The Business and Regulation of Insurance: A Primer
Most adults are familiar with what insurance companies do. In our personal lives and at work, we benefit from a wide variety of insurance products--auto insurance, property insurance, life insurance, and health insurance, to name a few. But few consumers of insurance products understand how insurance companies provide financial protection against accidents and illnesses. This lack of information can lead to frustration and misunderstandings if premiums increase or claims are refused.
This primer is intended to remove some of the mystery from insurance markets and insurance company operations. It describes the role insurance companies play in the economy. It also provides basic information about the insurance industry's size and the fundamentals of industry operations. Finally, the primer reviews insurance company regulation.
The value of insurance to policyholders is determined by the probability of an insured-against event occurring and the expected financial loss associated from the event. If an insurer attempts to charge policyholders premiums far in excess of their expected losses, individuals will refuse to purchase the insurance because the coverage provided is not worth the cost. When individuals can choose not to purchase insurance, insurance companies will be forced to base premiums on expected claims costs. As a result, private insurance companies in a competitive market typically do not "spread" risk in the sense of charging lower risk policyholders premiums that help cover the claims costs of higher risk insurance customers. Expected claims costs account for both the general level of insurance premiums and the differences in insurance premiums charged to different groups of policyholders.
The insurance industry is regulated by the states. There is no federal regulation of insurance. Each state is largely responsible for monitoring the solvency of insurance companies headquartered there. Guaranty funds, which protect claimants in the event of an insurance company's failure, are also operated by the states. Regulation of insurance contracts is typically undertaken by the state in which the policyholder resides. Contract regulation addresses the premiums charged and/or the terms of the contract. Insurance policies sold to individuals generally attract more regulatory attention than do commercial policies.
The state-based insurance regulatory system has been criticized (especially by federal lawmakers) because of differences that exist among the states in terms of the resources devoted to insurance regulation and the stringency with which various rules are applied. It is worth noting, however, that the insurance industry survived the economically tumultuous 1980s in better shape than did the federally regulated savings and loan or banking industries.
Important questions remain about state insurance regulation, however. For example, how far should regulators go in identifying appropriate investments for insurance companies? State-imposed limits on the premiums that insurance companies can charge also cause serious problems for some insurance companies. Rate regulation has, in some cases, led to reduced availability of insurance, making it difficult for consumers to find coverage they want to purchase.
The largest insurance companies in the country have substantial financial assets at their disposal. This creates the temptation to view insurers as “deep pockets,” capable of addressing society's financial ills. It is important to remember that the largest insurance companies also have substantial potential liabilities. Insurance companies required today to pay unexpected claims because of legal or regulatory interpretations of contractual terms that are overly generous to policyholders may not have the resources needed tomorrow to meet claims arising from other policyholders.
Furthermore, insurance companies are not charitable organizations. They are in business to make a profit. When regulatory policies prevent insurers from earning profits on a line (or lines) of insurance, the supply of the unprofitable line of insurance will be reduced. Insurance companies must answer to their stockholders just as companies do in any other industry. If insurance company owners can earn more money in another industry, they will take their capital elsewhere.
The development of private insurance markets benefits society generally. Businesses and individuals with insurance need not set aside funds for unforeseen contingencies. They can invest in other activities. The claims-based premiums charged by insurance companies also provide important information about the risk associated with different activities and how specific risks can be reduced.
Risk-based pricing also allows premiums to respond to the behavior of individuals. People who take care to make fewer claims should not be required to pay the same premiums as individuals who make more frequent claims on the system. It is not surprising that compensation systems without risk-sensitive pricing generally see claims costs rise as claims increase in number and average size.
Private insurance plays a role in the economic body similar to the nervous system in the human body. Just as a person's nervous system warns of danger through sensing pain and discomfort, a well-functioning insurance market sends signals to economic actors about riskier and less risky activities. Regulatory policies that interfere with the "insurance" process interfere with the "pain" signals insurers would normally send. When insurance premiums do not reflect differences in risk, society may not realize it is being "burned" until considerable damage has been done.