Insurance in the United States
Insurance in the United States refers to the market for risk in the
United States of America. Some main features of insurance could be said to be,
*the benefit provided by a particular kind of indemnity contract, called an insurance policy;
*that is issued by one of several kinds of legal entities (
stock insurance company, mutual insurance company, reciprocal, or Lloyd's syndicate, for example), any of which may be called an insurer;
*in which the insurer promises to pay on behalf of or to indemnify another party, called a policyholder or insured;
*that protects the insured against loss caused by those perils subject to the indemnity in exchange for consideration known as an insurance premium.
The first insurance company in the
United Statesunderwrote fire insurance and was formed in Charles Town (modern-day Charleston), South Carolina, in 1732. Benjamin Franklinhelped to popularize and make standard the practice of insurance, particularly against firein the form of perpetual insurance. In 1752, he founded the [http://www.contributionship.com/ Philadelphia Contributionship for the Insurance of Houses from Loss by Fire] . Franklin's company was the first to make contributions toward fire prevention. Not only did his company warn against certain fire hazards, it refused to insure certain buildings where the risk of fire was too great, such as all wooden houses.
Insurance is primarily regulated at the state level. The federal
McCarran-Ferguson Act, passed in 1945, established that federal acts that do not expressly purport to regulate the "business of insurance" do not preempt state laws and regulations that regulate the "business of insurance." Each state operates independently to regulate their own insurance markets, typically through a state department of insurance. Model acts and regulations promulgated by the National Association of Insurance Commissioners(NAIC) provide some degree of uniformity between states. These models do not have the force of law and have no effect unless they are adopted by a state. They are, however, used as guides by most states, and some states adopt them with little or no change. In recent years, some have called for a dual state and federal regulatory system for insurance similar to that which oversees state banks and national banks.Fact|date=April 2008
In the state of
New York, which has unique laws in keeping with its stature as a global business center, former New York Attorney General Eliot Spitzerwas in a unique position to grapple with major national insurance brokerages. Spitzer alleged that Marsh & McLennan steered business to insurance carriers based on the amount of contingent commissions that could be extracted from carriers, rather than basing decisions on whether carriers had the best deals for clients.Fact|date=April 2008 Several of the largest commercial insurance brokerages have since stopped accepting contingent commissions and have adopted new business models.Fact|date=April 2008
In recent years this kind of operational definition proved inadequate as a result of contracts that had the form but not the substance of insurance. The essence of insurance is the transfer of risk from the insured to one or more insurers. How much risk a contract actually transfers proved to be at the heart of the controversy. This issue arose most clearly in reinsurance, where the use of Financial Reinsurance to reengineer insurer balance sheets under
US GAAPbecame fashionable during the 1980s. The accounting profession raised serious concerns about the use of reinsurance in which little if any actual risk was transferred, and went on to address the issue in FAS 113, cited above. While on its face, FAS 113 is limited to accounting for reinsurance transactions, the guidance it contains is generally conceded to be equally applicable to US GAAP accounting for insurance transactions executed by commercial enterprises.
Risk transfer requirement
FAS 113 contains two tests, called the '9a and 9b tests,' that collectively require that a contract create a reasonable chance of a significant loss to the underwriter for it to be considered insurance.
9. Indemnification of the ceding enterprise against loss or liability relating to insurance risk in reinsurance of short-duration contracts requires both of the following, unless the condition in paragraph 11 is met:
a. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance contracts.
b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction.
Paragraph 10 of FAS 113 makes clear that the 9a and 9b tests are based on comparing the
present valueof all costs to the PV of all income streams. FAS gives no guidance on the choice of a discount rateon which to base such a calculation, other than to say that all outcomes tested should use the same rate.
Statement of Statutory Accounting Principles ("SSAP") 62, issued by the
National Association of Insurance Commissioners, applies to so-called 'statutory accounting' - the accounting for insurance enterprises to conform with regulation. Paragraph 12 of SSAP 62 is nearly identical to the FAS 113 test, while paragraph 14, which is otherwise very similar to paragraph 10 of FAS 113, additionally contains a justification for the use of a single fixed rate for discounting purposes. The choice of an "reasonable and appropriate" discount rate is left as a matter of judgment.
No brightline test
Neither FAS 113 nor SAP 62 defines the terms "reasonable" or "significant". Ideally, one would like to be able to substitute values for both terms. It would be much simpler if one could apply a test of an X percent chance of a loss of Y percent or greater. Such tests have been proposed, including one famously attributed to an SEC official who is said to have opined in an after lunch talk that a 10 percent chance of a 10 percent loss was sufficient to establish both reasonableness and significance. Indeed, many insurers and reinsurers still apply this 10/10" test as a benchmark for risk transfer testing.
It should be obvious that an attempt to use any numerical rule such as the 10/10 test will quickly run into problems. Implicit in the test is keeping the 10/10 that either are upper bonds for the comment made by the SEC official therefore, the rest of this paragraph doesn't apply. Suppose a contract has a 1 percent chance of a 10,000 percent loss? It should be reasonably self-evident that such a contract is insurance, but it fails one half of the 10/10 test.
It does not appear that any brightline test of reasonableness nor significance can be constructed.
Excess of loss contracts, like those commonly used for umbrella and general liability insurance, or to insure against property losses, will typically have a low ratio of premium paid to maximum loss recoverable. This ratio (expressed as a percentage), commonly called the "rate on line" for historical reasons related to underwriting practices at Lloyd's of London, will typically be low for contracts that contain reasonably self-evident risk transfer. As the ratio increases to approximate the present value of the limit of coverage, self-evidence decreases and disappears.
Contracts with low rates on line may survive modest features that limit the amount of risk transferred. As rates on line increase, such risk limiting features become increasingly important.
"Safe harbor" exemptions
The analysis of reasonableness and significance is an estimate of the probability of different gain or loss outcomes under different loss scenarios. It takes time and resources to perform the analysis, which constitutes a burden without value where risk transfer is reasonably self-evident.
Guidance exists for insurers and reinsurers, whose CEO's and CFO's attest annually as to the reinsurance agreements their firms undertake. The American Academy of Actuaries, for instance, identifies three categories of contract as outside the requirement of attestation:
*Inactive contracts. If there are no premiums due nor losses payable, and the insurer is not taking any credit for the reinsurance, determining risk transfer is irrelevant.
*Pre-1994 contracts. The attestation requirement only applies to contracts that were entered into, renewed or amended on or after 1 January 1994. Prior contracts need not be analyzed.
*Where risk transfer is "reasonably self-evident."
Risk limiting features
An insurance policy should not contain provisions that allow one side or the other to unilaterally void the contract in exchange for benefit. Provisions that void the contract for failure to perform or for fraud or material misrepresentation are ordinary and acceptable.
The policy should have a term of not more than about three years. This is not a hard and fast rule. Contracts of over five years duration are classified as ‘long-term,’ which can impact the accounting treatment, and can obviously introduce the possibility that over the entire term of the contract, no actual risk will transfer. The coverage provided by the contract need not cease at the end of the term (e.g., the contract can cover occurrences as opposed to claims made or claims paid).
The contract should be considered to include any other agreements, written or oral, that confer rights, create obligations, or create benefits on the part of either or both parties. Ideally, the contract should contain an ‘Entire Agreement’ clause that assures there are no undisclosed written or oral side agreements that confer rights, create obligations, or create benefits on the part of either or both parties. If such rights, obligations or benefits exist, they must be factored into the tests of reasonableness and significance.
The contract should not contain arbitrary limitations on timing of payments. Provisions that assure both parties of time to properly present and consider claims are acceptable provided they are commercially reasonable and customary.
Provisions that expressly create actual or notional accounts that accrue actual or notional interest suggest that the contract contains, in fact, a deposit.
Provisions for additional or return premium do not, in and of themselves, render a contract something other than insurance. However, it should be unlikely that either a return or additional premium provision be triggered, and neither party should have discretion regarding the timing of such triggering.
All of the events that would give rise to claims under the contract cannot have materialized prior to the inception of the contract. If this "all events" test is not met, then the contract is considered to be a retroactive contract, for which the accounting treatment becomes complex.
Other US insurance topics:
Health insurance in the United States
Insurance Regulatory Information System
National Association of Insurance Commissioners
General insurance topics:
History of insurance
Insurance systems in other countries:
Insurance in Australia
Insurance in India
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