
health insurance, title insurance, and property and casualty insurance;
and:
* Is not a product or service of a bank as described in the section;
and:
Any annuity contract, the income on which is subject to tax treatment
under section 72 of the Internal Revenue Code.
Description of Nonpecuniary Losses:
Pecuniary or economic losses have a market price or can be calculated
in monetary terms. Some examples include:
* The cost to repair or replace a damaged vehicle, or:
* A family's loss of future expected income from the death or
disability of an income-earning parent or spouse.
Nonpecuniary or noneconomic losses do not have a market price. These
losses are the reduction of insureds' welfare such as their health,
well-being, and happiness.
Nonpecuniary Losses Lack Certain Common Elements, but Some Coverage
Provided:
Nonpecuniary losses lack certain common insurance elements. For
example:
* Nonpecuniary losses cannot be calculated as a definite amount;
* The principle of indemnity does not apply; and:
* There is no insurable interest for some types of nonpecuniary losses.
Insurers provide coverage for some nonpecuniary losses by paying:
Predetermined monetary amounts, such as life insurance paying the
amount chosen by the insured at time of purchase; or:
Amounts calculated in monetary terms under specific circumstances, such
as uninsured motorist insurance covering damages for "pain and
suffering."
Identity Theft Insurance Covers Pecuniary Expenses:
Although the theft of one's identifying information is a nonpecuniary
loss, identity theft insurance only pays for associated expenses that
have a market price or can be calculated in monetary terms. These
include:
* Costs of certified mail and long-distance calls;
* Lost wages from time taken off work; and:
* Fees, such as attorney and loan application fees.
How States Define and Regulate Insurance:
States rely on a variety of sources to help define and regulate
insurance. These include:
* State statutory definitions,
* Court interpretations,
* Regulatory descriptions of insurance products, and:
* Uniform Product Coding Matrices (UPCM) categories of insurance.
However, some products are not universally recognized or regulated as
insurance.
State Statutory Definitions:
Many states have a statutory definition that is general and inclusive,
similar to the following:
Insurance is a contract whereby one undertakes to indemnify another or
pay a specified amount upon determinable contingencies (Kentucky
Revised Statutes § 304.1-030):
Some states have explicit inclusions and/or exclusions. For example,
Kentucky's definition includes annuities and sureties, while
Wisconsin's excludes continuing care contracts.
A few states do not have a statutory definition. For example, Illinois'
insurance statutes list classes of products subject to or excluded from
regulation. When a product is not listed in the statutes, the
regulators apply a functional definition consisting of the elements
articulated in a court case.
Court Interpretations:
Two court cases have helped guide states in defining and regulating
insurance:
* Jordan v. Group Health found that courts may look at the nature of
the contractual relationship to determine whether risk transfer or
distribution is its "principal object and purpose."
* Griffin Systems v. Washburn found that courts may look to see whether
a product contains certain elements within a definition of insurance.
These elements include:
- A contract between an insurer and insured that exists for a specific
period of time,
- An insurable interest possessed by the insured,
- Consideration in the form of a premium paid by the insured to the
insurer, and:
- The assumption of risk by the insurer who agrees to indemnify the
insured for potential loss resulting from specified perils.
Regulatory Descriptions of Insurance Products:
NAIC worked with insurance departments in 20 to 25 states to develop
the UPCM that lists and describes:
* Property/Casualty insurance products, and:
* Life/Accident/Health insurance products.
NAIC developed the UPCM to:
* Identify all products regulated by state departments of insurance,
* Standardize terminology for insurance products across all states,
and:
* Aid filings of insurance products (rates and policy forms).
UPCM Categories of Insurance:
[See PDF for image]
[End of table]
Products Not Universally Recognized or Regulated as Insurance:
[See PDF for image]
[End of table]
Substitutes for Regulated Insurance Products: Debt Cancellation or
Suspension Contracts:
Description:
* Created by lenders as substitutes for credit insurance;
* For a fee, lender retains risk in lieu of pursuing collection and
potential recovery on loan if borrower defaults;
* Lender agrees to cancel or temporarily suspend loan under conditions
such as death, disability, or unemployment of borrower;
* Unclear whether these are a transfer of insurance risk or forgiveness
of financial obligation;
* Equivalent to credit insurance from consumer's viewpoint.
Information on regulation:
* Illinois-does not view as insurance; no indemnity payments from third
parties;
* Michigan-does not view as insurance but as incidental to loans;
* New York-views as insurance but does not regulate when sold by
financial institutions.
Substitutes for Regulated Insurance Products: Gap Waivers:
Description:
* Created by auto dealers and others as a substitute for gap
(originally, guaranteed auto protection) insurance;
* For a fee, creditor retains risk by agreeing to waive the excess of
the lessee's or debtor's obligation to pay the amount owed on a
property over its actual cash value in the event of total loss due to
theft or physical damage;
* Unclear whether these are a transfer of insurance risk or forgiveness
of financial obligation;
* Properties include autos, boats, and computers;
* Some offer gap waivers as alternative to gap insurance that other
entities offer.
Information on regulation:
* New York-views as insurance under certain conditions; auto dealers or
lenders who are not licensed as insurance agents or brokers may offer
gap waivers; providers of gap waivers that in turn buy gap insurance
from licensed insurers must not charge customers more than they pay:
* Mississippi-has not determined whether gap waivers are insurance and
does not regulate them.
Substitutes for Regulated Insurance Products: Rental Car Damage and
Theft Waivers:
Description:
* Created by car rental companies as a substitute for rental insurance;
* For a fee, rental company retains risk by agreeing not to hold driver
liable in the event of certain damages involving a rental vehicle;
* Unclear whether these are a transfer of insurance risk or forgiveness
of financial obligation;
* Equivalent to rental car insurance from consumer's viewpoint.
Information on regulation:
* New York-rental company must obtain driver's written consent to buy
the waiver before the driver signs the rental agreement;
* Texas-does not view as insurance; are waivers of rental company's
right to recover on damages to auto.
Products That Could Be Insurance or Payment Plans: Legal Services
Plans:
Description:
* The term is used to characterize plans that;
* provide legal services;
* pay for the cost of obtaining legal services;
* prepay for future legal services, at discounted prices;
* reimburse for legal services costs;
* prepay for future legal services, if needed;
* Unclear whether these are transfers of insurance risk, price
discounting plans,
prepaid expense plans, or some combination.
Information on regulation:
* New York-included in the list of authorized insurance is legal
services insurance that is defined as providing legal services or
reimbursement for the cost of legal services;
* South Carolina-prepaid legal service contracts regulated by the
state's Department of Consumer Affairs;
* Texas-prepaid legal insurance is insurance if one party prepays
another for future legal services that may or may not be needed and if
the other party assumes the risk that such services may be needed.
Products That Could Be Insurance or Payment Plans: Medical Services
Plans:
Description:
* Some physicians and medical groups offer prepayment plans to
patients:
- to avoid the administrative burden of third-party health insurance;
- that appear to operate as insurer/providers (such as HMOs) on a
smaller scale;
* Unclear whether these are transfers of insurance risk, price
discounting plans, prepaid expense plans, or some combination:
Information on regulation;
* New York-A plan in which patients prepay for future medical care
needs;
- would be insurance and require licensing if the plan provides
unlimited services dependent on the happening of a fortuitous event
that could cost more than the prepayment;
- would not be insurance and not require licensing if certain services
occasioned by the happening of a fortuitous event are offered for an
additional fee that covers the cost of the services, although
discounted from the usual fee.
Products That Could Be Insurance or Payment Plans: Extended Service
Contracts (ESC):
Description-typically sold for autos, "home" (major home appliances),
and consumer products:
* Providers assume future costs of repairs or maintenance for a fee;
* Not to be confused with written or implied warranties of fitness and
merchantability provided by the manufacturer;
* Some state courts have determined that ESCs are insurance when the
seller of an ESC is not the manufacturer but a repair service provider:
Information on regulation-Regulation in some states is based on state
court decisions such as those discussed in the Griffin v. Washburn
case:
* Arizona court-ESC is insurance because third-party insurer sold ESC;
* Texas and Virginia courts-ESC is not insurance because merchant of
product sold ESC and makes repairs.
Products That Could Be Insurance or Payment Plans: Preneed Funeral and
Burial Arrangements:
Description:
* Purchase of future funeral services and merchandise at locked in
current price;
* Can be unfunded or funded in advance of need;
* Advance payments are deposited in interest-bearing trust account or
used to buy funeral insurance;
* Can also be funded with future life insurance or annuity proceeds
upon death;
* Are typically revocable and movable at any time by consumer and trust
account prefunding is returnable;
* Unclear whether these are a transfer of insurance risk, price
discounting plans, or prepayment of expenses.
Information on regulation:
Arkansas-licenses and regulates sales of such services; state finance
division examines contracts and bank trust accounts;
California-Department of Consumer Affairs' Cemetery and Funeral Bureau
licenses and regulates funeral establishments that sell such services;
* Colorado-regulates sellers.
Products That Could Be Insurance or Payment Plans: Continuing Care
Retirement Communities (CCRC):
Description:
* Senior housing arrangements that provide for skilled nursing care, if
later needed;
* Three types of communities:
- Type A-fee is locked in if skilled care is later needed;
- Type B-fee for skilled care is locked in for limited time with later
increases that don't reach market rate;
- Type C-access to later skilled care is assured, but at full market
rate;
* Unclear whether these are transfers of insurance risk, price
discounting plans, or prepayments of expenses:
Information on regulation:
* California-Department of Social Services certifies and regulates
CCRCs, but state insurance code regulates uncertified CCRCs;
* North Carolina-CCRCs must be licensed by the commissioner of
insurance and state insurance code governs their activities;
* South Carolina-CCRCs do not include nursing home or residential care
facilities licensed by state Department of Health & Environmental
Control;
* Unclear how many state insurance departments regulate CCRCs.
Products That Could Be Insurance or Payment Plans: Preventive Health
Care Coverage:
Description:
* Covers health care to keep healthy or to prevent illness;
* Health insurance plans appear to typically cover preventive care;
* Includes annual physicals, pelvic exams, flu shots, screening
mammograms, and dental cleanings;
* Many preventive health care activities tend to be recurring and
predictable;
* Unclear whether these are a transfer of insurance risk, price
discounting, or prepayment of expenses:
Information on regulation:
* Required by some states to be included in health insurance;
* Traditionally included in health insurance.
Products Underwritten by Insurers Containing Investment Risks: Variable
Annuities and Equity-Indexed Annuities:
Description:
* Annuity-a contract that, in return for premium(s) paid, guarantees a
series of payments for a specified period or for life.
* Variable annuity-pays a rate of return based on the performance of
investments. Interest rate and principal are usually not guaranteed.
The customer retains almost all of the investment risks.
* Equity-indexed annuity-pays a minimum rate of return plus an extra
rate using a formula based on charges to an equity index such as the
S&P 500. The contract usually guarantees a minimum account value. The
customer retains some of the investment risk.
* Insurer assumes mortality risks through added features, if offered,
such as payments for life and death benefits.
Information on regulation:
* Variable annuities:
- Sold by insurance companies, but regulated by SEC;
- In some states, state securities regulators have authority over
variable annuities;
- State departments of insurance (DOI) regulate the insurer selling the
product.
* Equity-indexed annuities are sold by insurance companies and the SEC
is evaluating them to determine if they should be regulated as
securities.
Products Underwritten by Insurers Containing Investment Risks: Period
Certain Annuities:
Description:
* Pay a fixed rate of return over a specified term such as 5, 10, 15,
or 20 years;
* Customer shifts all investment risks to the insurer:
As with any annuity, the insurer could assume mortality risks through
added features such as death benefits or retirement benefits, if
offered.
Information on regulation:
* Traditionally regulated by DOI as an insurance product;
* Illinois--If an annuity transfers mortality risks to the insurer, it
is regulated.
Products Underwritten by Insurers Containing Investment Risks: Viatical
Settlements and Life Settlements:
Description:
* Viaticals-policyholders are usually ill with under 2 years of life
expectancy;
* Life settlements-policyholders are over 65 with normal life
expectancy;
* Each product may be bundled together and sold to investors;
* In both cases:
- Third party pays policyholder cash and becomes a beneficiary of the
life insurance death benefit;
- The cash payment is more than the cash surrender value of the policy
but less than the expected death benefit.
* Unclear whether these products pose insurance risk or investment
risk.
Information on regulation:
Sometimes regulated by DOI, sometimes by state securities regulator,
and sometimes by both;
Some states adopted NAIC's Viatical Settlements Model Act, which
requires viatical companies to be licensed by a state DOI;
In California, Connecticut, New York, and Washington, settlement
providers are licensed by the DOIs.
Insurance and Insurance-Like Products That Are Not Always Regulated by
State DOIs: Surety Contracts:
Description:
A contract where the surety (similar to insurance company) agrees, for
a fee, to perform the principal's (similar to the policyholder)
obligations to a third party in the event the principal fails to
perform;
Surety assumes risk from the third party that the principal will not
perform contractual obligations;
Unlike insurer, surety has a right to seek indemnification from the
principal after performing contractual obligations.
Information on regulation:
New York and Utah-If an issuer sells surety bonds as a vocation, as
opposed to incidental to other business activity, then it is subject to
insurance regulation;
Kentucky and Delaware-Their statutory definitions explicitly include
those who "act as surety."
Insurance and Insurance-Like Products That Are Not Always Regulated by
State DOIs: Title Insurance:
Description:
For a fee, an insurer agrees to indemnify the insured up to a specified
amount of loss for defects in the title to real property;
Typically required by mortgage lenders at property settlement.
Information on regulation:
Iowa--This is the only state that does not allow the sale of title
insurance within its borders; the state's Finance Authority operates a
Title Guaranty Program.
Illinois--Regulated by the Division of Financial Institutions, not the
state DOI;
Regulatory treatment does not vary widely among the states.
Regulation of Products That Cover Insurance Risks in More Than One
Category:
Some products, while defined by NAIC as belonging to a particular
category of insurance, have characteristics that also fit in other
categories.
We have:
* Described the products, and:
* Identified the categories of risks covered by each product.
Product Descriptions:
Product: Accident;
Description: Coverage for death, dismemberment, disability, or hospital
and medical care caused by or necessitated as a result of specified
accidents.
Product: Credit Disability;
Description: Makes monthly loan/credit transaction payments to the
creditor upon the disablement of an insured debtor.
Product: Credit Life;
Description: Coverage sold in connection with loan and credit
transactions to provide insurance protection against death.
Product: Credit Insurance;
Description: Coverage of an obligation to a creditor upon the death or
disablement of the insured debtor; includes coverage that protects the
value of collateral for a loan.
Product: Disability Income;
Description: Coverage designed to compensate insured individual for a
portion of the income they lose because of a disabling injury or
illness.
Product: Employee Benefit;
Description: Liability protection for employers against employee claims
such as for wrongful termination or improper calculation of employee
benefits from pension plans, group life, health, or disability income
insurance or accidental death and dismemberment insurance.
Product: Employers Liability;
Description: Coverage for the legal liability of employers arising out
of injury to employees.
Product: Workers' Compensation;
Description: Coverage for an employer's liability for injuries,
disability, or death to persons in their employment, without regard to
fault, as prescribed by state or federal workers' compensation laws or
other statutes.
Source: GAO analysis of lines of insurance descriptions.
[End of table]
GAO Regulation of Products That Cover Insurance Risks in More Than One
Category:
Categories of Risks Covered by One Product:
[See PDF for image]
[End of table]
Reinsurance:
Some of the principal elements of reinsurance and its uses include:
* The definition of reinsurance,
* Reinsurance contracts,
* Reinsurance and risk transfer,
* The 9a and 9b "tests" for risk transfer,
* The benefits of statutory reinsurance accounting for insurers, and:
* Reinsurance contracts permit the transfer of varying levels of risk.
Definition:
The Reinsurance Association of America defines reinsurance as:
A transaction whereby the assuming reinsurer, for a payment, agrees to
indemnify the ceding insurer against all, or a part, of the loss which
the latter may sustain under the policy or policies which it has
issued.
Reinsurance Contracts:
Reinsurance is not sold as a standardized product. Each contract is
separately negotiated.
Regulators look for risk transfer in each contract to determine if
reinsurance has occurred.
Two basic methods of assuming risks in reinsurers' contracts are:
* Treaty reinsurance, which usually covers a part or a percentage of a
book of an insurer's business, for example, all of an insurer's medical
malpractice policies with hospitals; and
* Facultative reinsurance, which covers individual policies, usually of
a unique nature, for example, an insurer's medical malpractice policy
with the Mayo Clinic.
Reinsurance and Risk Transfer:
Statement of Statutory Accounting Principles:
Reinsurance is the assumption by an insurer of all or part of an
insurance risk undertaken originally by another reinsurer. (Accounting
Practices and Procedures Manual, NAIC, underlining added)
Statement of Financial Accounting Standards:
Insurance provides indemnification against loss or liability from
specified events during a specified period. The insurer (or ceding
enterprise) pays (cedes) an amount to the reinsurer, and the reinsurer
agrees to reimburse the insurer for a specified portion of claims paid
under the reinsured contracts indemnification against loss or liability
under a reinsurance contract generally referred to as risk transfer.
(Financial Accounting Standard No. 113, underlining added)
Reinsurance and Risk Transfer:
Risk transfer requires that the reinsurer indemnifies the insurer for
unexpected losses.
Insurance risk does not include investment risk.
Insurance regulators bear responsibility for determining whether risk
transfer has occurred for statutory purposes.
Risk transfer is determined by applying financial and statutory
accounting guidelines:
* Reinsurer assumes significant insurance risk under the reinsured
portions of the contract ("9a test"), and:
* It is reasonably possible that the reinsurer may realize significant
loss ("9b test").
The 9a and 9b Tests for Risk Transfer:
9a test:
* The amount and timing of reinsurer's claims settlements should vary
directly with the severity and timing of the loss event.
* The extent of risk transfer is determined by examining contract
features.
9b test:
The 10/10 rule means the reinsurer has a 10 percent or greater chance
of incurring a 10 percent or greater loss of the premium under the
contract. While regulators do not universally agree with the "10/10
rule," it is commonly used by industry.
The extent of risk transfer is determined through risk transfer
analysis, but it can yield different results.
If a reinsurer's contract passes the 9a and 9b tests to the regulator's
satisfaction, reinsurance accounting can be applied to the entire
contract.
Benefits of Statutory Reinsurance Accounting for Insurers:
Insurers attempt to structure reinsurance contracts to transfer
sufficient risk to qualify for reinsurance accounting in order to
* Improve net income on the income statement,
* Improve the surplus on the balance sheet,
* Improve the regulatory ratios used for solvency regulation, and:
* Increase the insurers ability to write more policies with existing
capital.
Reinsurance Contracts Permit the Transfer of Varying Levels of Risk:
Simple quota share reinsurance is a basic form of treaty reinsurance
contract that fully transfers risk. In this contract, insurer and
reinsurer share all business in a fixed proportion. For example, in a
70 percent quota share, 70 percent of premiums, losses, and loss
expenses would be ceded to the reinsurer, while 30 percent would be
retained by the insurer.
Elements added to a simple contract may limit risk transfer:
* By adding certain types of features into the contract (for example, a
sliding scale ceding commission), or:
* Through verbal and written side agreements that limit risk transfer.
Finite Risk Contracts:
Finite risk contracts are a mechanism for limiting risk transfer. We
discuss:
* Their definition,
* Their purposes,
* Current domestic and international scrutiny, and:
* Organizations reviewing finite risk issues.
Definition:
Finite risk contracts:
* Have no global definition;
* Are called by many other names, such as financial reinsurance,
financial engineering reinsurance, or structured reinsurance;
* Can take place between a reinsurer and an insurer, or an insurer and
a noninsurance entity;
* May transfer to a reinsurer less insurance risk than traditional
insurance or no insurance risk while emphasizing other features; and:
* May cost less than traditional insurance or reinsurance.
Purposes:
Insurers may structure finite risk contracts to appear like traditional
reinsurance:
* To qualify for preferential accounting and tax treatment while
transferring minimal insurance risk;
* To maintain certain financial ratios, such as premiums to surplus,
within acceptable or favorable limits for regulators, rating agencies,
and investors; or:
* For financing purposes, such as spreading multiyear timing risks,
that have priority over transferring insurance risk (for example, long-
tail risks).
Similarly, noninsurers might use finite risk contracts for smoothing
earnings by deferring recognition of losses on major events that might
otherwise be fully charged against current earnings, or for evenly
spreading cash outflows associated with such events.
Such contracts, if not legitimately structured, may result in
misleading financial statements.
Domestic and International Scrutiny:
International and U.S. organizations are reviewing issues related to
finite risk contracts such as:
* Disclosure requirements for finite risk contracts,
* Certification by company officials,
* Different accounting treatments for insurance risks and noninsurance
risks when a reinsurance contract contains more than insurance risks
("unbundling"), and:
* What constitutes the transfer of insurance risk.
NAIC has approved new requirements for property-casualty insurers that
include:
* Insurers reporting contract terms and management objectives for
certain finite reinsurance contracts, and:
* CEO and CFO attesting that no side agreements exist and that risk has
transferred.
Organizations Reviewing Finite Risk Issues:
U. S. organizations currently reviewing finite risk issues include
* NAIC,
* The American Academy of Actuaries,
* The Casualty Actuarial Society,
* The Financial Accounting Standards Board, and:
* The Internal Revenue Service.
International organizations currently reviewing finite risk issues
include:
* The International Accounting Standards Board, and:
* The International Association of Insurance Supervisors.
Summary:
Insurance has no single, universal definition, but definitions have key
elements of risk transfer and risk spreading.
Although definitions of insurance differ among some states and certain
products are not universally recognized and regulated as insurance
across all states, states generally define and regulate the same
products as insurance.
Products that cover insurance risks in more than one category (life,
accident, health, property-casualty) could face uncertain regulation if
separate insurance definitions are developed for each category.
While reinsurance contracts can transfer various levels of insurance
and noninsurance risks, contracts that transfer sufficient insurance
risk are defined entirely as reinsurance and qualify for reinsurance
accounting.
Some finite risk contracts that received reinsurance accounting or
other preferred accounting treatment were later found to have
transferred insufficient insurance risk to qualify for such treatment.
[End of slide presentation]
[End of section]
(250230):
FOOTNOTES
[1] For example, the Gramm-Leach-Bliley Act, section 302(c) defines
insurance by, among other things, making reference to state insurance
laws (see slide 8).
[2] The Jordan case focused on insurance contracts that also contained
noninsurance features and looked at both the insurance and noninsurance
features to determine the "principal object and purpose" of the
contract Jordan v. Group Health Ass'n., 107 F.2d 239, 247-48 (D.C. Cir.
1939). The Griffin case articulated four elements of an insurance
contract: (1) a contract between an insurer and insured that exists for
a specific period of time, (2) an insurable interest possessed by the
insured, (3) consideration in the form of a premium paid by the insured
to the insurer, and (4) the assumption of risk by the insurer who
agrees to indemnify the insured for potential loss resulting from
specified perils Griffin Systems v. Washburn, 505 N.E.2d 1121, 1123-24
(Ill. App. Dist. 1987).
[3] An example of a statutory definition that is stated generally is:
"Insurance is a contract whereby one undertakes to indemnify another or
pay a specified amount upon determinable contingencies."
[4] Accident insurance is a form of health insurance against loss by
accidental bodily injury. ("Fundamentals of Risk and Insurance," by
Emmett J. Vaughan and Therese Vaughan).
[5] For clarity, contracts that do not transfer sufficient insurance
risk can be referred to as "reinsurer's contracts."
[6] The NAIC issues Statements of Statutory Accounting Principles
(SSAP) that provide guidance for required filings of insurance company
financial statements to state insurance regulators and the NAIC.
Another accounting organization, the Financial Accounting Standards
Board, also establishes financial accounting and reporting standards--
Statement of Financial Accounting Standards--some of which are
specifically for insurance and reinsurance companies and transactions.
NAIC's Statement of Statutory Accounting Principles No. 62 and FASB's
Statement of Financial Accounting Standards No. 113, paragraphs 9a and
9b, establish the necessary conditions of risk transfer for contracts:
(1) "reinsurer assumes significant insurance risk under the reinsured
portions of the contract" (commonly called the "9a test") and (2) "It
is reasonably possible that the reinsurer may realize significant loss"
(commonly called the "9b test").