Chapter1. Basic Principles of Life and Health Insurance and Annuities

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THE ROLE OF INSURANCE

Death may strike anyone prematurely. When death takes the life of a family provider, surviving family members often suffer if they are left without adequate income or the means to provide even basic necessities.

However, some people face the unpleasant prospect of outliving their income. Retirement may be forced upon them before they have adequately prepared for a non-income earning existence. Sickness and disability can also leave economic scars, often more intense than death.

Insurance evolved to produce a practical solution to economic uncertainties and losses. Health insurance also evolved from scientific principles to provide funds for medical expenses due to sickness or injury and to cover loss of income during a disability. Annuities provide income by making a series of payments to the annuitant for a specific period of time or for life.

AN INDUSTRY OVERVIEW

Reserves

Reserves are the accounting measurement of an insurer’s future obligations to its policyholders. They are classified as liabilities on the insurance company’s accounting statements since they must be settled at a future date. ► Liquidity indicates a company’s ability to make unpredictable payouts to policyowners.

Types of Insurance Companies

There are many ways to classify organizations that provide insurance. In the broadest of terms, there are two classifications: private commercial and government. Within these two classes are many categories of insurance providers as well as insurance plans and insurance producers.

Private Insurance Companies - Commercial

Commercial insurers offer many lines of insurance. Some sell primarily life insurance and annuities, while others sell accident and health insurance, or property and casualty insurance. Companies that sell more than one line of insurance are known as multi-line insurers.

Stock Companies - Nonparticipating

A stock insurance company is a private organization, organized and incorporated under state laws for the purpose of making a profit for its stockholders (shareholders). It is structured the same as any corporation. Stockholders may or may not be policyholders. When declared, stock dividends are paid to stockholders. In a stock company, the directors and officers are responsible to the stockholders. A stock company is referred to as a nonparticipating company because policyholders do not participate in dividends resulting from stock ownership.

Mutual Companies - Participating

Mutual insurance companies are also organized and incorporated under state laws, but they have no stockholders. Instead, the owners are the policyholders. Anyone purchasing insurance from a mutual insurer is both a customer and an owner. He has the right to vote for members of the board of directors. By issuing participating policies that pay policy dividends, mutual insurers allow their policyowners to share in any company earnings. Essentially, policy dividends represent a “refund” of the portion of premium that remains after the company has set aside the necessary reserves and has made deductions for claims and expenses. Policy dividends can also include a share in the company’s investment, mortality, and operating profits. Surpluses are typically distributed to policyowners on an annual basis.

Mutual companies are sometimes referred to as participating companies because the policyowners participate in dividends. Occasionally, a stock company may be converted into a mutual company through a process called mutualization. Likewise, mutuals can convert to stock companies through a process called demutualization. Stock and mutual companies are often referred to as commercial insurers. They both can write life, health, property, and casualty insurance.

Strong Assessment Mutual/Insurers

Assessment mutual companies are classified by the way in which they charge premiums. A pure assessment mutual company operates on the basis of loss-sharing by group members. No premium is payable in advance. Instead, each member is assessed an individual portion of losses that actually occur. An advance premium assessment mutual charges a premium at the beginning of the policy period. If the original premiums exceed the operating expenses and losses, the surplus is returned to the policyholders as dividends. However, if total premiums are not enough to meet losses, additional assessments are levied against the members. Normally, the amount of assessment that may be levied is limited either by state law or simply as a provision in the insurer’s by-laws.

Reciprocal Insurers

Similar to mutuals, reciprocal insurers are organized on the basis of ownership by their policyholders. However, with reciprocals, it is the policyholders themselves who insure the risks of the other policyholders. Each policyholder assumes a share of the risk brought to the company by others. Reciprocals are managed by an attorney-in-fact.

Lloyd’s of London

Contrary to popular belief, Lloyd’s of London is not an insurer but rather a syndicate of individuals and companies that individually under­write insurance. Lloyd’s can be compared to the New York Stock Exchange, which provides the arena and facilities for buying and selling public stock. Lloyd’s function is to gather and disseminate underwriting information, help its associates settle claims and disputes and, through its member underwriters, provide coverages that might otherwise be unavailable in certain areas.

Reinsurers

Reinsurers are a specialized branch of the insurance industry because they insure insurers. Reinsurance is an arrangement by which an insurance company transfers a portion of a risk it has assumed to another insurer. Usually, reinsurance takes place to limit the loss any one insurer would face should a very large claim become payable. Another reason for reinsurance is to enable a company to meet certain objectives, such as favorable underwriting or mortality results. The company transferring the risk is called the ceding company; the company assuming the risk is the reinsurer. A common reinsurance contract between two insurance companies is called treaty reinsurance, which involves an automatic sharing of the risks assumed.

Captive Insurer

An insurer established and owned by a parent firm for the purpose of insuring the parent firm’s loss exposure is known as a captive insurer.

Risk Retention Group

A risk retention group (RRG) is a mutual insurance company formed to insure people in the same business, occupation, or profession (e.g., pharmacists, dentists, or engineers).

Fraternal Benefit Societies

Insurance is also issued by fraternal benefit societies, which have existed in the United States for more than a century. Fraternal societies, noted primarily for their social, charitable, and benevolent activities, have memberships based on religious, national, or ethnic lines. Fraternals first began offering insurance to meet the needs of their poorer members, funding the benefits on a pure assessment basis. Today, few fraternals rely on an assessment system, most having adopted the same advanced funding approach other insurers use. To be characterized as a fraternal benefit society, the organization must be nonprofit, have a lodge system that includes ritualistic work, and maintain a representative form of government with elected officers. Fraternals must be formed for reasons other than obtaining insurance. Most fraternals today issue group and annuities with many of the same provisions found in policies issued by commercial insurers.

Industrial Insurer

Insurance is also sold through a special branch of the industry known as home service or “debit” insurers. These companies specialize in a particular type of insurance called industrial insurance, which is characterized by relatively small face amounts (usually $1,000 to $2,000) with premiums paid weekly.

Service Providers

Service providers offer benefits to subscribers in return for the payment of a premium. Benefits are in the form of services provided by the hospitals and physicians participating in the plan. They sell medical and hospital care services, not insurance. These services are packaged into various plans, and those who purchase these plans are known as subscribers.

Another type of service provider is the health maintenance organization (HMO). HMOs offer a wide range of health care services to member subscribers. For a fixed periodic premium paid in advance of any treatment, subscribers are entitled to the services of certain physicians and hospitals contracted to work with the HMO. Unlike commercial insurers, HMOs provide financing for health care plus the health care itself. HMOs are known for stressing preventive health care and early treatment programs.

A third type of service provider is the preferred provider organization (PPO). Under the usual PPO arrangement, a group desiring health care services (e.g., an employer or a union) will obtain price discounts or special services from certain select health care providers in exchange for referring its employees or members to them. PPOs can be organized by employers or by the health care providers themselves. The contract between the employer and the health care professional, whether physician or a hospital, spells out the kind of services to be provided. Insurance companies can also contract with PPOs to offer services to insureds.

Government as Insurer

As noted at the beginning of this unit, federal and state governments are also insurers, providing what are commonly called social insurance programs. Ranging from crop insurance to bank and savings and loan deposit insurance, these programs have far-reaching effects. Millions of people rely on these plans. Social insurance programs include the following:

► Old-Age, Survivors, and Disability Insurance (OASDI), commonly known as Social Security

► Social Security Hospital Insurance (HI) and Supplemental Medical Insurance (SMI), commonly known as Medicare

► Medicaid

The government plays a vital role in providing social insurance programs. These programs pay billions of dollars in benefits every year and affect mil­lions of people.

Self-Insurers

Though self-insurance is not a method of transferring risk, it is an important concept to understand. Rather than transfer risk to an insurance company, a self-insurer establishes its own self-funded plan to cover potential losses. Self-insurance is often used by large companies for funding pension plans and some health insurance plans. Many times, a self-insurer will look to an insurance company to provide insurance above a certain maximum level of loss. The self-insurer will bear the amount of loss below that maximum amount.

How Insurance is Sold

Insurance is sold by a variety of companies and methods. Most consumers purchase insurance through licensed producers who present insurers’ products and services to the public via active sales and marketing methods. Insurance producers may be agents, who represent a particular company, or brokers, who are not tied to any particular company and can represent many insurers’ products. In a sales transaction, agents represent the insurer and brokers represent the buyer. An agent has an agent’s contract; a broker has a broker’s contract. Agents are also classified as captive or career agents and independent agents. A captive or career agent works for one insurance company and sells only that company’s insurance policies. An independent agent works for himself and sells the insurance products of many companies.

  • The agent’s contract and appointment with the insurance company grants the authority to bind an insurer to an insurance contract

In any dispute between the insured or beneficiary and the insurer, the agent who solicits an insurance application represents the insurer and not the insured or beneficiary. In most states, however, the agent may represent as many insurers as will appoint him. There are three systems that support the sale of insurance through agents and brokers. These are the career agency system, personal producing general agency system, and independent agency system.

Career Agency System

Career agencies are branches of major stock and mutual insurance companies that are contracted to represent an insurer in a specific area. In career agencies, insurance agents are recruited, trained, and supervised by either a manager employee of the company or a general agent (GA) who has a vested right in any business written by the GA’s agents. GAs may operate strictly as managers, or they may devote a portion of their time to sales. The career agency system focuses on building sales staffs.

Personal Producing General Agency System

The personal producing general agency (PPGA) system is similar to the career agency system. However, PPGAs do not recruit, train, or supervise career agents. They primarily sell insurance, although they may build a small sales force to assist them. PPGAs are generally responsible for maintaining their own offices and administrative staff. Agents hired by a PPGA are considered employees of the PPGA, not the insurance company, and are supervised by regional directors.

Independent Agency System

The independent agency system, a creation of the property and casualty industry, does not tie a sales staff or agency to any one particular insurance company. Instead, independent agents represent any number of insurance companies through contractual agreements. They are compensated on a commission or fee-basis for the business they produce. This system is also known as the American agency system.

Independent agent represent any number of insurance companies through contractual agreements.

Other Methods of Selling Insurance

While most insurance is sold through agents or brokers under the systems previously described, a large volume is also marketed through direct selling and mass marketing methods.

With the direct selling method, the insurer deals directly with consumers by selling its policies through vending machines, advertisements, or salaried sales representatives. No agent or broker is involved. A large volume of insurance is also sold through mass marketing techniques, such as over the Internet, newspaper, magazine, radio, and television ads. Mass marketing methods provide exposure to large groups of consumers, often using direct selling methods with occasional follow-up by agents.

Evolution of Industry Oversight

The insurance industry is regulated by a number of authorities, including some inside the industry itself. The primary purpose of this regulation is to promote public welfare by maintaining the solvency of insurance companies. Other purposes are to provide consumer protection and ensure fair trade practices as well as fair contracts at fair prices. It is very important insurance agents understand and obey the insurance laws and regulations.

History of Regulation

A brief overview of the history of insurance regulation will show a seesaw between the authority of the states and the federal government. Though a balance between these two bodies has been reached and maintained for many years, arguments favoring control by one governing authority over another are still being waged.

► 1868-Paul v. Virginia. This case, which was decided by the U.S. Supreme Court, involved one state’s attempt to regulate an insurance company domiciled in another state. The Supreme Court sided against the insurance company, ruling that the sale and issuance of insurance is not interstate commerce, thus upholding the right of states to regulate insurance. ► 1944-United States v. Southeastern Underwriters Association (SEUA). The decision of Paul v. Virginia held for 75 years before the Supreme Court again addressed the issue of state versus federal regulation of the insurance industry. In the SEUA case, the Supreme Court ruled that the business of insurance is subject to a series of federal laws, many of which were in conflict with existing state laws, and that insurance is a form of interstate commerce to be regulated by the federal government. This decision did not affect the power of states to regulate insurance, but it did nullify state laws that were in conflict with federal legislation. The result of the SEUA case was to shift the balance of regulatory control to the federal government. ► 1945-The McCarran-Ferguson Act. The turmoil created by the SEUA case prompted Congress to enact Public Law 15, the McCarran-Ferguson Act. This law made it clear that continued regulation of insurance by the states was in the public’s best interest. However, it also made possible the application of federal antitrust laws “To the extent that [the insurance business] is not regulated by state law.” This act led each state to revise its insurance laws to conform to the federal laws. Today, the insurance industry is considered to be state-regulated.

  • A fine of $10,000 or up to one year in jail is the penalty for any person who violates the McCarran-Ferguson Act

    The National Conference of Insurance Legislators (NCOIL) was formed to help legislators make informed decisions on insurance issues that affect their constituents and to declare opposition to federal encroachment of state authority to oversee the business of insurance, as authorized under the McCarran-Ferguson Act of 1945.

► 1958-lntervention by the FTC. In the mid-1950s the Federal Trade Commission (FTC) sought to control the advertising and sales literature used by the health insurance industry. In 1958 the Supreme Court held that the McCarran-Ferguson Act disallowed such supervision by the FTC, a federal agency. Additional attempts have been made by the FTC to force further federal control, but none have been successful.

► 1959-lntervention by the SEC. In this instance, the issue was variable annuities: Are the insurance products to be regulated by the states or securities to be regulated federally by the Securities and Exchange Commission (SEC)? The Supreme Court ruled that federal securities laws applied to insurers that issued variable annuities and, thus, required these insurers to conform to both SEC and state regulation. The SEC also regulates variable life insurance.

► 1970-Fair Credit Reporting Act. In an attempt to protect an individual’s right to privacy, the federal government passed the Fair Credit Reporting Act, which is the authority that requires fair and accurate reporting of information about consumers, including applications for insurance. Insurers must inform applicants about any investigations that are being made. If any consumer report is used to deny coverage or charge higher rates, the insurer must furnish to the applicant the name of the reporting agency conducting the investigation. Any insurance company that fails to comply with this act is liable to the consumer for actual and punitive damages.

  • The maximum penalty for obtaining Consumer Information Reports under false pretenses is $5,000 and 1 year imprisonment

► 1999-Financial Services Modernization Act. The Glass-Steagall Act of 1933, which barred common ownership of banks, insurance companies, and securities firms and erected a regulatory wall between banks and nonfinancial companies, came under repeated attack in the 1980s. In 1999 Congress passed the Financial Services Modernization Act, which repealed the Glass Steagall Act. Under this new legislation, commercial banks, investment banks, retail brokerages, and insurance companies can now enter each other’s lines of business. The chronology cited reflects the roles the courts and the federal government have played in regulating the insurance industry. Let’s now take a look at how individual states regulate this business and how the industry practices self-regulation.

Agent Marketing and Sales Practices

Marketing and selling financial products, such as life insurance and annuities, requires a high level of professionalism and ethics. Every state requires its licensed producers to adhere to certain standards designed to protect consumers and promote suitable sales and application of insurance products. Some of these standards are listed below.

► Selling to needs. The ethical agent determines the client’s needs and then determines which is best suited to address those needs. Two principles of needs-based selling include find the facts, and educate the client.

► Suitability of recommended products. The ethical agent assesses the correlation between a recommended product and the client’s needs and capabilities by asking and answering the following questions. 1. What are the client’s needs? 2. What product can help meet those needs? 3. Does the client understand the product and its provisions? 4. Does the client have the capability, financially and otherwise, to manage the product? 5. Is this product in the client’s best interest? ► Full and accurate disclosure. The ethical agent makes it a practice to inform clients about all aspects of the products recommended, including benefits and limitations. There should never be an attempt to hide or disguise the nature or purpose of the product nor the company being represented. Insurance products are highly effective financial planning tools. They should be presented clearly, completely, and accurately. ► Documentation. The ethical agent documents each client meeting and transaction. The agent uses fact-finding forms and obtains the client’s written agreement for the needs determined, the products recommended, and the decisions made. Some documentation is required by state law. Ethical agents know these laws and follow them precisely.

► Client service. The ethical agent knows that a sale does not mark the end of a relationship with a client, but the beginning. Routine follow-up calls are recommended to ensure that the client’s needs always are covered and the products in place still are suitable. When clients contact their agents for service or information, these requests are given top priority. Complaints are handled promptly and fully.

Buyer’s Guides and Policy Summaries

To help ensure that prospective insurance buyers select the most appropriate plan for their needs and to improve their understanding of basic product features, most states require agents to deliver a buyer’s guide to consumers whenever they solicit insurance sales. These guides explain the various types of life insurance products (including variable annuities) in a way that the average consumer can understand. In addition, a policy summary containing information about the specific policy being recommended must be given to a potential buyer. It identifies the agent, the insurer, the policy, and each rider, and includes information about premiums, dividends, benefit amounts, cash surrender values, policy loan interest rates, and life insurance cost indexes of the specific policy being considered. Most states require this to be done before the applicant’s initial premium is accepted. The policy summary also contains cost indexes that help the consumer evaluate the suitability of the recommended product. The net payment cost comparison index gives the buyer an idea of the cost of the policy at some future point in time compared to the death benefit. The surrender cost comparison index compares the cost of surrendering the policy and withdrawing the cash values at some future time. Because all states are interested in protecting the interests of the buying public, the actions of individuals soliciting insurance sales are strictly regulated. However, the laws regarding insurance marketing and trade practices vary from state to state. As a result, it is very important that you examine and understand your state’s laws.

A buyer’s guide and policy summary must be given to applicants before initial premium accepted.

National Association of Insurance Commissioners

All state insurance commissioners or directors are members of the National Association of Insurance Commissioners (NAIC). This organization has committees that work regularly to examine various aspects of the insurance industry and to recommend appropriate insurance laws and regulations. The NAIC has four broad objectives:

  1. To encourage uniformity in state insurance laws and regulations
  2. To assist in the administration of those laws and regulations by promoting efficiency
  3. To protect the interests of policyowners and consumers
  4. To preserve state regulation of the insurance business

Advertising Code

A principal problem of states in the past was regulating misleading insurance advertising and direct mail solicitations. Many states now subscribe to the Advertising Code developed by the NAIC. The Code specifies certain words and phrases that are considered misleading and are not to be used in advertising of any kind. Also required under this code is full disclosure of policy renewal, cancellation, and termination provisions.

Unfair Trade Practices Act

Most jurisdictions have also adopted the NAIC’s Unfair Trade Practices Act. This act gives chief financial officers the power to investigate insurance companies and producers, to issue cease and desist orders, and to impose penalties. The act also gives officers the authority to seek a court injunction to restrain insurers from using any methods believed to be unfair. Included in the context of unfair trade practices are misrepresentation and false advertising, coercion and intimidation, unfair discrimination, and inequitable administration of claims settlements.

State Guaranty Associations

All states have established guaranty funds or guaranty associations to support insurers and to protect consumers if an insurer becomes insolvent. Should an insurer be financially unable to pay its claims, the state guaranty association will step in and cover the consumers’ unpaid claims. These state associations are funded by insurance companies through assessments.

Rating Services

The financial strength and stability of an insurance company are two vitally important factors to potential insurance buyers and to insurance companies. The PRIMARY purpose of a rating service company, such as A.M. Best, Standard & Poor’s, and Moody’s, is to determine the financial strength of the company being rated.

  • A+: Superior ability to meet ongoing obligations.
  • AA-: Very strong capacity to meet policyholder & contract obligations.
  • AA-: Very strong financial security characteristics.
  • A1: Good financial security

Quiz

  • Question 1: What is the primary purpose of a rating service company such as A.M Best?

    • Determine which insurer offers the best rates
    • Determine which insurer offers the best policies
    • Determine financial strength of an insurance company <- The primary purpose of a rating service company is to determine the financial strength of the company being rated.
    • Determine which agent to use locally

  • Question 2: What is considered to be the primary reason for buying life insurance?

    • Provide death benefits <- The primary reason for purchasing life insurance is to provide death benefits.
    • Provide money for retirement
    • Provide living benefits
    • Provide money for college

  • Question 3: An insurer’s ability to make unpredictable payouts to policyowners is called

    • investment values
    • liquidity <- Liquidity indicates a company's ability to make unpredictable payouts to policyowners.
    • assets
    • capital

  • Question 4: Which of the following is NOT considered advertising?

    • A rating from a rating service company, such as A.M. Best <- An A.M. Best company rating is not considered advertising.
    • An illustration
    • A sales presentation
    • Direct mailing from an agency

  • Question 5: A plan in which an employer pays insurance benefits from a fund derived from the employer’s current revenues is called

    • A self-derived plan
    • A multiple-employer plan
    • A blanket plan
    • A self-funded plan <-

  • Question 5: A nonparticipating policy will

    • provide a return of premium
    • provide tax advantages
    • not pay dividends <- When an insurer offers a policy that is nonparticipating, the insurer's policy does not pay dividends.
    • give policyowners special privileges

  • Question 6: What kind of life insurance policy issued by a mutual insurer provides a return of divisible surplus (可分剩余)?

    • nonparticipating life insurance policy
    • participating life insurance policy <- A mutual insurer issues life insurance policies that provide a return of divisible surplus.
    • divisible surplus life insurance policy
    • straight life insurance policy

  • Question 7: Why are dividends from a mutual insurer not subject to taxation?

    • Because insurance premiums are tax-deductible
    • Because dividends are already subject to capital gains
    • Because dividends are payable directly to the policyholder
    • Because dividends are considered to be a return of premium <- Dividends are not subject to taxation because paying dividends is equivalent to returning a premium.

  • Question 9: A life insurance company has transferred some of its risk to another insurer. The insurer assuming the risk is called the

    • mutual insurer
    • reinsurer <- When risk is transferred from one insurer to another, the insurer assuming the risk is called the reinsurer.
    • reciprocal insurer
    • participating insurer

  • Question 10: A nonparticipating company is sometimes called a(n)

    • alien insurer
    • mutual insurer
    • reinsurer
    • stock insurer <- A stock insurer is referred to as a nonparticipating company because policyholders do not participate in dividends resulting from stock ownership.

  • Question 11: A type of insurer that is owned by its policyowners is called

    • domestic
    • mutual <- A mutual insurer is owned by its policyowners.
    • stock
    • in-house