Assembly Insurance Committee Seminar Business of Insurance, Regulation and Public Policy Overview

1. INFORM+INSPIRE Assembly Insurance Committee SeminarBusiness of Insurance, Regulation and Public Policy Overview Robert W. Peterson Professor of Law Director, Center for Insurance Law and Regulation Santa Clara University School of Law The Griffith Insurance Education Foundation

2. Brief History of the Regulation of Insurance • Paul v. Virginia (1869) • Samuel Paul was a New York licensed agent who was selling insurance in Virginia • Virginia claimed he needed a Virginia license and could sell only from a Virginia company. • Paul argued insurance was “interstate commerce” and should not by subject to intrastate restrictions. I.e., it could not be regulated by the states. • The Supreme Court held that insurance was NOT interstate commerce and could/should be regulated by the states The Griffith Insurance Education Foundation

3. Brief History of the Regulation of Insurance • United States v. SEUA (1944) • SEUA was an association of insurers accuse of monopolistic pricing. • SEUA argued that they were not subject to Sherman Clayton and other FEDERAL monopolistic pricing laws because they were and could be regulated only by the states • The U.S. Supreme court decided insurance IS interstate commerce and could be regulated by the FEDERAL GOVERNMENT The Griffith Insurance Education Foundation

4. Brief History of the Regulation of Insurance • States who had been regulating insurance in the meantime, lobbied to keep their autonomy. • In 1945 Congress obliged by passing the McCarran-Ferguson Act • This act reasserted the federal right to regulate insurance, BUT • Left regulation to the states so long as the states are doing an adequate job. • The States joined in the NAIC (National Association of Insurance Commissioners) to flex this delegated power and to show Congress that they were, indeed, discharging their duty. --The NAIC recommends model laws to help effect some uniformity across the 50 states, but has no authority to enforce laws. The Griffith Insurance Education Foundation

5. Brief History of the Regulation of Insurance • All states passed rating laws providing that rates must be • adequate • not excessive • not unfairly discriminatory • “No rate shall be approved or remain in effect which is excessive, inadequate, unfairly discriminatory or otherwise in violation of this chapter.”¹ ¹ (CIC) sec. 1861.05(a). The Griffith Insurance Education Foundation

6. Why states regulate insurance: • Consumers (insured) pay in advance for a service of uncertain cost to be rendered in the future. • Some of these services are considered essential or important. • Solvency of insurers is critical to the ability to deliver this service. • Destructive competition or poor/dishonest management impairs the ability to deliver the service. The Griffith Insurance Education Foundation

7. Why states regulate insurance: • Insurance is complex – perhaps the only product where the consumer has no idea how much it “should” cost or what it is really “worth”. • “Slow pay/No pay” insurers frustrate this public purpose, so regulators regularly engage in “Market Conduct” examinations of insurers to assess whether they are delivering on their promise and complying with applicable statutes and regulations. • Because of their complexity, policy forms are also subject to regulation The Griffith Insurance Education Foundation

8. SOLVENCY • To insure solvency, regulators require insurers to maintain enough capital to service their obligations • Insurers use unique, conservative accounting rules (Statutory Accounting Principals—SAP) rather than Generally Accepted Account Principals (GAAP).¹ • Regulators inspect financials yearly or more frequently. ¹10 CCR sec. 2643.5 The Griffith Insurance Education Foundation

9. INSOLVENCY • Insolvent insurers will be seized by the regulator and be placed in receivership, liquidated, or sold to another insurer. • To protect policyholders, all states have guarantee funds. These are funded by assessments on the premiums of insurers in the state. • California Insurance Guarantee Fund (CIGA).¹ • Capped at $500,000 per claim (100% for Workers Compensation).² • Funded on a post assessment basis – i.e., insurers are assessed to cover insolvencies that have occurred. Generally 1% of written premium. • After insolvency of a number of large Workers Comp. carriers, CIGA issues bonds to fund coverage and assessed the premiums against insurers. There is a worker comp. special bond “CIGA” surcharge to service these bonds—generally 1%, but has been as high as 2% or 2.5%. ¹ CIC secs1063-1063.77 ² CIC sec. 1063.1(c)(7) The Griffith Insurance Education Foundation

10. CIGA PAYMENTS1987-2011 Note the spike in worker compensation payments. $8,568,629 in 2000 to $405,132,579 in 2001! Total payouts for auto and homeowners from 1987 to 2011 was $522,668,055. Total payout for worker compensation for the same period was $5,579,527,327! The Griffith Insurance Education Foundation

11. What happened? • Two factors: • the insolvency of a number of large workers compensation carriers and • there is no $500,000 cap on workers compensation. The Griffith Insurance Education Foundation

12. Why did the W.C. Insurers Become Insolvent? • W.C. Insurers’ Premiums were inadequate. • Individual discounting to Employers • Not subject to prior approval by Department of Insurance • Could it happen again? The Griffith Insurance Education Foundation

13. Why Insurers Become Insolvent • Note that Fraud outranks Catastrophe Losses. The Griffith Insurance Education Foundation

14. REGULATING INSURANCE RATES • 4 general ways states regulate insurance rates. The first three rely primarily on competition to set rates. They are: • OPEN COMPETITION • FILE AND USE. • USE AND FILE • The forth general method is: • PRIOR APPROVAL State systems are listed and compared at: http://www.iii.org/issue_updates/regulation-modernization.html The Griffith Insurance Education Foundation

15. THE MAIN EVENT – CALIFORNIA SO YOU WANT TO INTRODUCE A BILL? Let’s take a concrete example: to enhance competition and lower costs, assume you want to allow a policyholder’s new auto insurer to offer the same loyalty (“persistency”) discount that a previous insurer is offering. What is the political/regulatory matrix in which you must operate? The Griffith Insurance Education Foundation

16. THE MAIN EVENT – CALIFORNIA • California’s current insurance regulatory scheme emerged from the smoke of the “Tort Wars” of the late 1980s. • In 1988 there were 5 propositions on the California ballot addressing torts or insurance. The only one to prevail (by slightly less than 51% of the vote) was Proposition 103. • Prop. 103 completely altered insurance regulation in Calif. • It may be amended only by a 2/3 vote of the legislature, and then only if the amendment “further[s] [the] purposes” of the proposition.¹ (statute passed by 2/3 vote invalidated because it did not “further” the purpose of Prop. 103). ¹ Foundation For Taxpayer and Consumer Rights v. Garamendi, 132 Cal. App. 4th 1354, 1365-66 (2005) The Griffith Insurance Education Foundation

17. WHAT DID PROPOSITION 103 DO? • 20% rollback in insurance rates.¹ • Established an elected Commissioner of Insurance.² • Moved California from an open competition state (no rate had ever been found excessive) to a “prior approval” state for most lines.³ • Mandated some rating factors, and mandated the order of their weighting (1st—Driving Record, 2nd—Miles driven annually, 3rd—Years driving experience).4 • Mandated a good driver discount of 20%.5 ¹ CIC sec. 1861.01 ² CIC sec. 12900(a) ³ CIC sec. 1861.05(b). See CIC sec. 1851 for excluded lines 4 CIC sec. 1861.05(a) 5 CIC secs. 1861.02(b), 1861.025. The Griffith Insurance Education Foundation

18. WHAT DID PROPOSITION 103 DO? (CONTINUED) • Invested the Commissioner with authority to adopt auto rating factors “that have a substantial relationship to the risk of loss.” • Forbad the Commissioner from giving any consideration to the degree of competition in setting rates.¹ • Forbad insurers from considering the lack of previous auto insurance as a rating factor.² • Provided that no rate may be CHANGED (note that this applies to raising OR LOWERING rates) without the filing of “a complete rate application.” ³ • Permits anyone to intervene in rate making or rule making proceedings.4 • Interveners who qualify as representing “the interests of consumers” are entitled to “reasonable advocacy and witness fees and expenses” if they made a “substantial contribution.” If in a rate application, the award is paid by the insurer—otherwise by the Department of Insurance (DOI).5 ¹ CIC sec. 1861.05(a) ² CIC sec. 1861.02(c) ³ CIC sec. 1861.05(b) 4 CIC sec. 1961.10(a) 5 CIC sec. 1961.10(b). The Griffith Insurance Education Foundation

19. WHAT DID PROPOSITION 103 DO? (CONTINUED) • The 20% role back was invalidated by the California Supreme Court on constitutional grounds.¹ With a few exceptions, the remainder of Prop. 103 was upheld, including the provisions above. ¹Calfarm v. Deukmejian, 48 Cal.3d 805, 258 Cal.Rptr. 161 (1989)(insurers entitled to a “just and fair return.”). The Griffith Insurance Education Foundation

20. THE CALIFORNIA DEPARTMENT OF INSURANCE • Approximately 1,200 employees. • Approximately 100 lawyers • Offices in San Francisco, Los Angeles and Sacramento • Budget of over $205,000,000 • Entirely supported by industry fees of various sorts. Nothing flows to the Department from premium taxes.   • If you are a glutton for information, here is the Department’s annual report: http://www.insurance.ca.gov/0400-news/0200-studies-reports/0700-commissioner-report/upload/2011CDIAnnualReportFinal.pdf The Griffith Insurance Education Foundation

21. THE CALIFORNIA DEPARTMENT OF INSURANCE • California is 6th largest insurance market IN THE WORLD • Regulates over 1,500 companies and over 340,000 brokers and agents. • Gross premium taxes are the fourth largest source of General Fund revenue for the state ($2,135,000,000 in 2009-10). Only personal income tax, sales tax and bank and corporate tax contribute more. This is over 4.5 times the tax revenue generated by California’s alcohol and tobacco taxes combined. • Consumer Line for information and assistance (a handy referral for your constituents). 1-(800-927-HELP (4357)(Calling from within California); 213-897-8921(Outside California);1-(800)-482-4833(TDD - Telecommunication Devices for the Deaf). See: • http://www.insurance.ca.gov/0100-consumers/0400-talk-to-us/ The Griffith Insurance Education Foundation

22. BACK TO YOUR BILL How do insurers make rates? • First, they create a “rate plan” which calculates the total premium needed to service the entire book of business in the particular line (including profit and overhead). • Next, they create a “class plan.” This plan divides the premium among policyholders according to rating factors – e.g., driving record, type of vehicle, age, location, gender of driver, etc. The Griffith Insurance Education Foundation

23. AUTO RATING FACTORS IN CALIFORNIA • All auto rating factors in California are either mandated by Proposition 103 or are adopted through regulation by the Commissioner of Insurance.¹ • In addition to the Good Driver Discount, there are three mandatory and 16 optional rating factors in California. • Three rating factors are MANDATORY, and must be weighted in the following order • Driving Record • Number of Miles Driven Annually • Number of Years of Driving Experience • All other rating factors approved by the Commissioner are OPTIONAL RATING FACTORS. ¹CIC 1861.02 The Griffith Insurance Education Foundation

24. AUTO RATING FACTORS IN CALIFORNIA Here they are in California: • Automobile Rating Factors • Mandatory Rating Factors (in order of “weight”) • (1) Insured's driving safety record. • (2) The number of miles he or she drives annually. • (3) The number of years of driving experience the insured has. The Griffith Insurance Education Foundation

25. Auto Optional Rating Factors (not in order of weight except #15 and #16) • (1) Type of vehicle; • (2) Vehicle performance capabilities, including alterations made subsequent to original manufacture; • (3) Type of use of vehicle (pleasure only, commute, business, farm, commute mileage, etc.); • (4) Percentage use of the vehicle by the rated driver; • (5) Multi-vehicle households; • (6) Academic standing of the rated driver; • (7) Completion of driver training or defensive driving courses by the rated driver; • (8) Vehicle characteristics, including engine size, safety and protective devices, damageability, reparability, and theft deterrent devices; • (9) Gender of the rated driver; • (10) Marital status of the rated driver; • (11) Persistency (but only if presently covered for automobile insurance “by the insurer or affiliate”) ; • (12) Non-smoker; • (13) Secondary Driver Characteristics; • (14) Multi-policies with the same, or an affiliated, company; • (15) Relative claims frequency. • (16) Relative claims severity. [15 and 16 are usually referred to as the “territorial rating factors.” Among optional rating factors, 15 and 16 must be weighted last] Source: Cal. Admin. Code tit. 10, § 2632.5 The Griffith Insurance Education Foundation

26. Auto Optional Rating Factors Note rating factor #11-- Persistency (but only if presently covered for automobile insurance “by the insurer or affiliate”). • 1. The Commissioner has not approved your rating factor. Optional rating factors are arguably committed to the Commissioner.¹ • 2. An insurer giving a discount to a migrant from another insurer must make up the difference from others purchasing policies from the insurer who have not been previously insured (i.e., they have no “persistency”). This would violate the provision of proposition 103 that prohibits insurers from considering the lack of previous insurance as a rating factor.² This raises rates for first-time purchasers of insurance, so it would not “further” the purposes of the Proposition. • Therefore, your legislation, although adopted by a 2/3 vote, is invalid.³ ¹ CIC 1861.02(4) ² CIC sec. 1861.02(c). ³ Foundation for Taxpayer and Consumer Rights v. Garamendi, 132 Cal.App.4th 1354, 34 Cal. Rptr.3d 354 (2005). The Griffith Insurance Education Foundation

27. Auto Optional Rating Factors • This illustrates the necessity and possible consequences of “Pumping” and “Tempering.” • Insurance is a zero-sum game. When a rating factor inaccurately reflects the risk, it may be “unfairly discriminatory” because policyholders in one category will pay too much, and those in another too little. • This also invites the twin terrors of insurers: Adverse Selection and Moral Hazard. • To comply with Proposition 103’s mandatory rating factors, or to allocate territorial rating below its actual significance, one must either “pump” a factor to boost its weight, or “temper” another factor to reduce its weight. • Creates cross-subsidies between groups of policyholders. • For a case discussing pumping and tempering in the context of territorial rating (currently factors #15 and 16), see Spanish Speaking Citizens’ Found. v. Low 85 Cal.App.4th 1179 (2000). The Griffith Insurance Education Foundation

28. Auto Optional Rating Factors • In discharging your legislative obligations, you work under the brooding omnipresence of Proposition 103, which enjoys nearly quasi-constitutional status. • After the persistency legislation was invalidated, the issue of “portable persistency” has spawned two ballot initiatives aimed at authorizing it. Proposition 17, June 2010 and Proposition 33, November 2012. Both failed (Prop. 33 – 55% to 45%). For a discussion visit: http://www.mcgeorge.edu/Documents/Publications/Measure1495.pdf The Griffith Insurance Education Foundation

29. Two more controversial rating areas • Territory (#15 and #16) • Credit Rating (not among California’s rating factors, but an important rating factors in many other states). The Griffith Insurance Education Foundation

30. The Marriage Relationship—Your Statutes and the Commissioner’s Regulations • When crafting legislation, keep in might that the Commissioner may, and likely will, use your legislation as a basis for promulgating further implementing regulations.¹ • Unclearly or ambiguously drafted legislation may spawn disputes about the scope of the Commissioner’s authority to adopt valid regulations. • Example: Fair Claims Practices Legislation and implementing regulations. ¹ CIC secs790.10 ² Globe Life dispute and CIC sec. 790.03. See esp. Par. 81-125 The Griffith Insurance Education Foundation

31. SOME REGULATORY ISSUES ON THE HORIZON • Delays in the rate approval process. Automobile dealers may charge what they will. Automobile insurers, however, MUST charge the approved rate. • In California, they cannot raise or lower a rate without filing a “complete rate application.” ¹ • Many states allow approved rates to “flex” within a range (Often 5% to 15% depending on the state). State rating systems are listed and compared at: http://www.iii.org/issue_updates/regulation-modernization.html ¹CIC sec1861.05(b) The Griffith Insurance Education Foundation

32. SOME REGULATORY ISSUES ON THE HORIZON • Filing a rate application triggers a process that is costly, time consuming, and delays “speed to market.”. The insurer has the burden proof on all of the issues.¹ • If a consumer organization intervenes and the rate goes to a hearing, more than a year may be required to bring the new rate to market. By then, it may be old news. • The Commissioner is aware of this and may propose some changes in the process (trammeled, perhaps, by Proposition 103 which dictates much of the underlying procedure, including timing and that “[d]iscovery . . . be liberally construed.” ² ¹ CIC sec. 1861.05(b) ² CIC sec. 1861.08(e) The Griffith Insurance Education Foundation

33. SOME REGULATORY ISSUES ON THE HORIZON • Self-driving cars. How reconcile the mandatory rating factors and the 20% Good Driver Discount with cars that do not require drivers? • Who will be responsible for those accidents that do occur? Owners? Manufacturers? The Griffith Insurance Education Foundation

34. Federal Incursion—Back to the Future—1945-46 again? • Some Insurance has been largely “federalized.” ERISA, the Affordable Care Act. There will be numerous bills designed to reconcile California law with federal requirements. • Dodd/Frank and the Federal Insurance Office (FIO)—Long awaited report. The Nose of the Camel? The Creeping Federal Octopus? • State Regulators are mustering their resources through the NAIC to protect their turf and (not surprisingly) state revenue. • Prior Approval for Health Care Rates? A health care “Proposition 103” narrowly missed qualifying for Nov. 2012 and will likely return. The Commissioner also supports prior approval for health insurance rates (ask him about it). See his comments at: http://www.insurance.ca.gov/0400-news/0100-press-releases/2011/release002-11.cfm The Griffith Insurance Education Foundation

35. Questions? Feel free to contact me: Robert W. Peterson Center for Insurance Law and Regulation School of Law Santa Clara University Santa Clara, CA 95053 Tel: (408) 554-4141 Email: rpeterson@scu.edu The Griffith Insurance Education Foundation