Satisfies Ethics

Insurance Marketing Issues

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CONTENTS
INTRODUCTION LEGAL & ETHICAL ISSUES OF SELLING INSURANCE
Sales Conduct & Client Needs Sales Conduct, Fundamental to Sales Conduct Choosing a Company Using Rating Services On Going Monitoring & Policy Replacement Company Deals Company Diversification Higgenbotham vs Greer Conflicts of Interest Insurance company failures & size Reinsurance Size of Company & Loan Portfolio State Admission Risked Based Capital Risked Based Capital Model Act Asset-Default Test Sales Conduct in Choosing Product Policy Choices & Risk Management Pure Risk vs Speculative Risk Risk Management Process Sales Conduct Life & Health Life Insurance Risk Analysis Disability Insurance Health Insurance Annuity Analysis Yield vs Liquidity, Annuities Business Insurance Sales Conduct Property / Casualty Homeowners Insurance Auto Insurance Commercial & Professional Lines Sales Conduct Quotes & Illustrations Legal Conduct for Agents Do You Cross the Line? Illustration Sales Conduct Agent Responsibilities Liability Based on Agent Duties The Law of Agency Insurer Producer Status Agent vs Broker Dual agency, creation of Agent vs Professional Special expertise Traditional Agency Law Conflicts Through Contract Disputes Failure to Act Failure to Notify Failure to Place Coverage Failure to Renew Policy Promises & Provisions Agent Promises How will you sell insurance in 10 years?

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46 46 47 47 47 47 48 48 48 49 50 50 51 51 52 52 52 52 53 53 53 54 55 57 58 60 60 61 63 63 63 64 65 65 66 68 68 68 68 68 69 70 72 73 73 74 74 74 76 77 78 78 79 79 79 80 80 80 81 82

Advertising Promises What Policies Say vs What They mean Client Understanding and Reading of Policies Minimum Standards Conflicts Created by Agent Torts Negligence & Misrepresentation Bad Faith Conflicts Created by Client / Agent Relationship Contributory Liability Dual Agency Agents as Fiduciaries ERISA Fiduciaries Insurer Claims Against Agents Secret profit, fiduciary duty Basic Agency Violations Misappropriating Premiums Failure to Disclose Risk Factors Failure to Cancel or Notify Authority to Bind Premium Financing Activities Unfair Practices Liability Created by Insurer Failures Misrepresentation & Insurer Failures Agent Relationships & Insurer Failures Managing Agent Conflicts Know Your Agent & License Responsibilities Agent Integrity License Responsibilities Agent Business & Marketing Practices Concealment Redlining Agent Ethics Agent Disclosure Client Disclosure Insurer Disclosure Claims Made Errors & Omissions Errors & Omissions Insurance Estoppel Argument Exclusions Ratification Working With E&O Claims Office Protocol Standard Operating Procedures Consumer Protection Issues You Cant Ignore Insurance Advertising Advertising Compliance Advertising, What it is not! Accurate and Truthful Advertising Other Unfair Insurance Practices Deceptive or Unfair Business Practices Uniform Consumer Sales Practices Act Unlawful Trade Practices Unfair Competition & Unfair Practices by Insurers Unfair Settlement Practices by Insurers Unauthorized Advertising Discrimination by Handicap or HIV testing Discrimination in Rates Benefits Protection Agent Blunders & Court Cases Legal Precedent Theory

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Bell vs OLeary Brill vs Guardian Life Benton vs Paul Revere Life Cartwright vs Equitable Life Crobons vs Wisconson Life Cartwright vs Equitable Life Great American vs York Lott vs Metropolitan Life MacGillivary vs Dana Bartlett Sobotor vs Prudential Southwest vs Binsfield

INSURANCE MARKETING ISSUES

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83 84 84 85 85 85 88 92 92 95 95

INSURANCE ON THE INTERNET

The Marketing of Insurance Over The Internet Internet Commerce Potential Uses of the Internet Electronic Commerce Internet Overview Internet Technology Universal Resource Locator Online RFQ Sales & Service of Insurance Over The Internet Single source sales site Insurance Malls Elements of Insurance Transactions Digital Signatures Advantages & Disadvantages of Insurance Sales Over the Internet Industry Advantages, Internet Insurance Regulator Disadvantages, Internet Problems With Selling Insurance Over the Internet Regulatory Issues Signature authorization, electronic signature Transaction situs Security Issues & Privacy Issues Encryption Digital Signature Conclusions & Recommendations Whos Who on the Internet How to Get Connected to the Internet Website Design Netiquette

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THE STRENGTH BEHIND THE SALE

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Insurance Regulation Why Regulate Insurance The History of Insurance Regulation Insurers Before 1850 McCarran-Ferguson Act of 1945 The Objectives of Insurance Regulation The Role & Process of State Regulation The National Association of Insurance Commissioners & Insurance Regulation History of the NAIC What Does the NAIC DO Insurance Regulators Information System (IRIS) Securities Valuation Office Recent NAIC Accomplishments Reinsurance Intermediary Model Act NAIC & Proposed Federal / State Regulation Federal Government Assistance State Regulation Layers of Protection

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169 170 171 171 175 171 179 178 182 183 183 184 186 191 191 193 196 198 200 200 201 205 205 207 210 211 211 212 213 213 214 215 216 217 218 219 221 223 223 225 226 229 232 233 233 234 234 237 238 240 240 245 245 249 251 252 254

BEYOND THE INSURANCE SALE

The Need to Look Beyond Insurance

Company Safety The Failure Rate Industry Troublespots Holding Company Abuses Future Operational Changes Problems in the Life Industry Interstate Compact Agreement Solvency & Financial Enforcement Trust (SAFE-T) The Rating Services AM Best AM Best Stated Mission FPI Rating AM Best Quantitative Evaluation Standard & Poors Standard & Poors Claims Paying Ability S&Ps Industry Risk Rating Z-Score Moodys Investor Service Moodys Long-Run Profitability Rating Moodys Qualitative Evaluation Duff & Phelps Weiss Research Weiss Research, Objective Quanitfiable Information Weiss Ratings Summary on Rating Services State Guaranty Funds Purpose of Guaranty Associations State Guaranty Funds Need for a Safety Net How Guaranty Funds Got Started Have the Funds Accomplished Their Goal? Structure & Workings of Current Fund Systems Guaranty Acts Exclude Life Funds vs Casualty Funds Who Pays for Guaranty Association Protection? The Consequences of Guaranty Funds Pay Offs The Reason Guaranty Funds Receive Federal & State Incentives Can Guaranty Funds Handle Major Insolvencies? Reinsurance Purposes and Practices Limits of Reinsurance Retrocession Reinsurance Regulation Alien Reinsurers Reinsurance Required Clauses Insurance Company Business How Insurance Companies Make Money Insurers Loss Ratio What Insurance Companies Own & Invest In Insurer Reserve Who Insurance Companies Owe Reasons Why Insurance Companies Fail Sources & Uses of Insurance Company Analysis Qualitative Considerations Asset Spin Off Quantitative Considerations Surplus to Admitted Assets Ratio Analysis Sources

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NEW FRONTIERS OF INSURANCE MARKETING

Life & Health Challenges Sales Conduct American Disabilities Act AIDS Defining Occupation Psychologically Induced Illness Experimental Treatment Rizk vs Dun & Bradstreet Language Barriers Defining Accidental Parker vs Metropolitan Life Casualty Challenges Tenants as Implied Beneficiaries EIL vs CGL Contamination Asbestos Lead Business Interruption

Expanding Liability When Insurance Fails to Insure Trigger of Coverage Insurer Drop Down Warranty or Condition Insurer Liquidation Order of Priority Asset Protection Planning Problems With Legal Entity Protection Exemption Planning Multi-Protection Multiple Entity Structuring in Action Implementing a Multi-Entity Asset Protection Plan Maintaining Control of a Multi Entity Program Is A Multi-Entity Plan Right for Your Client?

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INTRODUCTION In 10 Years, How Will You Sell Insurance?

Will your clients buy their insurance online? Will agents, as we know them today, be squeezed-out by huge direct sellers? Will every citizen of 2010 buy long-term care coverage? Will you be an agent representative for a bank or Microsoft? Will your exposure as an agent be less or more? Will insurance products still maintain their tax-deferred status? The truth is, any answer you give is nothing more than a guess. You dont know. No one knows. The reality is, whatever the shape insurance takes in the future it will be in direct response to issues of the day; be they political, legal, demographic or otherwise. And, the fact is, you will have to deal with and market to the issues because the alternative is something called poverty! The purpose of this course is to define the issues that effect insurance sales past and present -- and give you some insight as to where you might look for possible evolution. Positioning yourself for change is part of life and developing a workable solution is eighty percent of the marketing challenge.

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The Past
Change is not all bad. As a matter of fact, if it werent for change, insurance would not exist at all. Did you know that attempts to first market life insurance were deemed illegal because insuring someones life was considered betting and paying interest on accumulated values was considered usury. These were highly prejudicial issues prior to 1600. Pressures or influence of many kinds eventually convinced society that the need for death benefits and savings outweighed the stigma. Imagine how far weve come. Imagine where well be in another 500 years. Throughout history, the issues that created change and new marketing opportunities in the insurance industry have been significant and many. For example, early insurance policies were underwritten by individuals and small groups, not by companies. In the mid 1750s, the need to encourage growth in church ministry led to the chartering of the Presbyterian Synod of Philadelphia . . . the first corporation to pay death benefits to insureds and their dependents. In the mid 1800s states first realized the need for reserves when the issue of large-scale damage, such as the disastrous fires in New York and Chicago, increased as populations became more concentrated in cities. The Industrial Revolution was the trigger for many new flavors of insurance such as accident policies and workers compensation.

The Present
By the end of the nineteenth century, most major forms of insurance had been developed, and well in place all the result of changing issues and consumer needs. It is in the twentieth century, however, where the most dramatic changes in the field of insurance marketing have taken place. Twentieth century policies have became more versatile in order to meet the needs of a very specific groups. With flexibility, however, came waves of regulation as federal and state agencies vied to be the gatekeepers of good faith. A prime example is the Social Security Act of 1935 and the Federal Crop Insurance Act of 1938. Both sought to provide new protections for economic disasters of grand scale. During the Second World War, life insurance for our military became standard procedure. During the riots of the early 1960s, fearing high claims, insurers began the practice of redlining where insurance in certain neighborhoods was denied or priced beyond the reach of owners. Later, laws were passed forbidding this practice. Not all the changes involved regulation. The insurance industry remade itself in response to new issues and new technologies. For example, recreational activities that did not exist in the past, such as sky diving, led to insurers excluding these hazards from coverage. Technological advances such as alarm systems, medical diagnostics and human longevity have changed insurance products forever.. Premiums and marketing have been positive in many ways. On the downside, health care costs have risen far faster than the Consumer Price Index, worker comp fraud grew and the medical community began a specialization trend. In less than two decades, personnel working in the medical field have become highly targeted. There are respiratory therapists, occupational therapists, nutritionists, social workers and a host of other experts involved in the everyday care of patients. This has resulted in more effective care, but higher costs as well. And, as major portions of the population border retirement age, long-term care is a growing concern. All of these are changes that effect insurance marketing. Some marketing trends, however, result from issues as slight as consumer bias. During the 1980s, for example, life insurance companies scrambled to satisfy longstanding customers who transformed from savers into investors. Carriers quickly revised products to compete against high-yield offerings in the banking and securities arena. The fact that high rates offered by banks were federally insured put life companies at a disadvantage. Products became even more competitive with marketing shifting from the sale of security to rate of return. Companies were forced to achieve greater return on their own assets by assuming higher risk. This, in turn, led to a host of insurance company failures and market distrust.

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Politics are yet another element of the change you will encounter in marketing insurance products. If adequate health care is seen as a right of all citizens, for example, will mandated health care be enforced by congressional action? Will developments in health care cause more and more Americans to live beyond limits of social security and Medicare? Will long-term care be a required recommendation? Legal matters present more opportunity for insurance marketing changes , Malpractice, for example, is still alive and well in this country and it affects all sides of the equation. Insureds, like hospitals and highrisk occupations, are held accountable for the smallest indiscretions for inordinate amounts of time. Obstetricians can be sued in many states for malpractice against a child they delivered for TWENTY-ONE YEARS! Common sense tells us that any number of factors other than trauma at birth could cause a condition to be unidentified for many years. Agent exposure to clients and carriers is another issue for consideration. Dont fall into the trap that because you havent been sued up to now, you are in the clear. Legal precedent changes involving innocent and innocuous events today, could be huge problems. Market conduct, asbestos and toxic waste are recent examples of agent actions and policy coverage gone astray where agents have become a target. By now, you should see that there are many issues that drive the marketing of insurance. Some of these issues, such as politics and societal changes, are beyond your control. What you can manage, however, are the issues involving on-going client needs and agent liability. The dates and faces will change, but the issue will always be the same. Know your client and know your responsibilities as an agent. Also, consider the strength behind insurance sales. Will company safety again become a factor as it did in the late 1980s? Do you really understand the solvency issues behind contracts you write, i.e., state guaranty funds, reinsurance, risked based capital, ratings analysis? Is it possible that an insurance policy you sell today, will fail to insure tomorrow? Ten years from now? Would you be wise to prepare your clients for the worst case, i.e., plan beyond insurance in the areas of asset protection and multientity structuring? Yes! Yes! Yes!

The Future
Consider the marketing of insurance in ten years. Safety and common sense will always be a foundation for sales. But, instead of dealing one-on-one, maybe your clients will buy their policies ONLINE. Can you see more competition from direct sellers and banks? Will issues surrounding disability discrimination, AIDs, psychologically induced illness, language barriers and experimental treatments shape the landscape of insurance sales and agent liability? Again, no one knows. But, you need to have a plan to survive it all. You will need to justify your actions, manage your errors and plan ways to avoid making them again. There are many suggestions and guidelines provided within these covers to help you develop marketing procedures to better serve your clients and protect your own hide. Use this book as a source of issue ideas. Some will still be around in ten years, others will be cast aside. Go with the flow. Accept product evolution and become a student of change. Study it, learn from it, sweat and ALWAYS get proper advice before taking any action concerning a client or your own activities. GOOD LUCK!

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CHAPTER 1

LEGAL & ETHICAL ISSUES OF SELLING INSURANCE

The selling of insurance is a balancing of many disciplines. First and foremost is the determination of client needs and your conduct in choosing safe, appropriate product. Throughout this course, you will find many suggestions and ways to analyze your sales or market conduct performance as well as how to assess appropriate client risk analysis. Next, comes your legal responsibilities before and after the sale. Do you know what they are? Do you know when you exceed your role as an agent and assume additional exposure? If conflicts occur, are you able to settle them reasonably and do you have procedures in place to help avoid them in the future? What about consumer protection issues? Finally, are you someone who learns from the mistakes of others. As you will soon discover, it is a great training ground.

SALES CONDUCT & CLIENT NEEDS

In the section that follows, you will learn why agent legal conduct is a broad area of agent responsibility you are duty-bound to know. Sales conduct, on the other hand, is responsibility you choose to uphold in order to do a better job for your clients. It involves making reasonable decisions for your clients after analyzing their needs. If you need more reasons why you should practice proper sales conduct heres a short list: It might keep you from being sued by a client or your insurer. The cleaner your record, the less involved underwriters will be in the sales process, i.e., you have more control over the sales process and less compliance. Sales conduct violations drive up the cost of doing business which could effect your commissions, or, completely replace the current system of incentive pay with a salary or other form of measured compensation, i.e., violations can mean less money. Sales conduct problems erode the public trust and that can cut into your sales. Sales conduct lawsuits are now part of how companies are rated. More suits mean a lower rating and a harder sale for you.

Sales conduct is an optional agent duty that involves proper handling and choice of company, product and sales presentation to best serve a clients financial planning.
There are many industry groups and agent associations who feel that the movement toward sales ethics is way behind schedule. Too much emphasis and money has been spent on grooming sophisticated salesmen, they say, when there is a greater need for agent diligence and fair dealing. The cornerstone of this agent diligence movement is now called agent due care or sales conduct. Roughly translated, the meaning of sales conduct is an agent's professional and ethical handling and choice of company, product and sales presentation to best serve a client's financial planning. Others have embellished on this definition where the practice of sales diligence might read like this: 9

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Conduct business according to high standards of honesty and fairness and to render that service to its customers which, in the same circumstances, it would demand for itself. Provide competent and customer-focused sales and service. Engage in active and fair competition. Provide advertising and sales materials that are clear as to purpose and honest and fair as to content. Provide fair and expeditious handling of customer complaints and disputes. If you went a step further and combined legal conduct and sales conduct you might run your business by the following credo: I will know everything possible about my clients financial and insurance needs. I will have a complete understanding of all products I sell and present them fairly. I will find the most suitable product for my client and make sure I place him with financially capable companies without bashing the competition. I will document any lack of knowledge with a full disclosure agreement. I will request each client to sign a binding arbitration agreement for any potential misunderstanding or dispute. While it would be wonderful if every agent lived by these rules real world situations often get in the way. Taking the time to follow each and every rule would probably add to your work load. On the other hand, a little less free time today might save you considerable time and money by avoiding a major legal confrontation later. Likewise, the loss of a policy sale or two today might make it a whole lot easier to sell one . . . or be referred one . . . next year. Fundamental to sales conduct is the understanding that all insurance is constructed of the same elements -- expenses; experience (claims risk or mortality); and return or profit. Therefore, a policy that appears to be significantly better than others in the marketplace should be suspect. Once a suitable product can be found, the decision to buy should be based on the assumptions in the policy and the financial stability of the company. Policy illustrations and quotes are one method to make this assessment. Unfortunately, agents and clients rely too much on these presentations to the extent that policies are rarely read. As a result, agents should be sure that any projection or estimate disclose the assumptions that went into the projection and the fact that variations in these assumptions can significantly change insurance results. Recent laws have even made it mandatory to bold or highlight any "guaranteed" portions, as compared to simple projections. It is further suggested that illustrations be run again, without forecasting better times or improved rates into the future, to see if they still meet client expectations.

Proper sales conduct requires agents be suspicious about policies that sound too good to be true.

With reference to agents choosing safe companies to insure their clients, it will be demonstrated that sales conduct involves many disciplines including: disclosure, diversification among multiple carriers, product variation diversification, regulatory knowledge, multiple rating verification, key ratio comparisons, periodic monitoring and more. A recent business magazine survey is a painful reminder to the industry that the road to agent diligence may still be cluttered with potholes and a fair share of detours. Money Magazine tested 20 insurance agents on their accuracy and clarity in explaining their insurance products and the role they played in a client's financial planning. Most of the agents failed simple standards of due care, including the ability to demonstrate simple financial assumptions concerning the solvency of a chosen insurer -- either at time of purchase or later. Agents must realize, that doing "too little" concerning 10

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how and where they place client business can be hazardous to their financial health and moral responsibility to the people they serve. This takes on special meaning to agents when they discover that lawyers want to prove that a pocket rating card and other company supplied financial condition brochures may not be enough to demonstrate that an agent did his best in selecting a carrier who, after purchase, declined to unsafe or liquidated status. No doubt, it will be the same attorneys who expect an agent to quote code and verse about the company, a policy or illustration when something goes wrong. There is no question that young lawyers, and some very rich lawyers alike, are increasingly aware of the numerous legal theories available to hold the insurance producer liable for failing to meet some kind of professional standard. Could a jury be convinced, for example, that an insurance professional, especially one who has earned a designation such as CLU or CFP, neglected his professional duties in not explaining the full impact of estate taxation to a now deceased, but underinsured client? Is a casualty agent, possibly a CIC or CPCU, liable for placing a client with a B-rated carrier that liquidates at the very time a client files a claim or failing to recommend a specific policy option that later involves losses?

Agents are selling more than an insurance policy . . they sell security, peace of mind & freedom from financial worry in the event of a catastrophic event or claim

The answers to these questions are continually being litigated as you will see in the next section. The significance, however, is that the courts in just about every state, have made it absolutely clear that insurance agents are selling a lot more than a mere contract of insurance. They are selling security, peace of mind and freedom from financial worry in the event of a catastrophic claim .

Sales Conduct In Choosing A Company

Agent legal conduct in choosing a company centers on the ability to direct a client to an insurer that is solvent at the time of purchase and able to meet its contractual obligations. Sales conduct considers diversification, to spread risks among carriers and to meet state guaranty fund protection, and on going monitoring by private rating services. Policy owners must depend on agents for choosing insurers because they are generally unsophisticated in analyzing the financial complexities of solvency. Agents help businesses and individuals purchase property and liability insurance to minimize current financial losses. Life, health and annuity policies cover losses of future economic potential. In both cases, the purpose is to shift the financial consequences of loss. Sometimes, however, policy owners find that the "safety net" they purchased is not always as safe as it started out to be. The recent increase in frequency of insurance company failures and inability to pay claims is proof. It is further substantiated by the substantial increase in claims submitted to state guaranty funds which are forced to step forward and make good on failed promises of defunct or faltering companies. An agent is engaged by a client because he is an insurance professional. Clients should expect to be placed with financially reliable insurers. Too often, it is believed that state regulators are monitoring solvency closely and will advise agents and brokers by some mysterious "hot line" -- it just doesn't happen that way -- and we have recent examples to prove this is not the case. Regulators of insurance companies, like regulators of financial institutions such as banks and thrifts, do not make public 11

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announcements of pending problems. This could cause a "run on the bank" or a "run on the insurance company". Severe disintermediation, withdrawal of policyholder funds or policy cancellations could initiate a complete collapse similar to what happened with Mutual Benefit Life. By stepping in without public warning or fanfare, regulators hope to avoid the severity of a takeover and minimize consumer panic. That is why an agent will not receive advance warning from regulators. Unless the agent is tracking solvency by demanding full disclosure from an insurer BEFORE AND AFTER involving a client, he may experience the unpleasant experience of dealing with a disgruntled client or his attorney who just read about an insurer's demise, complaints filed with the insurance commissioner, or worse, a surprise visit from the "60 Minutes" investigative team!

Clients should expect to have their coverage placed with financially reliable insurers .

There are NO set rules on solvency due care techniques since the actual process must consider the risk capacity of a client, the current economy and the specific financial result or exposure needing coverage. However, there are some steps that agents might take to help mitigate bad choices. It is hoped that at least a few of the following sources and considerations will have application and will involve the agent in an area of due care that has been largely ignored. If this is considered too time consuming, an agent would be advised to concentrate only on those companies where this information can be acquired. In some cases, due care is not simply a matter of collecting a financial ratio. The story behind the numbers is often as important.

Using the Rating Services

An agent choosing a company for his or her client would be advised to consult the major rating services. The activities of insurance company rating agencies have become increasingly prominent with the industry's recent financial difficulties and the well publicized failures of several large life insurers. The ratings issued by these agencies represent their opinions of the insurers' financial conditions and their ability to meet their obligations to policyholders. Rating downgrades are watched closely and can significantly affect an insurer's ability to attract and retain business. Even the rumor of a downgrade may precipitate a "run on the bank", as in the case of Mutual Benefit, and seriously exacerbate an insurer's

When ratings of an insurer vary widely among rating companies, the financial safety of the insurer should be questioned.

financial problems. There is little doubt that rating organizations play a significant role in the insurance marketplace. Some have expressed concerns about the potential adverse effect of ratings on particular insurers and consumer confidence in the insurance industry in general. Once the province of only one organization, A.M. Best, a number of new raters emerged during the 1980s. Questions have been raised about the motivations and methods of the raters in light of the recent sensitivity regarding insurers' financial conditions and what some perceive to be a rash of arbitrary downgrades. On the one hand, insurer ratings historically have been criticized for being inflated or overly positive. On the other side, there are concerns that raters, in an effort to regain credibility, have lowered their ratings arbitrarily in 12

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reaction to recent declines in the junk bond and real estate markets and the resulting insurer failures and diminished consumer confidence. One consultant suggests a way to determine if an insurer is running into difficulty is to monitor several ratings. If the ratings vary widely, this should send a signal that there are other factors of concern regarding the insurer. A recent example is United Pacific Life. In 1992 it was rated A-Plus by Duff and Phelps, BBB by Standard & Poors and Ba-1 by Moody's.

On Going Monitoring & Policy Replacement

In the past, there has been no legal premise to hold agents responsible for monitoring solvency of a company after the initial sale. However, in Higginbotham v. Greer, it is suggested that agents need to keep clients informed about significant changes in the financial condition of the company on an on going basis. Sales conduct goes much further by emphasizing on-going due diligence, and when replacement is considered, documentation of files and published and third party testimonials as justification, especially for any recommendation to move a clients coverage from a company rated "A" or better to a lesser rated carrier . Even if the intent was to provide superior coverage, the client's security position has technically downgraded.

Company Deals
Agent sales conduct should carefully consider companies that offer deals that are "too good to be true". Agents might be advised to at least be suspicious of a company offering a "better deal" than anyone else. It is common sense that something along the way will suffer, as it did in the case of some life companies that invested in junk bonds and many casualty companies which participated in deep discount premium wars where expenses and claim costs at times exceeded income. This can only represent a degenerative financial condition for the insurer. Also remember that insurance agents, as salesmen, want to believe something is a better product or a better company. By their very nature, salesmen often "get sold" as easy as some clients. It would be wise to be critical of all brochures and analysis distributed by a carrier which portray it to be the "best" or "safest".

Company Diversification, Business Lines & Parent Affiliation

In the quest to exercise proper sales conduct, a strategy of multiple company coverage may be the answer. For a client's life insurance needs, some combination of term, whole life, variable life or universal

A strategy of using multiple companies may satisfy the need for client diversification.

life may be employed to spread the risks among many different insurers and product lines. The variable life component could be diversified even more by using multiple asset purchases. On the casualty side, similar diversification might be employed between business and home owners policies, workers compensation, professional liability, etc. The insurance consumer should also be educated by agents about the different types of insurers, i.e., 13

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stock versus mutual company, although it might be considered an error to generalize about the safety of an insurer or the price of its coverage or the service it provides, based solely on the insurer's legal structure. This disclosure may be particularly appropriate where an insurer, due to its legal structure, may NOT be covered by state guaranty fund protection, e.g., non-profit Blue Cross and Blue Shield. Or, where the legal structure of the product offered may NOT be "insured" by state funds, e.g., variable annuities. An agent may not have many choices concerning the company he writes, e.g., worker's comp coverage can only be secured with a carrier willing to write worker's comp. It has been suggested, however, that agents may consider the nature of multi-line companies to determine if one of the lines is weak enough to "down-drag" a profitable line. An example could be a life company that also writes health insurance as a direct line of business or by affiliation. If health carriers become threatened under a new national health care proposal, it could spell trouble for an insurer's health line which can affect ALL lines of business written. Of course, this is not to say that a multi-line carrier cannot be profitable and solvent. Who or what kind of company owns the insurer is another consideration. Is the parent sufficiently solvent that it will not recruit or siphon funds from the insurer? In a like manner, does the insurer own an affiliate that may likely need capital infusion from the insurer? Has the insurer recently created an affiliate, and are the assets in this affiliate some of the non-performing or under performing investments of the original insurer? Is a merger in the offing that might mingle your client's A-rated company with a larger B+ company? In what partnerships or joint ventures does the insurer participate? Do these entities own problem real estate properties of the original insurer? Has the insurer invested in other insurance companies, and have those companies, in turn, invested back in the original insurer or one of its affiliates? Name recognition can go a long way in giving a client a high level of comfort. In the early 1980's, for example, Cal Farm Insurance, a B rated company, was proud to point out that it was owned by the California Farm Bureau, a 100-year-old company. By the mid 1980's, however, Cal Farm Insurance was liquidated by the California Department of Insurance for overextending itself on financial guarantee bonds that it could not pay. Because the claimants were considered to be sophisticated investors, they received only 25 cents on the dollar and forced to foreclose on the properties behind the financial guarantee bonds themselves. The California Farm Bureau was not "forced" as a source to pay any deficiencies. Other abuses have occurred with a slightly different twist. For example, Senate investigations have revealed that the failure of many insurers can be directly tied to the "milking" of these companies by a "non insurance" parent. Further, not all abuses have been on the side of the parent. Insurance companies themselves have been known to tap huge sums of capital from their parents, commingle assets and devise elaborate schemes, including sale and leaseback arrangements and the securitization of future revenues.

Conflicts of Interest
Agents receive a commission for their expertise in selecting a suitable product and company. The fact that the agent receives this commission from the same company represents a definite conflict of interest. An ethical agent should disclose this fact in reference to the choice of the company selected. Where the commission is higher than normal, one might question the specific policy elements that will be affected, higher surrender or cancellation charges, etc or considerations about the financial qualifications of the insurer and include these facts in any disclosure. An insurer recently placed in liquidation, for instance, had a known history of paying higher than prevailing commissions.

Reinsurance
Reinsurance is an effective tool for spreading risk and expanding capacity in the insurance marketplace. The strength of the guarantees backing the primary company, however, are only as strong as the financial strength of the reinsurer. Abuses have occurred where the levels of reinsurance have been too high, the quality poor and the controls nonexistent. Industry analysts suggest that the total amount of reinsurance should not exceed 0.5 to 1.3 times a companys surplus. Agents should also be concerned about foreign 14

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reinsurance since U.S. regulator control and jurisdiction is difficult. See how much of the foreign reinsurer's assets are held in the United States. Ask if the reinsurer has directly guaranteed the ceding company or used bank letters of credit for this purpose. These credit letters have not been effective guarantees in the past. Also, under terms of the ceding contracts, can the reinsurance be "retroceded" or assumed by another reinsurance company -- it is possible to have layers of reinsurance which could create difficult legal maneuvering during a liquidation? Does the ceding contract have a "cut-through" clause which allows the reinsurer to pay deficient policy owners or insureds directly, rather than to the liquidator? Is the insurer writing a significant amount of new business that may require costly amounts of first- year reinsurance? Reinsurance surplus relief is another area of concern to investigate. The first year that an insurance policy goes on the "books", the insurance company suffers a loss. This is attributed to laws related to the accounting valuation of the policy and the high costs or expenses paid in the first year, such as commissions ,etc. A loss to an insurer also reduces a company's surplus. A strain on surplus can create all kinds of problems with regulators and lenders, so insurance companies go to great lengths to shore up their surplus from the losses of first year policies. This may be accomplished by raising additional capital or through some form of financing. More often than not, however, an insurance company will simply call up the local reinsurance company and obtain surplus relief reinsurance. Once in place, surplus reinsurance provides the ceding company, the insurer who uses the reinsurance funds, with assets or reserve credits which improve the insurers earnings and surplus position. The major difference between using reinsurance to cover first-year losses and a loan is how the transaction is reported. When an insurer obtains a loan, the accountant must record a liability. Reinsurance for surplus relief, however, is NOT considered a liability under statutory accounting because the repayment is tied to future profits of the policy or policies being reinsured. Collateral for the reinsurance, in essence, is future profits. Thus, reinsurers run substantial risks when the ceding company cannot pay. The fee or interest for providing the reinsurance is typically from 1 percent to 5 percent of the amount provided. Regulators are well aware of reinsurance surplus relief practices. Over the years, they have introduced rules which attempted to minimize abuses. The 1992 Life and Health Reinsurance Agreements Model Regulation was adopted by the National Association of Insurance Commissioners for implementation starting in 1994. The National Association of Insurance Commissioners also adopted a 1988 regulation which reads as follows: " . . . If the reinsurance agreement is entered into for the principal purpose of providing significant surplus aid for the ceding insurer, typically on a temporary basis, while not transferring all of the significant risks inherent in the business reinsured and, in substance or effect, the unexpected potential liability to the ceding insurer remains basically unchanged".

Size of Company & Loan Portfolio

What percentage of an insurer's non-performing or under performing real estate projects have been "restructured" -- sold and self-financed to a new owner at favorable terms to eliminate a "drag" on surplus? Statistically, fewer failures have hit companies with assets greater than $50 million. It is thought that larger companies have more diverse product lines, bigger sales forces, better management talent--in essence, they are better equipped to ride out financial cycles. In recent wide scale downgrading of insurers, A.M. Best seems to have favored significantly larger companies in the over $600 million category. However, another advisor feels that a small, well capitalized companies can deliver as much or more solvency protection as a large one suffering from capital anemia.

State Admission
Checking that an insurer is licensed or admitted to do business in the state at least assures that the company has met solvency and financial reporting standards. Most states offer toll free numbers for these inquiries. Some states will also divulge the rank of an insurer by the number of complaints per 15

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premium volume. Agents should realize, however, that to date no court has allowed an insured who has suffered a loss as a result of an insurer insolvency to recover from a state run department of insurance for failure to regulate the solvency of the insurer.

Risked Based Capital

Risked Based Capital guidelines could prove to be one of the most useful tools for quantitative analysis. In a nutshell, it is a capital sufficiency test which compares actual capital, surplus, to a required level of capital determined by the insurer's unique mix of investment and underwriting risks. Guidelines for this new regulation took effect in 1994 for life and health companies and 1995 for property/casualty insurers. Risk Based Capital is the brainchild of the National Association of Insurance Commissioners. Since its inception, the National Association of Insurance Commissioners has strived to create a national regulatory system by the passage of model acts or policies designed to standardize accounting and solvency methods from state to state. Risk Based Capital is one of many "model acts" recently adopted by the National Association of Insurance Commissioners. The Risk Based Capital Model Act defines acceptable levels of risk that insurance companies may incur with regards to their assets, insurance products, investments and other business operations. Insurers will be required, at the request of each state insurance department, to annually report and fill out Risk Based Capital forms created by the National Association of Insurance Commissioners. Formulas, under risk based capital, will test capitalization thresholds that insurers must maintain to avoid regulatory action; recalculate how reserves are used; reduce capitalization required for ownership of affiliated alien insurers and non-insurance assets; and allow single-state insurers to qualify for exemption from reinsurance capitalization if their reinsurance doesn't exceed 5 percent of total business written. The risked based capital system will

Risked Based Capital ratios define acceptable levels of risk an insurer may incur.

set minimum surplus capital amounts that companies must meet to support underwriting and other business activities. Because the standards will be different for each company, the guidelines run counter to existing state-by-state regulations that require one minimum capitalization requirement for all insurers regardless of their individual styles of business or levels of risk. Insurers reporting Risk Based Capital levels of say less than 70 percent to 100 percent may be subject to strict regulatory control. Scores from 100 percent to 150 percent might be issued regulatory orders requiring specific action to cure deficiencies. Higher scores might receive regulatory warnings and corrective action stipulations. Attaining 250 percent or more, would relieve an insurer from any further Risk Based Capital requirements in a given year. It is clear that Risked Based Capital encourages certain classes of investment over others. For example, an asset-default test under Risked Based Capital, called C-1, establishes varying reserve accounts be established for various classes of investments based on their default risk. These amounts could be as much as 30 percent for stocks and low quality bonds and 15 percent for real estate owned as a result of foreclosed mortgages. Industry critics say that the C-1 surplus requirements alone could be far greater than all other categories of Risked Based Capital like mortality risk assumptions, interest rate risks and 16

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other unexpected business risks. Since the 1994 Risked Based Capital reports are based on 1993 financial conditions, many insurers have already started to restructure their portfolios to avoid as many C-1 assignments as possible. This has included the wide scale disposition of real estate and real estate mortgages, the repackaging of real estate products into securities and large reductions in "junk bond" holdings. Despite these efforts, C-1-rated classes of assets continue to represent a sizeable share of insurer portfolios. In many cases, companies have very few options to unload foreclosed real estate as long as the market continues soft. A Saloman Brothers Inc study of almost 500 insurance companies clarifies the problem. Using 1992 financial reports for these insurers, the median level of surplus capital was found to be at 189 percent of their respective Risked Based Capital levels. Even though, a majority of companies exceeded the 150 percent threshold--thus , not requiring regulatory correction--the results indicate that hundreds of companies did not measure up. The concern by industry groups is that when Risked Based Capital is enacted, the results could generate significant "bad press" which could weaken demand for individual company and industry products. There is also speculation that companies will change investment portfolios to achieve higher Risked Based Capital ratios. This may critically hamper real estate investing for a some time to come. On the surface, Risk Based Capital seems to solve many regulatory concerns. Solvency rulings are standardized from state to state and specific action is mandated across the board. This would appear to be acceptable by insurance companies who could now predict regulatory response in any state. However, as we have seen, Risked Based Capital could also adversely affect financially sound companies simply because they own more real estate -- performing or not. Some in the industry also feel that the Risk Based Capital rules are simply too restrictive, subjecting many of the best known insurers to immediate regulatory action and "bad press". This, in turn leads to a "run on the bank" that could tip these insurers into worse condition. The concern of these parties is that the risk based capital system doesn't falsely identify adequate capitalized insurance companies and undercapitalized ones as being adequately capitalized. Too much is concerned with the type of investment, rather than its quality. Just how companies react to these guidelines remains to be seen. As mentioned, many life and health insurers have already changed their investment strategies to more favorably align with risked based capital guidelines by selling their large scale real estate investments and junk bonds.

Sales Conduct In Choosing Product

If an agent is truly using due care in selecting the right policy, before selling, he should: Obtain specific information on the client's current and anticipated risk exposure and review all existing policies. Review a "specimen" policy and policy amendments for every insurance contract he is marketing. Make sure that the client clearly understands the type and limit of coverage being purchased; the responsibilities of each party, the insured and the insurance company; and the services that will be provided by the agent. Monitor policy needs on a continuing basis. Regardless of the sequence of policy decisions, agents must recognize that the choice of a policy is viewed differently between agent and client.

The value of an agents service is a function of his care in making appropriate insurance decisions.

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An agent seeks coverage as a means of transferring pure risk. A client views policies in terms of obtaining reduced uncertainty, i.e., in most cases, your customers can only hope that the policy they purchase is appropriate. That is why agents are vital players in any insurance purchase. The greater agent due care exercised, the more valuable the service. It is also why, when viewed from an agent's liability, ALL options should be disclosed.

Policy Choices & Risk Management

The process by which agents help clients select the most suitable policy is known as risk management. The two basic rules concerning risk management are: 1)The size of potential losses must have a reasonable relationship to the resources of the client, and 2) Benefits of risk reduction must be related to its cost In essence, these rules advise risk takers not to risk more than they can afford to lose, to consider the odds and not to risk a lot for a little. The agent must also consider a client's pure risk vs. speculative risk. Both pure risk and speculative risk involve uncertainty, but in pure risk, the uncertainty relates only to the occurrence of the loss. In other words, there is no chance for a profit to be made. Speculative risk offers the opportunity for both gain and loss. An example of a speculative risk is when a dilapidated apartments burns and is replaced with new housing. Society can gain from speculative risk. However, the agent would do better to concern himself with the pure risk losses of the client. In the above case, for example, does the apartment policy provide pure risk provisions, such as a "lost rent clause" to provide the client and his family sufficient cash flow while the new apartment is being built? The process of risk management requires setting and achieving goals in at least four areas: pure risk discovery, options to deal with the risk, implementation and on going risk monitoring. Pure risk discovery requires knowledge about a clients assets, income and activities of his family or business. Several sources can be valuable, including: financial records (balance sheet and income statement), specific information on each asset (location, title replacement cost, perils, hazards they are exposed to). Questions about sources of income and expenses help determine the client's ability to selfinsure all or a portion of any potential loss. Physical inspections of the client's home and business might also pinpoint additional liability loss hazards. This can even include a study of all existing contracts such as leases, employment contracts, sales and loan agreements. Even when exposures are detected, no estimate of the maximum loss potential can be made with absolute confidence, since matters concerning the timing of a client's death, disability or health problem can change the desired resource amount. The same is true concerning property and liability exposures -- depth and breadth are hard to quantify. Options to deal with risk can be evaluated after specific risks have been identified. The risk manager's goal is to reduce the "post loss" resources needed by the client using the most efficient method. In essence, this is the age old battle of balancing costs and benefits. That is why risk management is maximized when using more than one insurance company to carry the burden. In this decision, however, there is temptation to resist paying for excess coverage of any type which can rob the client of cash flow that could otherwise be used to build assets more quickly and less expensively -- specifically, assets that are needed to provide for the present or to create a "living" for the future. As part of this consideration, it may just be that the client pays premiums for many years, is never disabled or does not die earlier that his life expectancy. Or, he may never sustain a loss of property. The responsible agent should advise the client that this too, is a possible outcome. Factors to consider include personal and business resources the client may wish to devote to covering 18

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losses (cash, assets, bonds, etc), available credit resources, the use of higher than average deductibles and any possible claims for reimbursement the client may make against outside parties who may be legally responsible to help pay all or part of the loss. Of course, it is likely that the major transference of risk, or the final source of loss coverage, is the insurance contract. Implementation of the insurance contract is made after the agent has developed specifications for coverage, established criteria or standards for insurers; compared rates and terms for the most efficient contracts and arranged for all contractual requirements, like the application, rating history, specimen tests, inspections, etc. Probably the most important contribution the agent can make at this phase is in aiding client indecision. Clients and agents alike can be frequently confused by the continuing arguments favoring term versus whole life or the value of an inflation rider to protect future property values. The result of these conflicting considerations and advice can be that too much time is spent wallowing in indecision about levels and type of protection for what reasons. The fallout may be over insurance or under insurance or no insurance at all. The professional agent who practices due care will also provide counseling to bring these decisions to settlement. On-Going Risk Monitoring can be as crucial as any one or all of the processes involved in risk management. Simply put, after the implementation of the appropriate policy, it should be the agent's duty to review coverage annually, evaluate on going adequacy, stay current with new coverage that might better suit the client's needs, alert the client when the policy needs to be renewed and be available to assist in servicing needs such as title changes, claims assistance, alternative payment planning, etc. While the process of risk management is conceptually similar across most product lines . . . life, health, disability, property, casualty . . . the analysis of exposure is quite different. Following is a discussion of possible due care precautions an agent might explore when working in each product line. In cases where the agent does NOT handle multiple lines of insurance, a simple disclosure and referral may be advised to meet minimum due care.

Sales Conduct Life & Health

Questionable market conduct in the 1980's and early 1990's created new demands for todays agent. For life and health agents, past abuses have centered around twisting, wholesale replacement, deceptive advertising, misleading illustrations and other unethical acts. Regulators have responded with replacement policy forms, insurer fines, agent reprimands, and in some cases, revocation of licenses. To compound the problem, the industry's image has been further tarnished by solvency problems. Further, stiffer competition, declining interest rates and thinner profit margins have impacted how insurers and agents work together -- less support in marketing and support materials. The bottom line in either case is that agents are forced to work harder and smarter. In lieu of sitting back and waiting for the market to improve, industry forecasters say that agents must accept new roles to survive. Repeat business, referrals and long-term rewards must center more around client needs, rather than the products agents wish to sell. The trend toward "agent as counselor" is the most obvious path. Putting oneself out to be knowledgeable in many financial matters, however, will come with a price tag as you will see in this chapter. Both regulators and clients will hold insurance professionals to ever higher standards. Agent due care and sales conduct will be more important than at anytime in our industry's history. This will involve a commitment by agents to polish skills and acquire a systematic approach to filling client needs. Following are some basic due care discussions which may help the agent get started. Of course, every situation will vary and require constant refinement:

Life Insurance Risk Analysis

Before determining the amount of life insurance needed by a client, due care would involve the agent and client in a discussion concerning the various types of life insurance available . . . annual renewable term, 19

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deposit term, decreasing term, level term, whole live, modified whole life, single premium whole life, universal life, variable life, etc. The attributes of these different policies are best left to a course on basic life insurance. However, it is critical, under due care, that agents recognize the "pure risk" need of clients and counsel them on the proper choice. For example, persuading a client to accept a high monthly premium whole life policy with a settlement payoff that leaves a significant financial gap at the death of a breadwinner, is NOT exercising due care. This is not to imply that whole life forms of insurance are inappropriate. Rather, there are situations here a client's age and situation call for the agent to consider future estate settlement costs and liquidity as prime directives in making policy choices. There may even be conditions where due care by the agent might involve a recommendation for a client to carry little or no life insurance at all. Issues regarding life insurance needs for singles, non working spouses and children are often debated among financial planners and agents alike. One process for determining an estimate of the amount of life insurance needed is called capital needs analysis. Financial planning courses cover this process in considerable detail and typically include a sample capital needs worksheet. For purposes of proper sales conduct by agents, factors to consider by agents include: Capital needs for family income . Most families will be able to maintain their standard of living with about 75% of the former breadwinner's income. Depending on the skills and resources of the surviving spouse, this fund may be large enough to provide lifetime income or for a specified period of transition. Capital needs for debt repayment Typical debts to consider include home mortgages, charge cards, bank notes, business debt, etc. A decision can be made to totally liquidate the debt or to use life insurance proceeds to set up a "sinking fund" to make payments for the life of the loan or a specified period. Other Capital Needs This might include emergency reserve funds, estimated to be between 50 percent and 100 percent of a client's annual after-tax income, and possible college education funds for surviving children. Estate Settlement Costs Final expenses can be expensive. Uninsured medical costs and funeral expenses are one aspect. In addition, there are federal and state death taxes. Although the Economic Recovery Tax Act of 1981 eliminates the federal estate tax on property passed to a surviving spouse, the estate of the survivor may face a large death tax liability. Further, there have been recent attempts by Congress to lower the exemption levels. State death taxes vary considerably. Current Assets Available for Income Production What current assets, such as savings accounts, investments, real estate, pension plans, etc, are currently available for income production or liquidity needs to offset the capital needs above? Net Capital Needs By combining the above factors, the agent can arrive at the net capital needed to be replaced by life insurance.

Where capital needs analysis indicate that a $500,000 gap will occur at the death of the breadwinner(s), the agent's due care life insurance recommendation should be for $500,000 of life insurance. Anything less could leave the client underinsured. Lesser amounts may be purchased where the client cannot afford the premiums or makes the choice to carry less. If there are additional concerns, such as a clients long-term health, the agent might be advised to disclose his recommendation even though a more expensive policy with less coverage is purchased. On going monitoring of capital needs is necessary to plan for new client objectives, repositioning of debt, inflation, estate settlement changes and potential health problems that may prohibit coverage in the future. Another due care consideration concerning life insurance is ownership or title of the policy. Agents should recognize conditions where it would be beneficial to keep life insurance proceeds out of a client's estate by using a life insurance trust or alternative ownership. Due care may be sufficient where agent disclosure of estate tax consequences of life insurance owned by a client and a proper referral to a competent estate planning attorney is pursued. 20

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INSURANCE MARKETING ISSUES Essential Life Insurance Due Care Questions

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What existing death benefit sources does the client have? Group life, survivor's income, individual plans, association group life plans, pension plan death benefits. Who is insured? Is someone contributing economically who must be added? Do all death benefits, along with available assets, meet client objectives? Are there other needs to consider such as dependents with special problems? Business debts? Personal debts? Are there existing life policies that can be cash surrendered or tax exchanged to more efficient plans? Is waiver of premium available? Is this a desirable benefit for this client? Is there accidental death benefit or double indemnity? If so, is this desirable or can it be dropped in favor a lower premium? Is coverage guaranteed renewable? To what age? Is the client's health stable enough to change policies? Is coverage decreasing term? Is the balance sufficient? Is there a substandard rating that can be removed? Are there policy dividends? Is the client making the best use of these dividends? Or, would reduced premiums be recommended? What are the settlement options available at death? (Lump sum, payment options, insurance trust, etc) Is there a plan for the "common disaster" involving BOTH husband and wife?

Disability Insurance
Statistics have surfaced which indicate that the average person is three times more likely to suffer a lengthy disability than die. Providing a source of financial income in the event of a major disability is probably the most overlooked portion of client financial planning. By definition, a disability can be a temporary or permanent loss of earned income due to illness or accident. Essential Disability Due Care Questions How much monthly protection is needed? Is an individual policy needed to supplement work plans? When does protection need to start? (30, 60, 90 days etc -- the elimination period), i.e., can the client "self-insure" for a period of time? Does the client have discretionary income to buy needed protection? Is the coverage noncancellable or guaranteed renewable? Can a block of insureds, including your client, be canceled? If multiple policies are owned (employer, association, individual), will the benefits of one be reduced by the other? Is there a case for eliminating a policy? Is there an employer supported uninsured sick-pay plan available? What is the definition of a disability in the client's policy? How severe? How long? Does the policy include occupational and non-occupational coverage? Is there a substandard rating or waiver of condition? Will the company remove it? Will another company write without a waiver? Is there a waiver of premium benefit? Would this be necessary for the client? Similar to life insurance, due care analysis by the agent involves "need analysis". Through inquiries and available financial papers the agent should determine the current after-tax income needs of the client. This amount could be reduced by expenses that might be eliminated due to the disability. For example, if the client is homebound, he will not need to cover transportation costs of commuting to work or other work related expenses. Next, an adjustment for possible government benefits can be made using 21

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Maximum Benefit Amounts that might be available from Social Security. Minimum employment history and limitations on the term of protection covered should also be considered. Other adjustments that an agent should investigate include earned income continuing from other family members, investment income that might be derived from current assets and inflation to keep pace with cost of living increases. For just about every client, the above process will establish that some form of disability protection is generally needed beyond the limits granted social security, and in some cases private, employer provided protection. Once a disability need is established, it can be compared to the participation limits allowed by insurers and the ability of clients to afford it. Disability sales conduct would involve an agent/client discussion explaining how disability insurers may ONLY offer certain maximum allowable coverage tied to income, e.g. a client who earned an after tax monthly income of $7,500 might be eligible for a maximum of $3,000 of monthly disability coverage. There may also be limits of how long this protection is covered, e.g., 24 months, five years, or to age 65. Further, there may be minimum waiting periods before coverage begins, e.g., 90 days, 180 days, etc. Also, there may be reductions in the amount of disability protection paid based on the degree of the disability, e.g., a partial disability that allows a client to continue working may reduce benefits substantially. Finally, watch for renewability features. Some policies are truly noncancellable and guaranteed renewable. Others may appear to be renewable unless cancelled by "class". Thus, if an insurer has a particularly bad block of business with a higher than normal claims experience, it can cancel that class of insureds. Clients need to be counseled that the "gaps" in coverage outlined by these events require them to seek alternative forms of protection, develop contingency plans or rely on available pension plans, family members and accumulated savings to make ends meet during times of disability.

Health Insurance
Health insurance is one of the most valuable segments of risk management and the most difficult to predict. This is further complicated by recent efforts to create a national health care system. Hours of agent due care to develop a long term plan for clients may be broadsided by an entirely different style of health care brought on by federal directives. The most efficient form of health protection is by group coverage. Group insurance is the predominant way of providing health insurance today with a definite trend toward HMOs (health maintenance organizations). Due care in health counseling would involve fact finding to determine sources of social insurance available to the client such as Medicare and occupational worker's compensation. Any gaps in coverage need to be filled through blanket health coverage or medical benefits under a liability policy if the health condition developed as a result of an accident. In addition, an agent-to-client discussion should cover points concerning: Basic Eligibility Exactly who is covered? Does "family" include the subscriber, spouse, one, two or more children? How old can the children be and still be covered? Does this change if the children are married? Will family members lose their eligibility when they turn 65 and Medicare takes over? How will a divorce affect a members coverage? Will a foreign or out of state residency longer than six months affect coverage? How long will a retarded or physically handicapped child or member be covered? Total Maximum Coverage A limit to coverage could be present in form of duration and/or a dollar cap. Is this a "lifetime cap"? Is this cap per family member or for the entire family? A lifetime cap of between $2 and $5 million, per family member would not be uncommon and might be considered a minimum considering the high cost of medical care.

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Deductibles How much is the deductible, if any exists? Is it per family member? Per year? Is there a maximum deductible per family? Are there specific deductibles for medicines vs. health care? Are there deductible surcharges if the client does NOT pre register with the insurer, say for non emergency care? Stop Loss & Co-Payments After deductibles, is the client expected to share or co pay any medical expenses? Is there an established time, usually after a specific amount of expenses have been incurred, that the co pay will stop and benefits will be 100% covered by the insurer? Pre-Existing Conditions & Waivers Are certain known pre-existing health conditions prohibited or waivered? If waivered, for how long? Is there a waiting period for unknown pre-existing conditions? Some policies specify a 6 to 12 month waiting period for listed conditions such as: hernia, tonsils, adenoids, hemorrhoids, varicose veins, nasal surgeries, foot and toe surgeries, breast reductions, otis media (ear problems),etc. Exclusions Possible policy exclusions or highly limited protection might include conditions and services as follows: medical costs exceeding limits, unlisted services, service covered by occupational insurance (worker's compensation, etc), health problems due to acts of war, government provided services, Medicare benefits, services from relatives, private nursing fees, custodial care, long-term care, inpatient diagnostics (x-rays not related to specific surgery), dental and hearing aids, vision care, speech therapy, cosmetic sex changes, infertility, weight reduction, orthopedic devices, maternity care, outpatient drugs, acupuncture, nutritional counseling, physical or occupational therapy outside the hospital. Some "bare bones" plans may cover costs ONLY at prescribed hospitals, although emergencies are typically covered no matter where. Some only pay for procedures incurred in the hospital by hospital employed physicians, i.e., regular doctor visits or follow-up sessions are not covered unless specified by the hospital doctor. Further, many plans may cover certain hospital procedures but NOT the supplies, e.g., a blood transfusion procedure may be covered, but NOT the cost of blood. One of the latest trends is the requirement that certain procedures, such as organ and tissue transplants, be pre-authorized. Additionally, some procedures, like bone marrow transplants, are considered experimental and not covered under any conditions. Mental health and home health care are usually very limited areas of care. Dollar limits per day with annual maximums are not uncommon, as are maximum visits per year. Guaranteed Renewability & Rate Changes Can the insurer modify or change premium costs? Under what conditions? Can a class or "block" of subscribers be changed without changing rates for all subscribers? Can the subscriber be canceled? If so, how long will benefits last if client is in the middle of a health crisis? Important Dates & Notification While many of the above exclusions and limitations are typically spelled out in policy brochures or in bold print, issues of important dates and notifications can "fall through the cracks". Proper due care would involve a discussion or memo to the client concerning policy time lines. Examples include: "All claims must be filed within 15 days on approved claim forms"; "the insurer must be notified within 60 days of any newborn or adopted children"; "annual notice is required to sustain coverage for a retarded or handicapped child who is older than the specified age limits"; "a family member must apply for his or her own plan within 31 days of the main subscriber's ineligibility"

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Agents who handle multiple lines of insurance for clients should consider health insurance a clear priority.

Agents who handle multiple lines of insurance . . life, health, disability, property/casualty . . . must consider the impact of health insurance on the client's financial planning. A medical catastrophe can permanently devastate a family. Despite the important of life insurance, disability protection and certain property/casualty coverage, health insurance is a clear priority. It would NOT be considered due care for an agent who handles different product lines to market a $250 per month whole life insurance plan to a financially limited client when there was NO health insurance in place. A more prudent approach would combine a "basic hospital plan" for major medical emergencies at $150 per month and a term life plan for $100 per month. Even the agent who specializes in a specific product line should exercise due care to inquire that clients have health coverage in place or at least budget for same before selling other forms of insurance. Essential Health Coverage Due Care Questions What available sources of health care are available to your client -- group plans (employer provided), HMO's, Medicare, other? Does your client have enough medical expense benefits to meet basic hospital needs or major medical expenses? What family members of the client require coverage and are they eligible? Does the client or family member need supplemental coverage? Should the client terminate any existing or duplicate medical expense premiums? Does the client have dependents who have or will soon terminate coverage under the family plan? If so, can they purchase their own? What conversion rights do they have? Is your client's policy guaranteed renewable? Does the client's health care continue to protect dependents in the event of his or her death? Does the client have a substandard rating or waiver of coverage? Will the insurer remove it? When? Will another company write without the waiver or rating?

Annuity Analysis
Sales conduct concerning annuity investing first involves fact finding to determine what portion, if any, annuities should play in a client's overall financial plan. Next, a needs analysis should be conducted to uncover growth vs. income requirements, risk tolerance, liquidity specifications, now and in the future, and whether tax deferral benefits are worthwhile to pursue. Who should invest in annuities? One rule of thumb follows that a client looking for a long-term investment with a tax bracket greater than 15 percent might consider annuities. Other likely candidates include moderate or high tax bracket individuals looking for a conservative way to shelter current income or growth over a long period of time, i.e., retirement monies. Fixed rate annuities might be an alternative for CDS, GNMAs (Ginnie Maes), T-Bills or other similar obligations. Variable annuities are better geared to individuals who seek tax deferral, yet willing to ride with the ups and downs that accompany stock and mutual fund investments.

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Once an annuity can be established as an appropriate investment opportunity, agents must carefully weigh the following choices and discuss same with each client: Immediate Annuity vs. Deferred Annuity Clients may have current income needs or the desire to defer income for greater growth. Perhaps a combination is appropriate. Tax planning and liquidity are key considerations for the agent. Single Premium vs. Flexible Premium Client's generally have a lump sum to invest or need to accumulate by paying into a savings plan. Short and long-term liquidity is an important consideration. Fixed Rate vs. Variable Rate Client's may have needs to lock-in their yields or go for growth. One group is typically a CD type investor as opposed to those who are willing and able to incur greater risk. Agents needs to carefully explain the potential loss of principal possible in variable plans. Agents should review potential interruptions in return of principal and yield that can develop with either fixed or variable contracts. Yield vs. Guarantees It is logical that the stronger the guarantee the lower the yield. Agents must explain that a higher first year yield may include bonuses or special incentives to invest that later disappear. This type of contract should be compared to other contracts that may offer a slightly lower yield that is locked in for a specific period, i.e., determining overall predictable yield over time is important due diligence. In the same vein, a disclosure would be appropriate as to the method used by the insurer to adjust yield. A contract with a guaranteed yield spread may be more appropriate for some clients than a yield that is adjusted by the insurer's board of directors. Equally important is whether yield is banded, i.e., are yields adjusted separately for certain blocks of investors or are investors who entered five years ago given the same yield as new investors. Yield vs. Liquidity Clients demanding easy access to their money should be prepared to settle for lower overall yields. Agents need to go farther to determine special needs such as the potential for large sums of money to pay for a potential illness or nursing home. Certain contracts allow penalty free withdrawals for special circumstances. Due care dictates that agents carefully and clearly explain all surrender charges associated with the contract and when they occur. Maturity options Annuity contracts may mature at specific ages. This can affect BOTH a client's long-term investment planning as well as tax planning. A client wishing to plan for long term deferral to age 95, for example, might be disappointed to learn that the contract must annuitize at age 85. Further, agents MUST disclose the potential tax affect of a maturing annuity. Pre-1981 Annuities deliver principal first, then tax interest or appreciation. Post 1981 annuities tax interest or appreciation first then deliver principal. Also to be considered is annuitization of the contract where a systematic withdrawal and payoff of the contract over time delivers some principal and taxes interest and appreciation with each payment. Withdrawals & IRS Penalties Where the client is withdrawing all or part of an annuity contract PRIOR to age 59.5, he should be apprised of the ten percent IRS penalty for early withdrawals. At present, this can only be avoided where the annuitant dies or becomes substantially disabled or, where annuitization is chosen within one year of investing in the annuity contract. Guaranteed Death Benefits Where agents assist in estate planning, due care would involve a disclosure concerning death benefits. Most fixed rate contracts guarantee the return of principal and any appreciation (interest left to grow). However, agents should uncover and review factors concerning potential surrender penalties or how they may be avoided, as well as the basis of the guarantee. Is the death benefit guarantee, for example, the 25

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greater of ALL contributions of principal OR simply the value of the contract on the date of the annuitant's death? Settlement Options & Taxes Clients should be made to understand that, at best, annuities represent tax deferral, not tax free income. Unless the beneficiary of the annuity is a surviving spouse, taxes on the accumulated growth will be due -- there is NO step-up in basis. The tax liability is the difference between the amount invested subtracted from the value of the annuity contract, multiplied by the beneficiary's tax bracket. Options to mitigate this include five year or lifetime annuitization of the contract. Other settlement options that should be discussed with the client include possible options such as life annuity, joint and last survivor, lifetime with period certain, etc. State Guaranty Fund Coverage Rules governing state guaranty coverage should be disclosed to the client. If the State does NOT permit advanced disclosure concerning guaranty fund protection, the agent should privately exercise diligence in planning annuity purchases. The primary concern? Is the full amount of the annuity covered against insurer failure. Perhaps due care is served by diversifying among several insurers and/or between fixed AND variable contracts to take full advantage of guaranty protection. Titling Options If the agent is advertising tax and estate planning advice he should disclose the consequences of titling contracts. Where no tax or estate counseling is provided, the agent should still exercise due care by disclosing the fact that titling consequences may result and offer to refer a competent attorney or tax expert before any purchasing decisions. As a general rule, the death of an owner or annuitant triggers a death benefit which carries tax liability. Unless the survivor beneficiary is the spouse, the beneficiary must take a lump sum and pay the tax or annuitize over a minimum five-year period. An important area for agents to investigate is whether the annuity contract enforces or waives surrender charges where a death of the annuitant or owner has occurred. In some contracts, the surrender charge can be deferred where an owner dies and a contingent owner is allowed. Essential Annuity Due Care Questions Is the client interested in growth or income? Is the client interested in current income or retirement income? How soon does he need to start receiving income? How much risk is the client ready to accept today and in the future? Could he stand the loss of his entire investment? How would an interruption in income affect him? What are the client's liquidity needs in the short-, intermediate- and long-term? What is the client's federal/state tax bracket? Does tax deferral through annuities make sense? Is the client under age 60, and is it likely that he will need to withdraw major portions of the annuity in the future? Will the ten percent penalty offset the benefits of tax deferral? Does the client demand full and complete protection of principal? Or, can the client afford to take risk in hopes of greater appreciation using variable contracts? Is the preservation of principal more important to the client than the effects inflation may have against a fixed yield? What are the survivor spouse/family needs in the event the client dies? How can these needs be accomplished?

Business Insurance
The risk managing agent recognizes that due care extends to businesses as well as individuals, since businesses are composed of the same people. The illness, disability or death of these people represent an exposure to businesses in terms of their survivability and commitments to principals, employees and 26

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their families. Sales conduct in business analysis involves a determination of the reduced revenues and increased expenses that may result from the death or disability of a key person in the business, including the possible costs to replace or sell the business, if necessary. The degree of risk protection in business insurance varies by the person who is affected and the legal structure of the company. Following are some due care considerations for three major forms of ownership -- sole proprietors, partners and corporations: Sole Proprietorships There is no legal distinction between personal and business assets . . . debts of the business are debts of the sole proprietor's estate. Agents should determine needs or preloss arrangements of the surviving family to continue the business, sell it or liquidate it in the event of the owners death and disability. Capital deficiencies can be filled through the appropriate insurance line. Partnerships The legal relationship between partners is personal . . . each is fully responsible for acts of the business and business debts of all others. If a partner withdraws or dies, the partnership must be terminated or reorganized. The disability of one partner can also create a significant financial strain on the entire business. Due care planning here involves learning the wishes of the surviving family and surviving partners. Where a deceased or disabled partner's family wishes to exit the business a buy-sell agreement can satisfy the purchase of his share with the business passing to the surviving partner. Alternatively, the heirs of the deceased may become partners or sell the lost partner's interest, assuming this is permitted in the partnership agreement. Again, preloss arrangements covering the possibility of reduced revenues and higher expenses during this transition must be considered. Corporations Most agents will deal with the "close corporation" where the stock is closely held by a few individuals and not offered for public sale. Typically, the stockholders are also employees of the company. In this case, situations similar to the partnership can develop. A key employee or stockholder can become disabled or die creating additional financial burdens on the company. Most corporation charters provide that remaining stockholders can purchase the share of the withdrawing or deceased shareholder. The risk manager needs to uncover the "formula" for purchase and plan available funds via buy-sell policies, disability protection, health care, etc. Other significant due care factors concerning business insurance include planning for taxes and liability. For planning purposes, most transfers or sales of business interest become part of your client's gross taxable estate for purposes of death taxes. Income taxes become a factor in corporations where the challenge is to transfer assets out of the corporation without claims of dividend. This is a very complicated area of planning best left to other courses. The issue of liability will be discussed in sections below. Essential Business Insurance Due Care Questions Who will control the business when your client dies or becomes ill for an extended period? Will there be a market for the business if it has to be sold? Will the business provide adequate income for the heirs of your client? How will the value of the business affect the taxes and liquidity needs of your client's estate? Will the client be able to continue in business if one of his associates dies? How will working capital be kept intact where a partner or owner dies or is seriously disabled? How can a business be transferred to a new owner without shrinkage in value? What will become of your client's interest in the business if he or she retires?

Sales Conduct Property & Casualty

Risk management in the property/casualty arena is extremely complicated, yet the primary goal is the same as other forms of insurance -- the transfer of risk. However, a higher standard of due care and 27

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agent liability exist in property/casualty because of binders, indemnity disputes and redlining. A binder can be written or oral. At the point when the client says "I want it" and the agent says "You're covered", a binder has occurred. Immediately upon creating any oral binder, the agent should make note of the terms of coverage, when the binder was made and the parties involved. Further, to reduce the possibility of disputes, the agreement should be reduced to writing as soon as possible. Abuses occur where agents do NOT have binding authority, yet lead clients to believe they do. Likewise, clients may use binders as a means of obtaining free insurance for limited periods. Property and casualty insurance contracts are contracts of indemnity in that they provide for compensating the insured for the amount of loss or damage. Due care is accomplished when an adequate amount of compensation is provided that will avoid profit or loss from a peril or hazard. Elementary insurance defines a peril as the cause of a loss. Fire, lightening and collision are all examples of perils. A hazard is anything that increases the chance of loss. A loose gas connection to a main heater system is an example of a hazard. Hazards, however, can also take shape in "morale" form. Reckless driving is one such example of a morale hazard. While there are, as yet, no formal rules on insurance redlining, there is pending legislation that would force insurers to comply with rules similar to Community Reinvestment requirements now imposed on banks. If passed, a majority of the burden would fall on underwriters. However, agents should be aware that clients living in inferior, low income or minority communities should NOT be denied application for coverage. The logic behind this is obvious -- without access to insurance, clients would not be able to buy housing.

Clients depend more on agents in casualty matters because there is less public understanding of casualty policies than other insurance.

Compared to life and health contracts, it can be said, that fewer property/casualty policies are read by clients. There is generally less understanding of liability or casualty matters, and therefore, a greater reliance is placed on agent advice and counsel. That is why proper sales conduct would encourage clients to read their policies and help them review the fine print to fully understand exact limits of coverage, define perils, clarify what constitutes a hazard and recognize policy owner duties. Having specimen policies available for this purpose should be standard procedure. Areas where agents should exercise additional due care involve the "agent as counselor". Insurance is the first line of defense in asset protection. The role of the property/casualty agent in preserving what clients have already accumulated is vital. This should not occur, however, without also recognizing the value of other forms of insurance, i.e., A deluxe homeowner's policy should be scaled back where high premiums might not allow clients to purchase basic health insurance. There may also be validity to the argument that insurance premiums should not be so excessive as to preclude clients from starting necessary retirement savings plans. In addition to these points, there are many contributions that can be made by agents to promote greater client understanding of risk, loss control and proper valuation. (See below). By educating clients in these disciplines, a higher level of insurance efficiency will be realized. The result can be stabilized or lower premiums through a lower claims experience. It is true, that this may NOT initially improve agent commissions, but in the long run client retention and income stability will be greater. 28

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INSURANCE MARKETING ISSUES Essential Liability Due Care Questions What is the insured's "insurable interest"? Is the peril covered? Is the property covered? Is the type of loss covered? Is the person covered? Is the location covered? Is the time period covered? When does the policy take effect? Are there hazards that exclude or suspend coverage? What are policy owners duties after a loss? What are the insurer's options in settling a loss? What are the time limits for the policy owner to recover from the insurer? What are the time limits for the insurer to pay a claim?

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Next, a due care discussion might include: Risk A client's perception of risk influences how insurance dollars are spent and, to some extent, how the industry is regulated. Unfortunately, much of society has set a low priority on reducing risk, i.e., "That's why I buy insurance". Many in the industry, however, feel it is extremely important to reassess societal views on risk by assuming more responsibility for risk consequences. An example would be clients who continue to build in flood plains or high-risk fire areas, despite knowledge of their existence. When disaster strikes, should these individuals receive subsidies through taxpayer financed state and federal disaster aid, government flood control projects and mandatory shared-market insurance programs? Should accident victims who violate seatbelt laws receive full compensation? Should people who live in hurricane and earthquake country be responsible to better secure a structure with inexpensive metal ties? Some believe that people must realize what they can do for themselves before risk priorities can change. Agents can play a valuable role in helping clients accept a certain level of risk and strategies to reduce it. Loss Control In the insurance industry, the process of risk reduction is called loss control. Loss control procedures involve the steps necessary in eliminating exposures to risk and reducing their frequency or severity. Today, loss control makes the workplace safer and reduces a broad range of liability exposures in homes as well. Offering loss control advice and services to clients has potential rewards as well as risks. Reasons agents might consider advising clients on safety issues include: client credibility, client retention, new client generation, insurer qualification and attractibility, favorable insurer status and additional profits where "advice fees" are permitted by law. With competition stiff, some larger agencies are establishing entire subsidiaries to perform loss control-for-fee services. In these cases, loss control fees can represent from two percent to ten percent of total agency revenues. Smaller companies may contract to outside loss control consultants or simply rely on insurer provided services. Loss control services can run the gamut from standard, non-controversial safety recommendations to complicated compliance advice. Whatever level of service provided to attract or retain clients, agents should realize that loss control advice exposes him to additional liability. There may also be statutory violations, particularly in the commercial area, for offering safety expertise without required licensing. Code compliance is an extremely important area of loss control. It is a discipline usually reserved for underwriters and typically outside the venue of agents. This does not mean it should be ignored by the agent. Due care should involve the agent at least to the extent of a physical inspection of the property to determine that fire sprinklers are indeed in place or that a security fence has been installed around a construction site before delivery of materials. The importance in doing so is underscored by a mitigation of exposure when an accident hits -- particularly by third parties. 29

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Valuation A recent survey by a well known real estate statistics firm found that almost 70 percent of the homes in the U.S. are underinsured by an average of 35 percent. With an increased awareness of this problem, many insurers of large policies are sending appraisers to high-value neighborhoods to determine if policy replacement values adequately reflect current values. In addition, companies are directing it encouraging agents to re-evaluate coverage levels. In many cases, this involves inspections of properties to account for recent improvements, such as finished basements, patio covers, garage conversions; deterioration; code compliance to rebuild; i.e., new hurricane or earthquake standards; and illegal uses, e.g., a business run out of the home. Bringing inadequately covered premises to full coverage levels increases underwriting income, which may allow a carrier to lower rates within a class of policy owners. Equally important is the liability protection afforded carriers and agents. Both were targets of litigation for misrepresentation and negligence after the catastrophic Oakland fires in California.

Homeowners Insurance
Agents should exercise due care in several important capacities: Selection of Policy The selection of policy type . . . HO-1, HO-2, HO-3, HO-4, HO-6 and HO-8 . . . should be a function of client need. Obvious factors to consider include dwelling type, dwelling size, dwelling construction, dwelling replace ability, additional structures, type and extent of personal property, loss of use and basic liability. Refinement of the process occurs where agent due diligence uncovers clients the true "limits of need" and special circumstances. This can only be accomplished by interview or systematized fact finding concerning key issues: Value The amount of dwelling insurance requested is typically a reflection of the mortgage amount. Does this reflect the true replacement value? Is an appraisal in order for larger policies or where a special construction has been used? Remember, like kind and quality does not mean "exact" kind and quality. Clients must understand that replacement cost is limited to the style, quality and function of the destroyed or damaged property. Few or no allowances are made for increased costs of repair or reconstruction caused by ordinances or laws regulating construction or repair. An example is new construction school fees or special fees that are currently charged for construction that were not around when the client's house was built. Concerning personal property, does an inventory exceed policy limits? Is replacement value available? Should items be "scheduled" like paintings, historical documents, original manuscripts, exotic pets, etc? Are "sublimits" of the policy meeting client needs, cash, gold, coins, stamps, securities, deeds, trailers, jewelry, watches, furs, precious stones, silverware, guns, etc.? After primary values are established, the client's "insurable interest" must be determined since a policy owner will NOT recover for an amount greater than their insurable interest. Eligibility Due care discussions with clients should cover circumstances where their eligibility to recover a claim may be jeopardized. Is the policy owner the intended owner occupant or does he intend to rent the property? Will only one family occupy? Is a business being operated out of a home? Are there code violations like additions without permits, zoning violations, etc? Will the client be unable to perform his duties to mitigate losses (draining pipes to prevent freezing, maintaining heat if the structure is vacant, minimal repairs to protect the property from further damage, etc.)? Is a detailed inventory necessary to track descriptions, purchase dates, values, etc? Are clients aware that they should hold on to damaged property and make it available for adjuster inspection? Do clients need to produce books of account or fill out a proof of loss? Will the client be available to assist and cooperate with the adjuster? Are insureds aware that they should NOT make any voluntary admissions of guilt or make voluntary payments to someone they have injured? Many of these circumstances can be brought to surface in an initial meeting or physical inspection of the 30

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INSURANCE MARKETING ISSUES property.

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Deductibles Clients should be apprised of their deductible options. Although higher deductibles mean lower premiums and lower agent commissions, they represent a fair opportunity for clients accept part of the financial consequences of risk taking. This, in turn, can lead to fewer claims and a generally more stable client. Policy Exclusions If the policy is in "readable form" it should be easier for the client to pinpoint policy exclusions. Some obvious disclosures, however, should include exclusions related to damages caused by earthquakes, flooding, sewer flooding, flooding driven by wind, power interruption, owner neglect, war, freezing of appliances or pipes (especially if vacant over 30 days), theft of a dwelling under construction, breakage of glass if vacant over 30 days, continuous or repeated seepage from plumbing or heat & air system, normal wear & tear, latent defects, mechanical breakdowns, rust, mold, wet or dry rot, contamination, smog, settling, cracking, expansion of pavements, patios, foundations, walks, walls, floors, roofs or ceilings, rodent or pest infestations. Liability & Liability Exclusions Primary to determining liability limits is the client's overall exposure. What is his or her personal net worth that could be at risk? Will the limits of the policy or an umbrella cover the exposure? Are there any liability exclusions in the policy that leave the client uncovered? Some common areas of neglect include: Boats over 50 horsepower, aircraft, motor vehicles loaned or rented by the insured, certain professional services, most business pursuits, outside premises, cases where insured is liable for worker's compensation, for damage to property used by or rented by the insured, etc.

Auto Insurance
Auto policies are typically divided into different segments covering liability, medical, uninsured motorists and damages (comprehensive, collision, towing, labor and transportation expenses). Insuring agreements traditionally offered "split limits" which apply to each person for each occurrence of liability, damage, etc. Today, the trend is more toward a single limit of liability, which can expanded within the policy or through the addition of umbrella coverage, that applies to all covered liability losses arising out of an accident regardless of the number of persons injured or the amount of separate property damage. Minimum due care considerations in this area include: Policy Limits A needs analysis to determine that liability limits of the policy adequately shield client assets and meet financial responsibility laws of the state which may assign specific minimums relating to liability, bodily injury, property damage and/or uninsured motorist coverage. Policy Eligibility Clients should be apprised of the specific vehicles eligible for coverage, e.g., private passenger autos owned or leased, longer than six months, AND those which are NOT eligible, e.g., less than four wheel vehicles, autos used to carry persons or property for a fee and those needing to be named as additional vehicles, e.g., trailers, off-road vehicles, etc. Clients should also be advised that new or replacement vehicles must be reported within 30 days of purchase to receive full coverage. Clients with poor driving records should be referred to assigned risk plans or "fair" plans organized through state programs. Policy Conditions Agents should direct clients to specific areas of the policy pertaining to "duties of the insured after an accident". Clients should be told that they should promptly notify the company of the accident, the time limits within which they should act and steps that they should take to reasonably protect the covered auto from further harm or damage. Policy owners must provide sufficient evidence of loss, cooperate in any insurance investigation and notify the police if a hit-and-run driver is involved or if the covered auto is 31

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INSURANCE MARKETING ISSUES stolen.

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Policy Endorsements Clients should know the options they have to broaden their coverage to include coverage such as full replacement cost, towing and labor costs, rental reimbursements, specialized vehicle coverage, extended nonownership liability, additional damage coverage for special vehicles, named nonowner endorsements, coverage for special personal property coverage for items like tapes, CDS, CBs, portable phones, etc. Some attorneys might advise agents to prepare a written list of available endorsements and the applicable cost to present with the original quote. Clients who incurred claims but refused the option to buy these endorsements would have a difficult time pursuing agents for not making them available. Policy Exclusions Due care discussions should also disclose to clients items of coverage specifically excluded. Examples include: property being transported, bodily injury to an employee of a covered person, motorcycles, offroad vehicles, etc. Also excluded is coverage in areas outside the United States, its territories or possessions and Canada. Clients should understand that an endorsement for extended coverage should be considered when traveling outside these domains. Policy Effective Date It should be clear that coverage begins at 12:01 AM standard time on the date of inception to 12:01 AM on the date of expiration. Named Insured Who is the insured? Is the insured the policy owner, his spouse, a resident of the household, other family members? Auto User Is everyone who uses the auto a named insured? Associated Named Entities What is the name of any other person or organization who may not use the auto but may still have legal responsibility for the acts of omissions of the covered insured?

Commercial & Professional Lines

Commercial and professional insurance takes many forms: investment and commercial property coverage, business owners insurance, farm coverage, commercial auto plans, commercial liability policies, for directors, officers and professionals, workers compensation and more. A full discussion of each goes beyond the scope of this course. However, there are some important due care factors for agents to disclose and discuss with clients. Policy Limits As with most other forms of insurance, a client needs analysis should determine the extent of assets to protect, including any personal exposures. Policy endorsements and/or commercial umbrella protection may be considered as options. Special occurrences may have individual limits which must be evaluated for each client. For example, a "products-completed" limit may be small for a bakery but should be expanded for a lawnmower repair service. Eligibility Rules of eligibility in the commercial arena are very complex. Suffice to day, clients should be aware of ALL limitations that might exclude coverage, including: building size or height restrictions, e.g., buildings not exceeding 15,000 square feet and no more than four stories; business class restrictions, e.g., office uses permitted / manufacturing prohibited or retail permitted / restaurants prohibited, etc. Where liability is concerned, is the policy based on a "claims made" basis or a "claims occurred" basis? Clients should 32

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be well informed that coverage may exist ONLY while they are in business and paying premiums. A claim made ten years after a client retires can be financially devastating. Policy Endorsements Due care should involve the listing of available options to extend coverage, reimburse for loss of use, loss of rents, loss of income, business expense coverage, builders risk protection, for buildings under construction, add or exclude specific accidents, products, work or locations, employment occurrences (termination, defamation, discipline, discrimination, etc), liquor liability, products completed protection, pollution liability, malpractice, errors and omissions, personal and advertising violations, contractual liability, employee use of vehicles coverage, product defects or deficiencies, product recall protections, inflation upgrade protection, replacement cost coverage, personal effects protection, debris removal, etc. Scheduled Losses The exact property or premises covered should be disclosed, buildings, insured's business personal property and the personal property of others located at the business premises. In the case of liability policies, premises and operations exposure is the heart of coverage. Options should also be disclosed concerning upgrades to broader forms of coverage perils like extended reporting periods or extending coverage beyond termination of the policy, earthquake damage, crop insurance, livestock, loading/unloading accidents, window glass breakage, falling objects, weight of snow, water damage, etc. Policy Exclusions As important as what is covered, clients should understand exactly what is excluded: Building ordinances, government actions, power failure, water damage, bursting pipes, explosion of steam boilers, mechanical breakdown, money, animals, autos for sale, illegal property, underground pipes, fences, antennas, signs, etc. Named Insured Since multiple parties may share insurable interest, it is important that ALL parties understand that the "first insured" is typically the "notified insurance partner". In the event of cancellation and policy changes, the conditions of the policy normally name the first insured to be responsible to notify other named insureds. In essence, the first insured is the "point man" for most policy transactions.

Sales Conduct Quotes & Illustrations

In the past few years, media "sound bites" and state regulator attention concerning the financial stability of insurers and sales misrepresentations have been the primary focus of sales conduct. Not far behind are the issues and supporters demanding agent due care in choosing the right policy -- after all, an industry cannot rise to responsible status, perhaps even survive, if its members take a "sale at all cost" attitude. Both these issues have and will be the target of new company compliance procedures and new regulatory standards. These efforts, however, have been pursued more in a "broad brush" fashion with an emphasis on concerns such as fraud, misrepresentation and twisting. Many professional agent groups feel that sales conduct should include a new dimension: fair and understandable illustrations and quotes. The reason? Most insurance purchasing decisions are made by clients and agents using illustrations and quotes. Minor variations in the assumptions that go into these projections can produce dramatically different results -- especially if they are spread over long periods of time. With the advent of computers, multiple page illustrations, some with graphics, literally predict results a client can expect from almost any given product, at any given time in the future using an almost unlimited choice of assumptions. Agents also use mass mailing technology that can tap public records, such as property values, ages, names to personalize and customize a quote without even visiting the property or client. Stiff competition has made the use of computerized quotes and illustrations widespread. Given the sophistication and high quality of these proposals, agents and clients are depending more and more 33

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on the face value of the illustration, rather than the actual policy itself. In many instances, clients and agents alike completely pass on reading the policy. This, in turn, has resulted in some surprises for clients and the call for greater scrutiny of sales presentations from professional associations and some regulators. The problems that surface with most illustration sales relate to the disclosure of assumptions made in illustrations, e.g., interest rates that went down instead of up, insurer insolvencies that could not meet minimum policy rates and/or return of principal, surrender values well below projected results, premiums that were expected to "vanish" simply continued, premium quotes well below replacement value of the property, quotes that do not reflect necessary endorsements, etc. For the most part, the responsibility of misleading illustrations lie with insurer actuaries and marketing departments that produce them. Some agents have also manipulated quotes to specifically avoid true comparisons, i.e., presenting only projected cash values NOT guaranteed values OR quoting skeleton plans void of necessary endorsements. In recent cases, the misuse of illustrations has led to significant charges of questionable sales tactics by state regulators. The MetLife case involved fines totaling $20 million among 40 state agencies and $75 million in restitution to as many as 60,000 customers. Shortly after these fines were levied, the Florida department of insurance filed charges against the company's top agent, and at least 100 more, accusing them of fraudulent sales practices. While there is no one single solution to the problem, some remedies are underway in the areas of education, disclosure and better illustration design. In the MetLife case, the company has created a corporate ethics and compliance department which will audit agent offices in the area of sales techniques, including the use of illustrations. Regulators have threatened to prohibit certain proposal techniques altogether, require specific "full disclosure" requirements. Others are launching new compliance orders like requiring insurers to conduct internal investigations designed to uncover illegal illustration marketing practices. Further, the National Association of Insurance Commissioners has outlined the misuse of policy illustrations as a violation of their Unfair Trade and Practices Act and Congress has proposed the Insurance Marketing and Sales Reform Act to strengthen consumer protection laws concerning advertising and illustration mishandling by agents, brokers and insurers. Currently, illustration disclosure is different from company to company. Certain professional organizations and government agencies, such as the National Association of Insurance Commissioners, are proposing "model" illustration disclosures. In the mean time, some states have already passed laws requiring agent due care to disclose all assumptions of the quote and/or highlight or bold the guaranteed portions of these proposals to contrast the "anticipated" results. Further, life insurance companies are required to answer certain questions in their annual statement filings pertaining to the "basis" of dividend and interest rate projections. These questions include: What is the company's opinion of its ability to continue supporting nonguaranteed elements (interest rates). current dividends and

Are company assumptions of these factors exceeding the company's current experience level.

To a great extent, the answers to these questions fall on the shoulders of company actuaries. These individuals maintain personal standards of practice that require full and complete disclosure. The Society of Actuaries has also promoted education of this problem to its members and the Academy of Actuaries has made recommendations to the National Association of Insurance Commissioners (NAIC) on possible regulatory actions that could be useful now and in the long term. Some industry groups, feel that much of the pressure to greatly restrict or eliminate the use of illustrations is unwarranted. They believe that illustrations can be a valuable tool to educate clients with visual interpretations of their options. Rather than scrap the entire illustration system, for example, it is 34

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suggested that, as a minimum, agent illustration sales conduct can focus on treating the client fairly by implementing the following considerations: Specimen policies should be on file to compare with specific illustration issues and/or client questions. Before doing business with a specific company, request a copy of illustrations for policies the agent intends to handle. Clear up any questions as soon as possible. If the company's management say they don't know the answer, or they avoid requests altogether, it may be a clue that they will handle client policies in a similar way. Agents should be certain that all illustration pages are printed and that all projected interest rates are disclosed and discussed with the client. In casualty quotes, if an AAll Risk policy is presented list ANY & ALL exclusions. Particular attention should focus on matters of age, gender, classification, avocations, past experience and other "default" conditions of the life illustration. For casualty, does the quote match the requested coverage, is the principal disclosed, do words imply that client is bound? Be sure that the client receives all pages and disclosures. On the life side, look for sudden jumps in cash values or premiums -- especially in later years.

LEGAL CONDUCT FOR AGENTS Do You Cross The Line?

The line between legal responsibility and agent misconduct is often thin. Few agents can say they have never crossed the line. . . went out on a limb for a client . . . looked the other way or fudged just a little when selling or serving a client. These indiscretions, hopefully tiny and few in number, usually lead to nothing. But when something goes wrong an agents biggest fear comes true. . . a malpractice lawsuit. Anyone involved in one can tell you its a living nightmare. Beyond the financial liability, victims are dragged, kicked and punched through the legal maze known as our justice system. It is the domain of judges, attorneys and plaintiffs, a place no one cares to revisit. If you are worried about this happening to you, you wont be able to put this book down. If you think it cant happen, you should know that almost 15 percent of the agent population is sued each year, and nearly three-fourths of these claims are frivolous, virtually beyond your control. The longer you stay in the business and the more expertise you develop, the bigger the target you become. YES, the litigation explosion is coming to a neighborhood near you and it might just end up on your door-step. The reason this threat is greater now than ever before is a matter of public record. Insurance companies are fighting back, evolving from an almost cavalier attitude in settling nearly every claim, to a wholesale frenzy for standing firm . . . taking plaintiffs to trial. Of course, this has come at the great expense and frustration of every personal injury attorney who liked the old methods of settling a claim . . . before trial, but hated the big battles and courtroom antics glorified in LA LAW. For the more lucrative cases, attorneys are pushing back. Others are looking for greener pastures . . . directions where there is less resistance. In the case of insurance conflicts, can you think of anyone these attorneys might pursue who might be easier to get at than a major insurance company? Someone without staff attorneys, little time to spare and a lacking a huge legal pocketbook. Are there individuals who might fold quicker than a big insurer and belly-to-the-bar to settle a claim to avoid a long and protracted trial? If you havent guessed by now . . . its you, the working insurance agent! You could be the next victim of a clever attorney looking to cash-in on a quick settlement when something goes slightly astray with your clients coverage. Even if you are lucky enough to avoid a claim for now, every time another agent is sued, it gets closer to you because our court system makes legal decisions based on precedents. Litigation experts believe this system is destined to expand liability to higher and higher levels because each decision in the chain 35

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sets the stage for the next step of expansion. For example, the recent Southwest vs Binsfield (1995) case decision automatically creates added exposure for MOST agents, i.e. a legal precedent is established . Agents who fail to comply, are potentially closer to a lawsuit than others. This, coupled with the willingness of judges and juries who sanction the expansion of legal theories in our courts, means that liability gets closer and closer to you for smaller and smaller violations. As a matter of fact, you will learn from these pages that you can be held responsible for matters related to the fact that you are a licensed insurance agent and your client is not! You will also learn that the root of most agent conflicts lies in the inability to understand statutory and fiduciary duties. When you know what is expected of you, proper legal and sales conduct can be followed and conflicts minimized. In another section in this chapter you will hear about the blunders agents have made and how insurance conflicts boil to the surface. Dont panic if you suddenly discover that you have made some of these same mistakes . . . most agents are guilty of something. However, dont believe that because you havent been sued you are in the clear. Thanks to our legal precedent system, seemingly innocent events of the past are potential big problems today. To survive it all you need to justify your actions, manage your errors and plan ways to avoid making them in the future, i.e., you must change the way you do business. There are many suggestions and guidelines provided under these covers to help you develop office and sales procedures that may be critical if a lawsuit develops. Finally, dont depend on this book to be a universal solution for avoiding litigation or handling your own defense, rather it is a big, bright WARNING BEACON. Study it, learn from it, but get legal advice before taking any action to reduce or defend a possible insurance conflict.

Agent Responsibilities
The agent of the late 1990's and the new millenium deals with stiff competition, fast-paced decisions and some very unpredictable insurance markets. To aggravate this condition, we live in an era where courts are very sympathetic to consumers. People feel entitled to seek complete and generous compensation for the smallest problems, even when they are contributors or the discovered source. Furthermore, the consumer of our time has lost all respect for the status of the professional, any professional. This includes doctors, lawyers, teachers, clergy, real estate brokers, stockbrokers and insurance agents. Few would think twice about suing any one of these professionals to receive satisfaction for an honest mistake, let alone one leading to a financial loss or injury. Understanding this, it is easy to see that the selling of insurance can lead to conflicts and legal disputes. When an insurance agent and his client cannot resolve differences, agent liability can result, even when the agent is right. In fact, about 75 percent of all insurance malpractice claims are frivolous, and while an agent may never pay any damages from these claims the process of responding is very costly, BOTH in money and lost production. Claims against you may surface as a result of events that occur before or after a policy is issued, and they may involve you and a client, your insurer or a third party who is an intended beneficiary. Cases can

Courts are sympathetic to consumers who have lost all respect for the professional and feel entitled to compensation for the smallest problems.

be built around issues of legal conduct (the subject of this section) as well as sales conduct (last section). 36

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INSURANCE MARKETING ISSUES Throughout this book you will learn the triggers that launch insurance related lawsuits.

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They can be as basic as failure to secure the type or amount of coverage requested by the client to more complex and seemingly "blue sky" claims where clients demand recoupment of losses and damages simply because of a relationship that existed between agent and client. Other claims span the gamut from client losses due to an insurance company failure to refusal to pay a claim. Sometimes, an agents liability is the result of simply being too busy to witness a signature or too rushed when entering a policy premium payment . . . small blunders . Of course, a single incorrect digit or a blank you forgot to fill can make the difference between a policy in force and a cancellation or denial of claim -- a matter that is a guaranteed BIG DEAL to a client when an accident, death or problem occurs. Agents who have never been sued are sometimes lulled into believing that the way they do business must be working. Unfortunately, this ignores the real possibility that the same events of the past, that werent a problem, can now become a problem. It is a world of legal rights and little trust. The long-term client who you trusted, can change. Also, regulations change, industries change, economies change and no one can really keep up or control every aspect of their present business, let alone the future. Can you imagine, for example, the changes that will occur over the life span of a whole life policy between today and when it endows in fifty or sixty years? Will a state or federal regulation change the way automobile or health policy benefits are triggered? Will the IRS retroactively disallow tax benefits for a an annuity contract or single premium policy you sold three years ago?

The selling of insurance carries definite risk. Agents need to accept it and manage it.

No one knows the answers to all these questions, but it should be clear by now that as an insurance agent you are prone to errors, some beyond your control. As a business person you need to accept the fact that your business carries risk. Then, you need to find ways to manage and plan for these risks to minimize the fallout when a claim occurs. You will notice we said when a claim occurs not if a claim occurs. We say this because statistics prove that anyone who stays in the business long enough WILL suffer the wrath of a client or insurance company claim. You can try to avoid conflicts, make friends with your clients, buy errors and omissions insurance, incorporate and practice other means of asset protection, but you will always be at risk for the one problem that seems to fall through the cracks and rear its ugly head at your doorstep. You have to plan for that day NOW. In subsequent chapters, we suggest several steps to help you reduce and manage this exposure. Now, lets look at the deciding issues that establish your legal conduct and create agent liability.

Liability Based on Agent Duties & Status

The most critical questions in determining agent liability is the extent to which accepted legal standards, state licensing and agency status obligates the agent. This process involves the investigation of many areas, including: Basic Agent Duties, The Law of Agency, Producer's Status (relationship to the client/insurer) and the classification of the producer as Agent/Broker or Agent/Professional.

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Basic Agent Duties

The agent/broker generally assumes duties normally found in any agency relationship. The primary obligation here is to select a company and coverage and bind the coverage (if the agent has binding authority, i.e., property/casualty agents). However, since clients typically request coverage, the basic duty may expand to include the agent deciding whether the requested coverage is available and whether the insured qualifies for it (Harnett, Responsibilities of Insurance Agents - 1990). The mere existence of an agency relationship, or the simple selling of insurance, imposes no duty on the agent/broker to advise the insured on specific insurance matters (Jones vs Grewe - 1987). Duty also DOES NOT require the broker/agent to secure complete insurance protection against any conceivable loss the insured might incur, but there may be a duty to explain policy options that are widely available at a reasonable cost (Southwest Auto Painting vs Binsfield - 1995). An agents duty to provide correct coverage is not triggered by a clients request for full coverage because that request is NOT a specific inquiry about a specific type of coverage (Small vs King - 1996). In other words, just because a client asks for full coverage an agent may not be liable to provide it. However, if a client requests a specific type of coverage, the agent is responsible to see if it is available and determine if the client qualifies.

Agents are not required to obtain complete insurance protection for clients but may need to explain widely available options, gaps in coverage and in some cases monitor policies after the sale.

An insured is entitled to rely on an agent/brokers advice on the meaning of policy provisions. In Stivers vs National American Insurance - 1957, it is suggested that client reliance may sometimes be unjustified, as when the advice given by the agent is in patent conflict with the terms of the policy It is a clear legal responsibility of agents to understand the difference between two products that he is attempting to sell (Benton vs Paul Revere Life - 1994). Whether an agent has an affirmative duty to inform a client of possible gaps in coverage depends on the relationship of the parties, specific requests of the client and the professional judgement of the agent Born vs Medico Life Insurance Co - 1988). Once a policy is issued, traditionally theories of legal conduct provide that an agent does not have the duty to ferret out, at regular intervals, information which brings the policyholder within provisions of a policy (Gabrielson vs Warnemunde - 1988). In essence, it seems the courts have been more concerned about general agent duties to inform clients of appropriate coverage at the time of sale. Recent

Knowing the difference between two different policies in an agents own product line is a legal responsibility that cant be ignored.
departures from this opinion include a case where an agent was found liable for failing to determine that the insurance policy was no longer needed by the client (Grace vs Interstate Life - 1996). In another example, an agent assured his client that the limits of the policy continued to meet his needs when they actually fell short (Free vs Republic Insurance - 1992), i.e., agent duties may also include informing clients their coverage is appropriate after the sale. Although each case stands on its own, the underlying 38

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determinant of after sale duty may be the special relationship that exists between client and agent, e.g., an agent handling the clients business for an extended period of time may assume a higher standard of care. These are the basic agent responsibilities. Agents are not precluded from assuming additional responsibility, which they normally do in most client transactions. When a lawsuit arises, however, it is the clients burden to show that greater duty is the result of an express or implied agreement between agent and client (Jones vs Grewe - 1987) where the agent has taken more responsibility. In most instances, the facts of the particular case determine whether the court finds a greater duty has been assumed. Another area of legal conduct involves the Law of Agency.

The Law of Agency

The Law of Agency is a universal area of the law that determines producer status and specifically binds the agent/broker for his acts and his omissions or errors. Simply stated, the law of agency, for most states, establishes many categories of insurance agents and concludes that the authorized acts of the agent automatically create duties and obligations an agent must follow. These responsibilities occur between agents and principals (insurance companies) and as between agents and third parties (clients or intended beneficiaries).

The agency status you hold when a problem occurs can affect your liability. Will you considered an agent for the client or an agent for principal (insurer)?

An agency relationship begins when agents are granted authority to operate by expressed, implied or apparent agreement. This can be created by contract or agreement or it can take the form of casual mutual consent. What is interesting about the business of insurance is that most agents start out as an agent for the client, when coverage is requested, and then become an agent for the company, when business is placed. As you will see later, the exact status you occupy when a problem occurs affects your liability exposure. A person who markets insurance is typically referred to as a producer . The insurance market and many state laws describe different kinds of producers -- general agents, local agents, brokers, surplus or excess-line brokers or agents and solicitors. Following is a brief description of these categories: General Agents The general agent assumes many responsibilities, greater liability and usually incur higher business expenses. As a result, they are typically paid the highest commissions. In the property/casualty field, many sales agents with general agent contracts do not serve all the functions of a general agent but are important enough to their insurers to receive general agent commissions. In all lines of insurance, general agency contracts, or similar classifications, are frequently awarded as a competitive device to obtain or retain a particularly outstanding agent or firm. Local Agents The local agent represents the insurer. He or she may represent more than one company. Commission schedules are typically lower for local agents because they do not usually perform technical services 39

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usually reserved for the general agent or branch/regional office; such as underwriting, policy implementation, claims support, etc., and are subject to a lower level of liability than other agent categories. The local agent is principally a sales representative of the insurer who acquires business and counsels clients. Brokers Theoretically, brokers are agents of insurance buyers and not of insurers. Their job is to seek the best possible coverage for clients. This is can be accomplished in a direct manner with the broker acting as salesperson or through a network of agent contacts. Premiums paid by clients include the cost of commission paid to the broker by the insurance company, so the client indirectly pays the commissions of both the broker and agent. In the liability/casualty area, some brokers maintain a loss-control staff to help counsel clients on safety and prevention matters thereby aiding clients to secure a lower premium. In a sense, these brokerage firms act as insurance and risk managers. Surplus Brokers / Agents Sometimes a client will seek a highly specialized coverage not written by an insurer licensed in a home state. Examples might be an unusually high excess liability plan, auto racing liability, strike insurance, oil-pollution liability, etc. To handle these limited lines of coverage with "non-admitted insurers, states typically license surplus or excess line agents and brokers. Solicitors Another type of producer is the solicitor who usually cannot bind the insurer or quote premiums. The solicitor seeks insurance prospects and then handles the business through a local agent, broker, branch office or service office. Marketing Organization & Clusters A off chute form of producer status occurs when agents join marketing organizations or clusters. Neither is a legal entity, but both can represent exposure to the agent if operated in a certain way. Most marketing groups and clusters are a simple banding of individual agents operating as sole proprietors for the obvious advantages that come with numbers (better contracts, group perks, access to information, etc. In this instance, member agents have no responsibility for one another or the entity itself. However, these groups are potentially more dangerous arrangements if the member agents have formed a general partnership to operate as a group. Here, the acts of one agent can hold ALL others responsible. Producers can also be classed as actual agents/brokers -- those given express or implied authority -or ostensible agents/brokers -- those whose actions or conduct induces others to reasonable believe the they are acting in the capacity of an agent/broker. An agent binds his principal when he acts within the scope of his authority. The exception is when an agent and an insured are proved to have colluded with intent to defraud an insurance company. In such a case, the principal or insurer is not culpable or bound by the policy. Insurance companies always attempt to tightly define or narrow the authority of agents to limit their exposure to agent wrongdoing. In practice, however, the law generally considers the agent and the insurer as one and the same, even though the agent works as an independent contractor. So, the insurer is most often legally responsible for the acts of the agent and are regularly sued by third parties (clients of the agent) who feel they have been wronged. Of course, when a policy owner sues his insurance company, agents are often named for various breaches of duty between client and agent.

Agents who advise clients they are covered with knowledge that the intended insurer has not yet agreed to coverage are liable for client losses, i.e., i.e., the agent acts as the insurer until coverage is accepted.
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Agent liability may also exist where insurance companies sue their own agents. Insurance companies and errors and omission carriers alike exercise their right to sue an agent under various legal theories, typically for indemnity of any judgement losses they may have incurred through a policy owner claim (see Liability From Insurer Claims Against Agents -- later this chapter)

Insurance Producer Status

When marketing insurance, the agent may assume the character of a mere sales representative or the specified agent of the client. As mentioned earlier, agents generally start out representing the client who requests coverage and then become the agent for the company when business is placed. Other than brokers, agents rarely retain principal status throughout a transaction. When a dispute occurs and a producers status cannot easily be determined the courts usually rule in the direction of agency relationship. This bias is commonplace for two reasons. 1) It is easy to establish

When disputes occur, and agency is not clear, the courts generally lean to the assumption that an agency relationship existed to establish links to the deep pockets of the insurer
that an agent is representing his insurance company since there is typically a preexisting, written agency contract between the parties (the agent and the insurer). This relationship is distinguished from a principal-agent relationship where the client requests that the agent accomplish a specific result such as "Buy $150,000 of coverage from XYZ Company". 2) Holding a producer to be a true principal could block many claims a client might have against the deep pockets of the insurance company (Canal Insurance vs Harrison - 1988). If the insurance company was not made part of the claim, the clients only recourse would be the resources of the agent which are likely to be a lot less than the insurer. In cases where the producers status is unknown at the time a problem occurs, the courts have the difficult task of trying to determine who initiated the relationship. Here again, when in doubt the law leans to the assumption that the majority of insurance transactions are agency relationships even though the client may have called the insurance agent first. Otherwise, the mere fact that clients request coverage . . . which they do in virtually every instance . . . would establish a principal-agent status every time. The courts feel this is NOT an appropriate conclusion. A huge problem for agents occurs when they act as principals, when, in fact they are not, or when they have neglected to identify the principal, i.e., an undisclosed principal. An agent who advises a client that he is covered, with knowledge that the intended insurance company has not yet agreed to accept such coverage acts as the insurance company until coverage is accepted, i.e., the client has FULL RECOURSE against the agent for any uncovered loss. If it can be proven that it was reasonable for the client to assume that the agent actually had real authority to act for the principal, the client can hold the insurer to the contract, even when one did not exist (Stock vs Reliance Insurance Company - 1968). The client who incurs coverage shortfalls is in a much better position to recover from the agent where a principal (insurance company) is NOT disclosed. Of course, a written disclosure agreement indicating that the agent was a representative of the insurance company, acting as principal or not disclosing the principal for a specific reason would go a long way to clarify that the status between the agent and client, or agent and company. In commercial insurance transactions, agents go to great lengths to clear the air concerning agent status by using a broker of record letter. These letters authorize or terminate agency and stand as proof of evidence that an agent is representing the client/principal or out of the loop. 41

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In a dispute, agents should be prepared to prove their agency status. A disclosure agreement between agent and client could help establish an agency relationship vs. the higher liability of a principal-agency or broker relationship.
In some agent liability cases, status is not the consideration at all, rather claims are filed for a variety of activities outside the scope of an agency contract. In essence, agents create dual agency, when representing themselves as agents of the insurance company and as principal to the client in the form of an expert or consultant. As you will see, outside activities such as these create additional liability. Further, it is doubtful that the court will care whether an agency status or agent-principal relationship actually existed because wrongdoing will be actionable against any agent acting as a principal. Additionally, claims of this nature are difficult for agents to defend and NOT typically covered through errors and omission insurance. Producer status problems also occur when unlicensed employees of the agent are found to be doing the work of a licensee. A small mistake here can become a big deal (Williams Insurance Agency vs Dee-Bee Contracting Co -1984). You can be held responsible for any claim or shortfall and it will likely void your errors and omission coverage. Insurance department sanctions, fines and possible revocation of license could also follow.

Agent vs. Broker

In actions against an insurance agent, the plaintiff's attorney will first try to determine whether the agent's status is that of an agent or a broker (primarily casualty agents). The outcome of this initial task will provide the malpractice attorney with legal procedures and strategies to proceed against the agent, his insurer, his errors and omissions insurer or ALL OF THE ABOVE. For this reason, it is extremely important for agents to know their legal status. An agent is legally defined as "a person authorized by and on behalf of an insurer, to transact insurance". Agents must be licensed by the state and typically require a notice of appointment be executed. This document appoints the licensed applicant as an agent of that insurer in that state. Thus, an insurance agent is the agent of the insurer, NOT the insured (client). Of course, an insurance agent may be the appointed agent of more than one insurer. An insurance broker is "a person who, for compensation on behalf of another person, transacts insurance, other than life with, but not on behalf of, an insurer". Brokers must be licensed through most states and are not prohibited from holding an insurance agents license as well. A broker who is also a licensed agent is deemed to be acting as the insurer's agent in the transaction of insurance placed with any insurer who has a valid notice of appointment on file. Basically, an insurance broker is an independent business or business person that procures insurance coverage for clients. Brokers generally receive commissions from the insurer once coverage is actually placed, and except when collecting premiums or delivering the policy, is the agent of the insured for all matters connected with obtaining insurance coverage, including negotiation and placement of the insurance (Maloney vs Rhode Island Insurance Company). Typically, brokers are insurance professionals who maintain relationships with several insurers but are not appointed agents of any of them. The purpose of determining whether the insurance producer was acting as a broker or as the insurer's agent when an insurance contract was placed helps establish the theories of liability that the client may 42

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plead and what defenses the agent or his insurer may raise. In many court cases, it is not clear whether the producer was acting as a broker or an agent. So, attorneys typically plead their case under the banner of each status thereby plucking the feathers of the agent and the deep pockets of the insurance company at the same time. Agents should be prepared to prove or disprove legal status at any given time. Under basic liability theory, a client and his attorney may find it quite difficult to seek recovery from a producer acting ONLY as an agent. Traditional agency law in most states concludes that the insurance agent, acting as agent of the insurer, owes duties primarily to the insurer. Of course, this assumes that the agent performed in the ordinary course of his or her duties as agreed between the agent and insurer per terms of the agency contract. Where an agent is acting properly, a person wronged by an agent's negligence has a cause of action against the principal or insurance company, although this does NOT preclude clients from naming the producing agent also. Another general rule of agency law states that if an insurance agent acts as the agent of a disclosed principal, the principal -- NOT THE AGENT -- is liable to the client (Lippert vs Bailey - 1966). Broker liability is different. The insurance broker is normally considered the insured's agent and owes a much higher level of care to the insured. Brokers can be liable if these duties are not adequately performed. Additional liability can accrue where the broker is ALSO acting as the agent of the insurer. Here, the insurance company may pursue the broker for breach of duty. Where a dispute arises and the insurance company can make out the party who solicited the insurance business to be a broker, rather than an agent, then any errors and omissions on the part of that party will exempt the insurance company for the broker wrongdoings. One very important reason why broker liability is greater than agent liability lies in the fact that the broker, when acting within the scope of authority granted by the client, binds or obligates the client to perform. Obviously, the broker is in a position of greater trust and, therefore, bears greater liability.

Agent vs. Professional

Despite rules which seem to offer reasonable protection of the agent producer, it should be made clear that agent wrongdoings outside the agency contract and other torts, WILL subject the agent to additional liability exposure, and it is easier than you think to step outside your agency agreement. A few pages back, we described a dual agency as the situation where the agent first represents the client as agent, then switches to agent of the company when business is placed. Now consider that dual agency, and the added liability it creates, also occurs when an agent assumes non-agency duties by agreement or simply by professing to have special expertise . A slogan on a business card, letterhead or company brochure may have sufficient information to establish you as an agent and a expert in the eyes of the law. When dual agencies such as these exist, the agent may be held liable for a breach of fiduciary duties owed directly to clients (Sobotor vs Prudential Property & Casualty - 1984) and, perhaps, contract and statute duties to the insurer. (Kurtz, Richards, Wilson & Co vs Insurance Commun Marketing Corp - 1993).

Agents can be held liable for lack of reasonable follow through in obtaining coverage or simply by their silence when coverage is unavailable.

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It is clear that activities beyond the scope of an agency contract can be dangerous to your financial health. If you go there you need to proceed cautiously. This is NOT an indictment of any agent who seeks to improve his practice by becoming a true insurance professional, complete with degrees and designations. The existence of these honors, by themselves, is not the problem nor a target. As a matter of fact, some feel that the presence of these awards may inhibit a clients willingness to file a claim. Rather, it is the agent who, regardless of his degrees or credentials, professes to be an expert but fails to deliver. In essence, we are talking about failed promises. Agent wrongdoings in this area represent the majority of ALL insurance conflicts.

An agent who professes special expertise, establishes a dual agency and assumes additional liability exposure to both his client and insurance company.

If you are somewhat confused about this agent / professional controversy you are not alone. There are many agents of professional status, such as CLUs, CPCUs, CICs, AAIs, ARMs and more, who practice due care for all the right reasons. Most stay clear of conflict by managing it. There may also be an entire army of extremely qualified agents who stay clear of professional designations for fear that the added exposure cant be managed. Perhaps there is room toward the middle. A position we call responsible agent. These individuals also practice due care, yet operate strictly within the bounds of agency. They accurately describe policy options that are widely available, but pass on outside inquiries, not because they dont know, rather the request goes beyond the scope of their authority. They do not profess to be experts but know their product better than anyone. Their goal is simply to be the most responsible agent possible.

Conflicts Through Contract Disputes

Regardless of producer status, agent or broker, disputes develop where terms of an insurance contract are violated or promises are not kept. Producers can be liable under two principles : 1) The existence of an insurance contract or principal-agent agreement or an implied agreement, and 2) The breach of contract or nonfulfillment. A violation of contract terms is fairly clear cut. Primary breach of contract, however, can surface under any of the following headings:

Failure to Act/Procure Coverage

This is one of the most important areas of agent/broker liability because an estimated 60 percent of all claims result from agent malpractice in failing to procure coverage. In a typical transaction, a broker or agent agrees to procure a certain type of coverage for an insured. It is well established that the broker has a duty to exercise reasonable care in procuring that coverage. Consider the following cases: (Jones vs Grewe - 1987); a failure to actually procure coverage (Keller Lorenze Company vs Insurance Associates Corp - 1977); or, a failure to perform some function related to the insurance coverage -failure to see that policy was actually provided (Port Clyde Foods vs Holiday Syrups - 1982); or, failure to forward premiums to prevent lapse (Spiegal vs Metropolitan Insurance ). In general, when an agent negligently fails to obtain coverage for a client, he steps in the shoes of the insurance company and becomes liable for loss or damage the limits of the policy until insurance is found (Robinson vs J. Smith Lanier Co - 1996). Liability may also be held to result from an agreement to procure a desired coverage at the lowest obtainable premium rate (Hamacher vs Tumy - 1960). Prior knowledge of an insureds 44

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condition is also considered failure to procure coverage (Soho vs Tri City Brokers 1998).

Failure To Notify Lack of Coverage

Agents/brokers can also be liable for silence or inaction, as in an agents failure to reasonably notify the applicant that the he is unable obtain insurance (Bell vs O'Leary - 1984). The key here is how long a delay is normal before informing the client. The courts have not established any parameters other than that what is reasonable. In one case this meant 2 days, in another four weeks. The best advice is keep clients fully and continually informed.

Failure To Place Coverage At Best Available Terms

As part of the duty to exercise good faith, reasonable skill, and ordinary due diligence in procuring insurance, a broker has a higher duty than agents to be informed of the different insurers and policy terms and to place coverage at the best available terms. If other brokers working in the same market knew that better terms were readily available, the broker who failed to obtain these terms for the client could be liable for the client's loss (Colpe Inv. Co vs Seeley & Co - 1933). This case dealt primarily with the fact that the broker failed to obtain "coinsurance" clauses that were commonly available and carried a lower premium. This must be distinguished from cases proving that the broker does NOT have an absolute duty to obtain the lowest possible rate (Tunison vs Tillman Ins. Agency - 1987).

Failure To Renew
If an agent has a history with a client of automatically and voluntarily renewing or reminding them to renew a policy, he can assume exposure for the one and only time he forgot (Siemorama vs Davis Manufacturing Co - 1988). With the trend toward direct billing of clients by insurers, agents are not as close in contact as before. However, agents may still have renewal responsibility if the client depended on this service in the past. Other issues concerning breach of contract include the following:

Policy Promises & Provisions

Agents should ALWAYS review client policies and retain "specimen policies" on file to answer prospect/client questions and compare with policies received. In most states, agents are legally bound to accurately describe the provisions of policies they procure for their clients ( Westrick vs State Farm Insurance - 1982) and point out the difference between different products he is selling Benton vs Paul Revere Life - 1994).

Agents are legally bound and responsible to accurately describe the provisions of policies they sell.

Many lawsuits have been pursued on misunderstood policy time limits which restricted the clients ability to perform or file a claim. Agents can easily become a focus of these dispute. Another misinterpretation might be: What is an "accident" defined to be? An insurer may deny a claim for lack of requirements establishing an "accident". Or, what is "reasonable medical treatment"? Some agents might be taught NOT to volunteer information on an issue such as this. But, insurers and agents have a fiduciary duty 45

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to their insureds to disclose full and complete information. Failure to do so may result in a claim of fraud (Ramirez vs USAA Casualty Insurance Co - 1991).

Agent Promises
From time to time, agents make promises that EXCEED what the actual policy promises. Obvious violations and examples would be intentional or unintentional misquoting of policy limits, specified

Agents can be held personally responsible for any promise that exceeds the limits of the policy .

coverages and exclusions. Agent liability also existed in a case where a producer promised to arrange "complete insurance protection" for a business or where an agent promised , but never did, to evaluate an appraisal of an individual's property or to determine its "insurable value" in order insure a certain percentage of that value. Additionally, an agent might promise to implement or increase a client's coverage "immediately" yet actual coverage might not be in force for 24 hours or until expiration of the existing policy. Less obvious, but equally as serious, are failed promises. A recent example is the marketing of "personal pension plans". Clients, who were promised a "pension plan", received a universal life insurance policy. Agents involved in this scheme are now subject to huge fines, client actions and possible license revocation.

Advertising Promises
Advertising violations are among the most costly mistakes. Regulators have been known to levy stiff fines of $1,000 or more per violation. In other words, 1,000 non-compliant flyers distributed in the mail or otherwise could amount to a fine of $1 million or more ($1,000 X 1,000 flyers). We have devoted an entire section to advertising in the section titled CONSUMER PROTECTION ISSUES YOU CANT IGNORE. By contract, agents are required to secure company approval of all advertising. Few agents, however, would think twice about scrutinizing company provided ads. However, it is suggested that agents carefully review advertising provided by the insurer to make sure it honestly reflects the promises of the policy. Violations that result in claims would probably not be actionable against the agent, but may name the agent nonetheless or may establish some form of "alleged" agreement that binds the agent / insurer.

What Policies Say vs What They Mean

No matter how clear the language, all policies will contain areas of ambiguity. The universal rule of policy ambiguity, generally upheld by most state courts, goes something like this: If the policy could imply to a reasonable or average policy holder that coverage is in force, yet that exact language does not exist in the policy, then coverage DOES extend to the policy holder. Agents may easily be involved in claims

At the minimum, policy holders should expect their policies to be fair and say what they mean. Policy ambiguity is typically decided in favor of the client.
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INSURANCE MARKETING ISSUES resulting from contract ambiguity.

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Client Understanding and Reading of Policies

In days gone by, courts required people to be accountable for their actions. Clients were required to live up to the terms and conditions of a policy even though they did not read them or fully understand what they read. Agents have been cleared in many policy conflicts simply by pointing out the applicable clause or meaning. Consumer groups kicked and screamed and pushed for simplified wording. Today, policies are indeed more user friendly and the courts are still sympathetic to consumer confusion about their policies. Now, policy conflicts are determined by whether it was reasonable for a certain client to have read his policy and/or understand its meaning. The decision can be based on how simple or complex the policy is written or the clients level of sophistication (Karem vs St Paul - 1973) or Greenfield vs Insurance inc - 1971). Each case stands on its own.

Minimum Standards
Courts have upheld that even though a policy does not promise to expressly act in good faith and fair dealings, it is the minimum that policy holders can expect. Agents owe a duty of good faith and fair dealings to their clients and their insurer ( American Indemnity vs. Baumgart - 1982).

Conflicts Created By Agent Torts

In an action against an agent or broker, the plaintiff's (client's) attorney rarely distinguishes between contract and tort wrongdoings. BOTH are routinely pleaded. In the case of tort action, agents can be pursued on two fronts 1) Applicable professional standards and 2) The broker/agent's acts or omissions that do not meet these standards. Who decides what these standards are? In most court cases, the plaintiff's attorney will arrange for "expert testimony" by an agent or broker working in the same field. The fundamental issue is whether the accused broker's professional judgment and methods were appropriately exercised in line with acceptable standards. Following are some important areas of agent wrongdoing (torts) considered be outside acceptable standards:

Negligence & Misrepresentation

Agents and brokers can be liable for failure to procure the requested coverage (Mayo vs American Fire & Casualty - 1972). Wrongdoing also occurred where an agent promised to procure "complete" business premises liability coverage and represented that a policy he procured afforded the desired protection when, in fact, it omitted coverage for a freight elevator occasionally used to transport people (RiddleDuckworth inc vs Sullivan - 1969). In Hardt vs Brink, the agent was negligent in failing to advise fire insurance coverage on a leasehold made known him by the client in advance. Another agent negligently obtained non-owner motor vehicle liability coverage for a client knowing it would NOT provide the coverage desired (Rider vs Lynch - 1964). In Walker vs Pacific Indemnity Co - 1960 , the agent negligently obtained a policy with smaller limits of coverage than had been agreed upon. In yet another case, the agent notified the client that the original insurer was insolvent and that a replacement policy would be needed. The broker replaced this policy with a new policy having LESS coverage. The broker was held personally liable for $150,000 because of the gap between the insured's primary and excess coverage (Reserve Ins Co vs Pisciotta - 1982). Liability was also upheld in the case where a lending institution which was licensed to sell credit life insurance failed to offer it to a client who later died (Keene Investment Corp vs Martin - 1963). Finally, in Anderson vs. Knox - 1961, an agent represented that $150,000 of life insurance, where premiums were so high that they had to be bank financed, was a suitable plan for an individual earning less than $10,000 per year knowing that it was not suitable. Another case of misrepresentation involved an application of life insurance with critical blanks (missing information). The deceaseds widow held that the agent told her husband that the missing information 47

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did not need to be disclosed on the application (Ward vs Durham Life Insurance Company - 1989).

Bad Faith
The insurance agent runs a great risk of personal liability in the event that he is less than fair or reasonable when dealing with either a client or claimant. Bad faith actions and violations of various statutes, such as the Unfair Claims Practice Act, are considered a breach of the implied duty agents have deal with clients in complete good faith. Agent liability may accrue due to unfair conduct by agents or allegations of fraud, deceit, misrepresentation or the statutes dealing with unfair settlement practices (where the agent is acting as a claims representative for the insurance company or in his individual capacity, independent of the agency). Agents must remember that the number one reason that people purchase insurance policies through agents is for service. When an insured makes a request to procure coverage or turns in a claim, he is not bargaining for promises, but rather action. Additionally, the insured is under the assumption that, due to his prudence in securing insurance in the first place, he will have peace of mind in knowing that he is

Agent negligence, bad faith and misrepresentation are proved in court using expert witnesses who testify that the accused agent acted outside the standards of other agents working in the same field.
being protected by the insurance company. Any breaches of this reasonable expectation will usually subject the insurance company and the agent to the exposure of insurance bad faith practices and a breach of the fiduciary duties owed to the insured. Licenses have been revoked for misrepresenting benefits of policies and entering false medical information on an application (Hihreiter vs Garrison 1947) or in the making of false and fraudulent representations about the total cash that would be available from a policy (Steadman vs McConnnell - 1957). In the property/casualty arena, many bad faith issues surface under the title of "claim avoidance". Some agents play judge and jury with client claims by advising them to NOT submit a claim since it would be cheaper to repair the vehicle or property or pay his own medical bills rather than incur potential insurance rate increases or even cancellation. Such conduct will expose agents to a breach of his fiduciary duty to the insured as well as a breach of the implied-in-law covenant of good faith and fair dealings. It may also be a breach of the unfair claims practices act in some states. This kind of agent deception even justifies potential punitive damages (Independent Life & Accident Ins Co vs Peavy - 1988).

Conflicts Created by Client/Agent

The insurance agent/broker is increasingly regarded as a professional whom clients turn to for advice and guidance in insurance matters. In some states, the insured's pattern of reliance on the broker's advice has been the basis for a higher standard of duty (Hardt vs Brink - 1961) and (United Farm Bureau Mutual Insurance vs Cook - 1984). Relationship liability generally occurs on two fronts 1) Contributory and 2) Agents as Fiduciary.

Contributory Liability
When an agent holds himself out to be an "expert", a "specialist" or a "professional", he is creating contributory liability and may be held to higher than normal standards or standards beyond the disciplines of insurance. The earning of credentials or designations further compounds the agent's 48

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exposure, since he is considered, in the eyes of the law, to be subject to a higher standard of knowledge and responsibility. Yet, faced with stiffer competition, agents are somewhat compelled to upgrade their

A higher standard of care is assumed by agents who profess to have special knowledge, particularly when their clients blindly and substantially depend on them for their insurance needs.

image by creating marketing "niche" expertise with titles, credentials and job descriptions like: financial planner, estate planner, retirement planner, "one-stop" insurance agency, loss control consultant, etc. Contributory liability relationships have also been cast simply because an agent has ALWAYS handled a clients business over the years, so much so, that clients have blindly depended on their advice. The result of these "titles" and "agent trust" is a higher level of culpability. In fact, plaintiff attorneys have and continue to develop legal strategies that establish contributory liability of agents by multiple approaches, including: Lack of Client Knowledge The insurance purchaser usually is not versed in the intricacies of the insurance business. Prospective insureds seek the assistance of the insurance "specialist" and come to rely on his knowledge. In some cases, the reliance on the agent is total and complete. When the agent procures coverage that turns out to be defective in some way or fails to make arrangements, the applicant should have a cause of action against the agent. This takes on more meaning today as agents and brokers have increasingly promoted their professional expertise in serving the public's insurance needs Sobotor vs Prudential Property & Casualty - 1984). Improper Advertising Advertising has clearly effected the importance and desirability of acquiring insurance, especially where the agent claims to have substantial or special expertise that can be used to guide the consumer. Advertising has lead clients to have reasonable expectations, true or not, that these agents are independent business entrepreneurs and, in some instances, are capable of expertise in a wide variety of business areas, e.g., financial planners, health specialists, catastrophe experts, business continuation consultants, etc.

Dual Agency
In many insurance transactions, the agent can generally be shown to have acted as a "dual agent" -representing BOTH the insurer and client. As such, he owes a duty to exercise due care and reasonable diligence in the pursuit of the client's insurance business regardless of the insurer chosen or represented by the agent. Errors & Omissions Insurance The availability and wide subscription of errors and omissions insurance for agents creates an argument that agents can be liability targets in any insurance disputes. In some cases, the absence of errors and omissions coverage has practically absolved the agent of liability where attorneys assume there is nothing go after. But, who wants to risk going bare in this market? Client / Agent Interaction There is a lot of discussion about building solid relationships with clients. Considerable study has been 49

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done on customer satisfaction and the close association that develops with agents who are responsive to customer questions, explain policies well and are able to get it right the first time. Some feel that the close ties often stop a lawsuit in its track . . . after all, they say, who wants to sue a friend!

Agents as Fiduciaries
New legal theories are continually attempting to establish an agent selling an insurance contract as a principal fiduciary and therefore a probable "deep pocket". A fiduciary is defined as someone who is held in trust or complete confidence. Compared to an agents contractual duty, which requires negligence or tort action, fiduciary duty is intrinsic to his business. In other words, an agents liability as a fiduciary simply comes with the territory . . . its part of selling insurance. In recent years, cases of fiduciary duty are more prevalent. The most obvious fiduciary responsibility of agents is to protect and safeguard client monies Glenn vs Leaman - 1983). Other fiduciary related liabilities relate to an agents duty of care. These cases even rear-up in a one-time business transaction, i.e., you dont have to be a longstanding advisor to be liable. More often than not, the issue of fiduciary exposure surfaces where an agent proposes a full coverage policy but failed to describe a certain provision or exclusion that existed in the written policy (Eddy vs Sharp - 1988). In addition, fiduciary problems are launched by special agent relationships where the insurance contract is established as a collateral issue of some greater purpose such as an insurance agent claim to have special expertise where the client is unsophisticated (Sobotor vs Prudential Insurance -1984) / Kurtz vs Insurance Communicators -1993), or when an agent promises to provide "complete coverage" (Magnavox Co of Tennessee vs Boles & Hite - 1979) The exposure also seems exist where the agent is the "exclusive" insurance provider for clients or in cases where the client, over time has come to be totally dependent on insurance decisions made by the producer. (Glenn vs Leaman & Reynolds - 1983). Another area of fiduciary responsibility concerns disputes dealing with Employment Retirement Income Security Act (ERISA) qualified funds. Many life agents help clients establish and fund retirement plans using insurance products. Under ERISA, a plan must designate a fiduciary to administer its operation. An ERISA fiduciary has been interpreted to be any person exercising managerial control over the plan or its assets, regardless of their formal titles . In recent years, the U.S. Labor Department, the federal agency that administers ERISA, has become more aggressive in reviewing insurance funded plans and the link to agents as fiduciaries. It is even proposed that agents and brokers be labeled ERISA fiduciaries simply by how they advertise and market their retirement plan services. In the past, it was typically the owner of the business, the board of directors or a specifically assigned fund manager that was considered the principal fiduciary. ERISA imposes a variety of duties on fiduciaries of life, health and retirement benefit plans, including a duty to act for the exclusive benefit of plan participants and beneficiaries. The act also establishes prohibited transaction rules governing plan fiduciaries that would disallow, for example, a fiduciary receiving personal benefit from a third party dealing with the plan. Does this mean that a commissioned agent who helps establish a retirement plan and recommends products to fund the plan violates these rules? The answer lies in whether the agent is actually deemed a fiduciary. If the agent arranges to receive a fee for consulting on the pension plan, he is clearly a fiduciary. If the agent has an ongoing relationship with trustees of a plan who regularly accept the agent's proposals without advice from other consultants, he can be classed as a fiduciary of the plan. On the other hand, where the agent is only acting in the capacity of an agent, offering a choice of products from which choose, and as a member of a team of plan consultants, he is less likely to be classed as a fiduciary. To summarize, ERISA fiduciary status may be established where the trustees of a retirement plan "relied" heavily on the agent's advice in the purchase of insurance contracts. In Brink vs Dalesio - 1981, the agent was found liable for unsound insurance purchases because the plan trustees relied on his advice. In Reich vs Lancaster - 1993, the agent was again found liable as a fiduciary when insurance transactions absorbed the majority of the fund's assets. In addition, the agent failed to disclose his compensation or relationship with the insurer. Since the fund trustees were inexperienced in insurance 50

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matters and accepted every recommendation offered by the agent he was considered a fiduciary. In Kerns vs Benefit Trust Life , an agent, as a courtesy, notified employees that their group term life coverage had lapsed shortly before their employer's death. But, he failed to forward the insurance company's routine offer to reinstate coverage and was found responsible. In yet another case, a Louisiana district court held that an insurance agent was a fiduciary a profit sharing plan, even though he only sold a whole life policy in the plan's name. The policies later proved unsatisfactory from an investment and tax perspective. In support of their decision, the court stated that the primary purpose of a qualified retirement plan is provide retirement benefits. The plan can provide life insurance death benefits only if those benefits are incidental to the retirement benefits. "Incidental", under IRS guidelines, would allow for premium payments LESS THAN 50% of the aggregate employer contributions to the plan. In the Louisiana Case (Schoegal vs Boswell), the plan had purchased life insurance on a plan participant IN EXCESS of 50%. Since the ERISA rule on incidental benefits had been violated and the life insurance agent had violated the rule, he was declared a fiduciary and seemingly responsible for the taxes, penalties and possible disqualification of the plan. In further implicating the agent, the court pointed to Boswells (the agents) strong relationship with the custodian bank, management of the company, its employees and the plan administrator, deciding that he was "...clearly more than a mere salesman ". In the court's view, he had sufficient discretionary authority and control to be a plan fiduciary. Fortunately, the court's ruling has recently been appealed and reversed on the basis that agent Boswell lacked the necessary authority and control over the plan investments and because there was no underlying agreement that his advice would serve as the primary basis for investment decisions for the pension plan. While this is a favorable decision for agents, it demonstrates the extremes and aggressive legal action to which agents are vulnerable, particularly if the insurance transaction does NOT produce the anticipated or desired results for plan participants. New fiduciary conflicts may also develop in the area of Medicaid Planning. Agents who routinely counsel clients on methods of transferring assets so as qualify for Medicaid benefits may be subject to fines and penalties under H.R. 3101 The Health Insurance Portability & Accountability Act of 1996 (Kassenbaum-Kennedy) . Under this bill, if the transfer of assets results in a period of ineligibility BOTH clients and agents could be subject to misdemeanor fines of between $10,000 and $25,000 per violation and/or one five years in prison. Many agents recommend that clients purchase annuities, previously exempt in calculating assets qualify for Medicaid. Under these new rules, if the payout of the annuity contract does not match the payout schedules established by the Department of Health (most dont) a disqualification of asset transfer and ineligibility period can be established. Look for future court cases here.

Insurer Claims Against Agents

When most agents ponder professional liability, they think client lawsuits. But agents and brokers also face exposure from the insurers they represent. When agents are sued by their insurer it is most likely for a violation of the law of agency. Most agents are familiar with the term fiduciary duty. Between agent and principal, (the insurer), fiduciary duty of the agent prevents him from competing with the principal concerning the subject matter of the agency or from making a "secret profit" other than what is stipulated or agreed as commissions. Fiduciary responsibility is especially pronounced when the agent writes

An agent is a fiduciary of the insurer and has a duty to exercise reasonable care, skill and diligence .

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insurance for himself (Southland Lloyds Insurance vs Tomberlain - 1996). Beyond fiduciary matters, agents are bound to his insurer by other statutory duties. They include Duty of Care and Skill, using standard care and skill; Duty of Good Conduct or acting so as not to bring disrepute the principal ; Duty To Give Information by communicating with the principle and clients ; Duty To Keep Accounts by keeping track of money ; Duty To Act as Authorized; Duty To Be Practical not attempt the impossible ; and Duty To Obey or comply with the principal's directions. A violation of these duties can be considered grounds for termination and represent legal exposure for the agent. Following are some examples:

Basic Agency Violations

When an agency agreement exists between agent and insurer, the agent/broker has a duty to exercise reasonable care. The agent is considered a fiduciary of the insurer. He or she must exercise skill and diligence and is liable for negligence that induces the insurer to assume coverage on which it suffers a loss. Brokers who have agency agreements with insurers have been found liable to the insurer for clerical mistakes -- incorrect policy dates, erroneous limits of liability and omissions of endorsements.

Misappropriating Premiums
As representatives of the insurer, agents and brokers owe a fiduciary responsibility to the insurer to remit premiums collected from clients promptly or hold them in a trust account. In Maloney vs Rhode Island Insurance Company - 1953, the agent converted premiums his own use, facing liability to the insurer and possible criminal charges for embezzlement.

Failure To Disclose Risk Factors

An agent has a duty of good faith and loyalty to his insurer and may be liable for negligently inducing the insurer to issue coverage on which it suffers a loss (Clausen vs Industrial Indemnity - 1966 . In this case, it was successfully argued that an insurer may obtain indemnity from a broker, if the broker knows or should know that insurer is relying on the broker to supply information about the client; the information furnished is incomplete or incorrect; the incomplete or incorrect information is material to the decision accept or decline the risk; and the insurer is forced to pay a loss under a policy that the insurer would NOT have issued if complete and accurate information had been provided by the broker. In a similar case (New Hampshire Insurance Co vs Sauer - 1978), the insurer sued its agent, alleging negligence for failing to notify the insurer of the exact nature of the insured's business when applying for business interruption coverage. The jury attributed 70 percent of the loss to the insurer and 30 percent to the agent's negligence.

Failure To Cancel or Notify of Cancellation

Agents do not normally have an obligation to the insurer with respect to canceling an insured's coverage. For example, if the policy is billed directly, the insurer usually notifies the insured directly of the insurer's intent to cancel and, thereafter, of the actual cancellation. The broker/agent is typically "out of the loop".

Agents are liable to their company for violations such as clerical mistakes, mishandling premiums, withholding information, twisting information, failure to perform, exceeding authority, fraudulent schemes and unfair trade practices.
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However, a broker who has undertaken responsibilities in canceling coverage (Gulf Insurance vs The Kolob Corporation - 1968) through agreement with the insured, owes the insurer a duty to follow the insurer's instructions promptly and correctly. In Mitton vs. Granite State Fire Insurance Company 1952, an agent was accepted as the insurer's general agent for purposes of signing policies, issuing endorsements, etc. As the insurer's agent, the broker was instructed by the insurer obtain a flood and landslide endorsement from an insured. If the insured refused to accept such an endorsement, the agent was to notify the insurer who would cancel the policy. The broker failed to do either and was held liable to the insurer for the insured's flood damage.

Authority To Bind
An agent may be a general agent with general powers, or his powers may be limited by the insurer. Some agents are authorized to issue insurance contracts that bind the insurer, they have binding authority (typically casualty agents). Some agents may have binding authority only as to certain classes or lines of coverage. Legally, the agent possesses the powers that have been conferred by the company or those powers that a third party has a right to assume he possesses under the circumstances of the case. In Troost vs Estate of DeBoer - 1984 the agent exceeded his binding authority yet his acts and representations were relied upon by the insured. The agent was held liable for the insurers' losses.

Premium Financing Activities

Frequently, brokers play a role in helping clients finance their insurance premiums by bringing the insured and the financing entity together. There have been cases where the financing company has been the victim of fraudulent schemes misleading them into issuing loans to nonexistent insureds. In an effort to recover its losses, the financing entity may look to the insurer on grounds that the broker was acting on the insurer's behalf in arranging the financing, even though the insurer may not have given the agent explicit authority engage in premium financing activities. In New England Acceptance vs American Manufacturers Mutual Insurance Company - 1976 , an insurer was held liable for its agents actions in such a financing scheme because it was "implied" that the agent had been authorized to conduct premium financing. In a similar case, Cupac vs Mid-West Insurance Agency - 1985, the court held that the insurer had not authorized its agent to engage in premium financing activities because nothing in the agency agreement referred such activity. The agent was held liable. Various states have split on the decision that the business of premium financing is an integral part of the business of insurance.

Unfair Practices
Insurers may also lash out against agents under the National Association of Insurance Commissioners "Unfair Trade Practices Law" which many states have enacted. The thrust of this code is contained below. "Persons (defined to include insurance companies and insurance agents) are prohibited in engaging in "unfair methods" of competition and deceptive acts and practices." Including, "making, publishing, disseminating, or circulating, directly or indirectly, or aiding, abetting, or encouraging the making, publishing, disseminating, or circulating of any oral or written statement or any pamphlet, circular, article, or literature which is false, or maliciously critical of or derogatory to the financial condition of an insurer, and which is calculated to injure any person engaged in the business of insurance." Under this act, it is conceivable that an insurer could commence litigation naming an agent where the company's insolvency was related agent "derogatory" actions. Consider a case similar to Mutual Benefit Life , where agents were actively involved in the disintermediation or withdrawal of "blocks" of client policies after rating drops occurred. Ultimately, this "run on the bank" was deemed the single greatest 53

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issue contributing to the companies liquidation. Were agents exercising "due care" for clients or breaching their legal and "unfair practice" duties to their contracting company?

Liability Created By Insurer Failures

To date, few courts have held that insurance brokers or agents are liable for the losses that policy owners might suffer from an insurer insolvency. Be assured, however, agents continue to be sued and pursued for malpractice in this area, and there are countless legal theories being proposed to force accountability. The basis for most tort actions where an insolvent insurance company is involved lie in certain cases and written code sections. At first glance, these regulations imply that agents are not responsible for involving a client with an insolvent company or a carrier that eventually is state liquidated. Here is how the law of liability is interpreted in most states: "The general rule in the United States is that an insurance agent or broker is not a guarantor of the financial condition or solvency of the insurer from which he obtains coverage for a client." (Harnett, Responsibilities of Insurance Agents and Brokers - 1990).

For now, agents are NOT usually responsible for client losses from an insurer insolvency UNLESS the agent knew or should have known that the insurer was insolvent at the time insurance was placed.
In an actual case against a California agent, Wilson vs All Service Insurance Corp (1979) similar results accrued: "An insurance broker has no duty to investigate the financial condition of an insurer that transacts business in California pursuant to a certificate of authority because the scheme of licensing and regulation of insurers administered by the Insurance Commissioner was sufficient for this purpose and could be relied upon by the broker when placing insurance." Before an agent rejoices in knowing that laws of this nature are on the books, he must realize that regardless of this implied protection, court cases continue to be tried and a trend is developing that places greater legal responsibility on agents concerning insurer insolvency. In Wilson vs All Service Insurance , for example, the client commenced a lawsuit in 1975 and even though the agent prevailed, the decision was not rendered until 1979 -- that's four years of attorney and court fees! So aggressive was the client that two different appeals the State Supreme Court were attempted involving more defense fees. One must also ask . . . If agent liability laws and codes represent a "safe harbor" and if agents are "untouchable", why do professional liability policies REFUSE to defend and REFUSE to indemnify agents where an insurer insolvency arises? The legal caveat that "muddies the waters", relevant to agents and insurer failures, is the results of a 1971 lawsuit -- Williams-Berryman Insurance vs Morphis, (Ark. 1971) 461 S.W.2d 577, 580. It proclaims the following: "The agent or broker is required to exercise reasonable care, skill and judgment in procuring insurance, and a failure in this regard may render him or her liable for losses covered by the policy but not paid due to the insolvency of the insurer ." What is "reasonable care"? In Wilson v. All Service (above), the fact that the carrier was an admitted company proved to be adequate care. In 54

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INSURANCE MARKETING ISSUES Higginbotham & Associates vs Green - 1987, however, the courts further clarified:

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"If, for some reason, it is shown that the agent or broker knew, or should have known, that the insurer was insolvent at the time of placement, he or she may be liable for the loss caused by insolvency."

Agents who induce clients to buy or move to an insurer, which then becomes insolvent, may assume liability if the agent made false promises or misstatements about the insurers financial condition.

In all these cases, the agents won, or prevailed on appeal. The reader should be aware, however, that in addition to the expense of lengthy trial a pattern is established. To summarize, the burden of agent liability involving financially distressed insurance companies is greater today for two reasons: 1) Because more liquidations are in process, and 2) Because the courts want agents to be more responsible for their actions. In addition to these known precedents and cases, agents are continually subjected to harassment suits from disgruntled clients and others that are settled out of court. Because these settlements are not published, it is impossible to know the depth and breadth of the problem. Most agents, however, know someone or has had some personal experience realize they occur frequently. One such case involved an Oregon couple who invested their $26,000 retirement fund in an annuity with Pacific Standard Life in 1987. About three years later, they attended a financial planning seminar where they learned that their insurance company had been taken over by the California State Insurance Department due to losses in "junk bond" holdings. The couple immediately demanded a surrender of their policy. Of course, they were blocked from withdrawing their money by the conservators and the six-month payment delay provision in their policy. Seven months later they received a check for about 70 percent of their annuity value. The agent was threatened with legal recourse to pay the deficiency. After weighing the possibility of a lengthy court case and to keep an action from going public, the agent agreed pay. From the above court recitals, this agent clearly had no exposure. The least path of resistance, however, was to pay the client and move on. Fortunately, the dollars involved were controllable. But what of the situation where multiple clients are seeking reimbursement or the numbers are significant? The answer is not easy to predict, but the solution involves a multi-faceted approach to managing exposure while still providing service.

Misrepresentation & Insurer Failures

Insurer insolvency cases against agents may be based on misrepresentations by agents. Where agents have made expressed warranties or specifically agreed to supply a solvent carrier or one with stated or minimum amounts of capital are the most obvious areas where liability abounds. An even worse situation occurs where an agent knowingly distorts actual capital or asset statistics of an insurer to make it more appealing. A similar violation occurs where an agent represents that he made a detailed investigation of the insurer when, in fact, he did not. Examples where agent liability is not so clear, however, include cases where an agent convinces a client to surrender or cancel a policy from one company for a policy of another company and it is determined that the second insurer is weaker and maybe even be liquidated at some later date. In this instance, the law might interpret the agent actions to be more than just a "usual transaction", where a policy product is simply "sold". Here, the agent acted more as an advisor. His actions might appear to be assurances that the new company is better than the old company when, in fact it was not, for purposes of generating a commission. 55

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In yet another legal strategy, agents may be culpable by his statements of confidence. Saying things like, "trust me" or "I guarantee it" could be construed as a warranty by the agent. Since most agents find it impractical to "clear" every representation with compliance departments, many oral declarations are made in the course of a sale or counseling clients. Technically, a guaranty should be in writing, but this would not stop an attorney from pursuing a talkative agent who made similar representations to more than one client. A common example is in the area of "safety" regulations. The following are terms probably used everyday by agents and though they stop short of creating an absolute financial guarantee for policy owners, they infer financial stability and give the purchaser a measure of confidence that the company behind the product is financially secure. An agent who cites these utterances is likely to be responsible for their truth: Claims of Regulation by the State Insurance Department An agent might say: "All insurers are regulated by the State Insurance Departments in the states in which they do business. These departments enforce the states' insurance laws. These laws cover such areas as insurer licensing, agent licensing, financial examination of insurers, review and approval of policy forms and rates, etc. Generally speaking, an insurer's and reinsurer's operations are at all times subject to the review and scrutiny of state regulators." Claims of Minimum Capital and Surplus Requirements "Among the requirements imposed by state laws are minimum capital and surplus requirements. These provide that an insurer or reinsurer will not be allowed to do business unless it is adequately capitalized and has sufficient available surplus funds with which conduct its operations." Claims of Minimum Reserve Requirements State laws require insurers and reinsurers to post reserve liabilities to cover their future obligations so that financial statements accurately reflect financial condition at any given point in time." Claims of Annual Statements "Insurers and reinsurers are required to file annually a sworn financial statement with each insurance department of the state in which they do business. This detailed document provides and open book of the insurer's financial posture and is reviewed closely by state regulators." Claims of Periodic Examinations "State regulators perform examinations or audits in the home office of insurers and reinsurers as often as they deem necessary, but generally no less frequently than every three years. The primary purpose of such examinations is to verify the financial condition of the insurer. In addition, a reinsurer may perform period audits of the company they reinsure. Finally, an annual audit is also conducted by a public accounting firm." Claims of Statutory Accounting "In reporting state regulators, insurers and reinsurers are required by state laws to practice "statutory accounting", as opposed to conforming with "generally accepted accounting principles (GAAP). The statutory method is generally acknowledged to be a more conservative approach and thus much less likely to overstate a company's true financial condition."

Most states discourage the advertising of an insurance product as safe due to the backing or existence of state guaranty funds.

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Claims of Investment Restrictions "State insurance laws restrict the manner in which insurers and reinsurers can invest the funds they hold. Insurers and reinsurers generally may invest only in assets of a certain type or quality and must diversify their investments to minimize overall risk." Guaranty Fund Claims "It is possible that, in spite of these and other safeguards, an insurer could become insolvent. If this should occur, there still remains the likelihood that a policy owner will retain most, if not all, of the value of his policy from funds still remaining with the insolvent insurer through the state guaranty fund. Virtually every state has enacted what are commonly know as "guaranty fund" laws for the added protection of the policy owners of insolvent insurers. These laws generally provide that other insurers doing business in that state will contribute funds to alleviate any deficiency of assets in the insolvent insurer. The provisions of the laws generally cover all policy owners, wherever located, of insurers domiciled in such states and all residents of such states who are policy owners of insurers who are not domiciled in such states, but who are authorized to do business there. The law in some states, however, limits protection on several fronts: There are coverage limits or caps ranging from $50,000 to $1 million per claim; some completely eliminate claims or place severe restrictions on certain policies including life, variable life blends, disability, mortgage guaranty, ocean marine, surplus lines, HMOs, PPOs and other non-traditional markets. Learn more about guaranty funds in a later section. Many states disallow advertising or use of any statements regarding state fund insurance prior to the sale. The premise is that guaranty fund warranties made to fortify the financial security of a weaker insurer could lull the public into overlooking the need to deal with sound companies. Further, violations of sales tactics using guaranty funds may cost an agent more than a liability suit. It may result in additional monetary fines and license suspension.

Agent Relationships & Insurer Failures

Often, agents develop special relationships with clients which can result in additional liability exposure. This can occur when an agent has handled all the insured's business or when a client has come completely depend on the agent for all his insurance decisions and the agent knows it. In these cases, there may be legal authority to proceed against the agent where losses are due to an insolvency. Even when faced with limited success, policy holders and their attorneys have pursued agents asserting a "personal" claim -- that is, the culpable conduct of a third party (the agent) was personal to the policy holders, who relied upon that wrongful conduct. Also, never let it be said that policy holders cannot sue an agent for any reason. This "right" has been upheld under Matter of Integrity Insurance Co., 573 A.2d 928 (1990). One justification for placing tort responsibility on the agent is the conclusion that : "The risk of loss in an insolvency setting should not rest with the insured or the claimant." Cal Ins Code, 780-790.1 (Dearing 1991), N.Y. Ins Laws, 2401-2409 (1990), Mass Ann Laws ch 175, 2B (1990). In essence, the courts are sympathetic concerning an insured's need for complete protection. This stems from the special circumstances that surround an insurance contract, i.e., the insured and insurer are not equal partners since the insured cannot protect itself by contract. Also, the insured cannot bargain or require a provision of the policy protect or indemnify for a potential insolvency. The insured can only seek other insurance with a more stable company. And, even when an insured is informed about the financial condition of an insurer, the courts feel that they would lack the knowledge and experience necessary to evaluate financial statements, reports and solvency terms like surplus, reserves, etc. Finally, an insured cannot mitigate or control his damages since 57

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insurance cannot be purchased after a loss, i.e., the insured could have already paid for a benefit he cannot receive if an insolvency occurs.

In the not-too-distant-future, it is likely that agents will be held responsible for monitoring the financial status of insurance companies and for client losses due to failures .

Recent legal research, which will be cited in claims against agents, presents a clear and loud indictment of agent and broker responsibility (A Proposal for Tort Remedy For Insureds of Insolvent Insurers Against Brokers, Ohio State Law Journal, vol 52, 4 (1991): "When one considers all of the factors of tort recognition, including the social policy aspects, the argument for the establishment of a tort duty on the part of the collateral parties (agents, brokers, reinsurers, etc) to the insurance relationship is compelling. Placing a duty on the collateral parties to investigate and monitor reasonably the solvency of insurers with which they deal yields a much more socially advantageous result. This duty logically extends the duty already existing for brokers to exercise care in the placement of insurance with solvent insurers. The proposed duty, however, requires affirmative investigation and monitoring. This investigation and monitoring should, at least, include an evaluation of National Association of Insurance Commissioners' data, Insurance Regulatory Information System data, ratings service data, and any other public information and general information circulating within the industry. Thus, the duty requires a more thorough investigation than present law apparently requires brokers to make. In addition, the duty continues past the placement of the insurance or the commencement of the insurance relationship." "The duties of these public parties is a high duty that encompasses nonfeasance (Pennsylvania v. Roy, 102 U.S. 451, 456). Imposing a duty on collateral parties (agents, brokers, reinsurers, etc) to conduct a reasonable investigation and monitoring of the solvency of insurers, and imposing liability for a failure to abide by that duty accords with prior treatment of public entities." Congress has also chimed in by suggesting that: "Brokers should be required to check the integrity of the people and records which determine ultimate premiums and losses charged on policies". "Failed Promises", Testimony before the Subcommittee on Oversight and Investigations for the U.S. House of Representatives (1990).

MANAGING AGENT CONFLICTS

It is estimated that one in seven agents face an errors and omissions claim each year. Charges like these will challenge your reputation, waste enormous time and could threaten your financial well-being. Basic measures to limit liability always begin by avoiding claims at the outset. Of course, this is easier said than done, since there is NO foolproof method to sidetrack a lawsuit from a client or an insurer. There are, however, some suggestions that agents can use to help reduce the possibility of a claim developing and present a reasonable defense if one does. Of course, this can NOT be considered a complete list since special circumstances may require additional precautions. 58

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Step 1 Know your basic legal responsibilities as an agent and only exceed them when you are absolutely sure what youre doing (see Legal Conduct last section). Pull out your agency agreement right now and read it!!! When you decide that you want to be more than an agent, i.e., a counselor to your clients, understand that it comes with a high price tag -- added liability. Also, make sure you are complying with basic license responsibilities to keep from becoming a commissioners target for suspension or revocation. Step 2 Learn from other agent mistakes (see Agent Blunders, two sections ahead ). The best school in town is the one taught by agents who have already had a problem. Study their errors, learn from them and make sure you dont repeat them. Step 3 Be aware of and avoid current industry conflicts that could develop into problems for your agency (see examples the last chapter). There are hundreds of professional industry publications that will help you keep abreast. Once you are aware of a potential problem, take action to make sure it doesnt end up at your doorstep. Step 4 Maintain a strong code of ethics (see this section). As you will see from our discussion of ethics, you dont need a list of degrees or designations to be ethical. Simply be as honest and responsible as possible. Step 5 Be consistent in your level of due care (see Sales Conduct, first section). Write a procedures manual that forces you to treat client situations the same way every time. Courts and attorneys alike are quick to point out any inconsistency or lack of standard operating procedures where the client with a problem was handled different than another client. Step 6 Know every trade practice and consumer protection rule you can (Consumer Protection, the next section will help). The violation of unfair practice rules is a really big deal to lawyers. They will portray you as something short of a master criminal for the smallest of violations. Step 7 Use client disclosures whenever possible (see this section). There is nothing more convincing than a clients own signature witnessing his knowledge of the situation. Step 8 Get connected to the latest office protocol systems (see this section). The ability to access a note concerning a client conversation or the way you package correspondence can make a big difference in the outcome of a claim or avoiding one at the outset. You want a system that will produce solid evidence not hearsay. Step 9 Maintain and understand your errors and omission insurance (see this section). This policy is your first line of defense, but know its limitations and gaps. The discussions that follow will expand on most of the steps we just mentioned.

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Know Your Agent & License Responsibilities

Agent/Client Duties
As we pointed out earlier, the agent/broker generally assumes only those duties normally found in any agency relationship. Your agency contract is a good source of basic duties. Overall, the basic duty of agents is to select a company and a coverage and bind it (if you have binding authority -- casualty agents). Where clients have come to you and requested coverage, you need to decide whether it is available and if the client qualifies. Agents have a responsibility to know the differences in product he is selling, and while you do not need to obtain complete coverage in every case, you have a duty to explain policy options that are reasonably priced and widely available for the policy you are suggesting. In some cases, agents have been responsible for after sale duties to see that a policy continues to meet client needs. The more that your clients depend on you for their insurance needs and the longer you do business with them, the higher your standard of care is in selling and serving them.

Agent/Company Duties
In addition to agent/client duties, you have duties to your company. Again, your agency contract is a good source to review. The problems occur in areas of fiduciary duties and statutory duties. When agents are sued by their insurer it is most likely for a violation of the law of agency. Most agents are familiar with the term fiduciary duty. Between agent and principal (the insurer), fiduciary duty of the agent prevents him from competing with the principal concerning the subject matter of the agency or from making a "secret profit" other than what is stipulated or agreed as commissions. Beyond this, however, agents are bound to his insurer by other statutory duties. They include Duty of Care and Skill, using standard care and skill; Duty of Good Conduct or acting so as not to bring disrepute to the principal; Duty to Give Information by communicating with the principle and clients; Duty to Keep Accounts by keeping track of money; Duty to Act as Authorized; Duty to be Practical and not attempt the impossible; and Duty to Obey or comply with the principal's directions. A violation of these duties can be considered grounds for termination or legal exposure to the principal or insurance company. Areas of additional concern include clerical mistakes, erroneous policy limits, omissions of endorsement, misappropriating premiums, failure to disclose risk, failure to cancel or notify cancellation, authority to bind, premium financing activities and unfair trade practices.

Agent Integrity
While many agents believe that "integrity" is a characteristic of choice, many state laws set minimum agent responsibilities to follow, such as: Qualifications Insurance Commissioners have been known to suspend or revoke an insurance agent if it is determined that he or she is not properly qualified to perform the duties of a person holding the license. Qualification may be interpreted to be the meeting of minimum licensing qualifications (age, exam scores, etc) or beyond. Lack of Business Skills or Reputation Licenses have been revoked where the agent is NOT of good business reputation, has shown incompetency or untrustworthiness in the conduct of any business, or has exposed the public or those dealing with him or her to danger of loss. In Goldberg vs Barger (1974), an application for an insurance 60

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license was denied by one state on the basis of reports and allegations in other states involving the applicant's violations of laws, misdealing, mismanagement and missing property concerning "noninsurance" companies. Activities Circumventing Laws Agent licenses have been revoked or suspended for activities where the licensee (1) did not actively and in good faith carry on as a business the transactions that are permitted by law; (2) avoids or prevents the operation or enforcement of insurance laws; (3) knowingly misrepresents any terms or the effect of a policy or contract; or (4) fails to perform a duty or act expressly required of him or her by the insurance code.

Many states set minimum standards for agent integrity.

In Hohreiter vs. Garrison (1947), the Commissioner revoked a license because the agent misrepresented benefits of policies he was selling and had entered false answers in applications as to the physical condition of the applicants. In Steadman vs. McConnell (1957), a Commissioner found a licensee guilty of making false and fraudulent representations for the purpose of inducing persons to take out insurance by misrepresenting the total cash that would be available from the policies. Agent Dishonesty Agents have lost their license because they have engaged in fraudulent practices or conducted any business in a dishonest manner. A licensee is also subject to disciplinary action if he or she has been convicted of a public offense involving a fraudulent act or an act of dishonesty in acceptance of money or property. Furthermore, most Insurance Commissioners will discipline any licensee who aids or abets any person in an act or omission which would be grounds for disciplinary action against the persons he or she aided or abetted. In McConnell vs. Ehrlich (1963), a license was revoked after an agent made a concerted effort to attract "bad risk business" from drivers whose license had been suspended or revoked. The Commissioner found that the agent had sent out deceptive and misleading solicitation letters and advertising from which it could be inferred that the agents could place automobile insurance at lower rates than could others because of their "volume plan". Moreover, the letters appeared to be official correspondence of the Department of Motor Vehicles. Clients would be induced to sign contracts with the agents where the agent would advance the premiums to the insurance company. The prospective insured would agree to repay the agents for the amount of the premium plus "charges" amounting to an interest rate of 40 percent per annum. The interest rates charged were usurious and violated state law. Catchall Category In addition to the specific violations above, most states establish agent responsibilities that MUST NOT violate "the public interest". This is an obvious catchall category that has been used where agents have perpetrated acts of mail fraud, securities violations, RICO (criminal) violations, etc.

License Responsibilities
There are agent responsibilities necessary to maintain licensing in "good standing": License Authority A person or employee shall not act in the capacity of an agent/broker without holding a valid agent/broker license. This becomes the "age-old test" of what activities constitute an insurance producer. It is generally 61

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assumed that anyone quoting premiums or terms of an insurance contract should be licensed. However, insurance departments across the country have pushed to constantly expand the definition of who in an agency should be subjected to licensing as an insurance producer. To avoid unintentional noncompliance, many agency principals have licensed almost all staff members, regardless of how limited and passive the functions they perform. By contrast, the staff of insurance companies are many times exempt from producer licensing for a wide variety of service functions such as collecting premiums, mailing and delivering insurance policies and taking additional information requested by the agent or the insurer concerning and applicant or other transaction over the phone (check your own state requirements). At the agency level, some insurance departments require agencies to be licensed both as corporate entities and as individual agency owners and principals. Temporary licensing can be requested when the agency principal or owner dies or to fill a void in an insurer's marketing force. This allows the surviving family to conduct business with existing clients. These licenses are usually limited to 30-days with two renewals for a total of 90 days. Recent controversy has surfaced concerning the granting of producer licensing and special privileges (exemption from licensing) to special interest groups like financial institutions and self-insured group purchasers. Independent agents are protesting this treatment and have requested new rules be established by the National Association of Insurance Commissioners. Notice of Appointment In addition to license requirements, states generally require a notice of appointment be filed with the insurance department. This document is executed between the agent and insurer and authorizes the agent to transact one or more classes of insurance business. An agent may be appointed with several insurers. Upon termination of all appointments, an agent's license becomes inactive. While inactive it can be renewed and reactivated by the filing of a new appointment. License Domicile Agent domicile is a rapidly changing area of law. Currently, many states will grant non-residents a producer license. The rules are fairly straightforward: Agents and brokers of insureds with exposures in several states must be licensed in those states before they can collect a commission for the coverage they have written. However, since a non-resident agent "exports" premiums and business outside a given state, many states are beginning to erect barriers to prevent outside solicitation. One state (Texas) has strictly prohibited agents and firms from entering to solicit property/casualty insurance business (life and health sales are permitted) without forming a corporation or agency and physically opening a Texas office. Soliciting is defined as direct mail, telephone or any other form of communication, such as fax. Other new rules and regulations enacted in some states require that insurance policies be countersigned by licensed resident agents of the insurer, regardless of where the contracts are made or the residency of the insureds. Many states require proof of continuing education credits for non-resident agents in those lines of insurance they are licensed or physically go to the state and pass a test before renewal or relicensing. Display of License Most states require that an issued license be prominently displayed in the agent's office or available for inspection. Where the business entity is a "fictitious name", such name should be registered with the insurance department. Records Agents, should maintain a record-keeping system that will provide a sufficient "paper-trail" to identify specific insurance transactions and dates. At a minimum, such record systems should track the name of the insurer, the insured, the policy number and effective date, date of cancellation, premium amounts and payment plans, dates premiums are paid and forwarded or deposited to a the insurer or trust account, commissions (and who gets them). Where an agent trust bank account is used, agents should maintain 62

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all bank statements, deposit records and canceled checks. Most records should be kept for a total of 5 years after the expiration or cancellation of the policy. Some states require that records be maintained "on-site" for one year after expiration or cancellation or stored off-premises but available within two business days. Agent Files While agent files may not be law in certain states, every policy transaction should be separately filed and include a copy of the original application for insurance or a memo that the client requested coverage, all correspondence between agent/client and agent/insurer, notes of client meetings and phone conversations, memorandums of binders (oral or written) and termination/cancellation dates with proof of notification.

Agent Business & Marketing Practices

Agents should pay particular attention to the responsibilities they have in the following areas: Concealment Concealment is neglecting to communicate what the agent knows or ought to know to be true. Concealment can be intentional or unintentional: In either case the injured party is entitled to rescind the contract or policy. Communication that is generally considered exempt from concealment include: Matters which the client/insurer waives (refuses or declines to discuss), matters which are not material and matters which, in the determination of the "prudent man theory", the other party ought to know. Presentations, Illustrations & Quotes It is illegal to induce a client to purchase or replace a policy by use of presentation materials, illustrations or quotes that are materially inaccurate. (See Sales Conduct, first section). Misrepresentations An agent, broker or solicitor shall not misrepresent any material fact concerning the terms, benefits or future values of an insurance contract. This will include misrepresenting the financial condition of an insurance company, making false statements on an application, disclosure of State Guaranty Fund backing of insurance contracts (some states), making false statements or deceptive advertising designed to discredit an insurer, agent or other industry group, making agreements that will result in restraint of trade or a monopolizing of insurance business, etc. Twisting & Churning The act of "twisting" or churning is defined as misrepresentation or comparison of insurers or policies for the purpose of inducing a client to change, surrender, lapse or forfeit an existing policy. Agent violators may be subject to fines, imprisonment and/or license suspension/revocation. Redlining An agent/insurer may not refuse to accept an application for insurance or cancel a policy based on a person's race, marital status, sex or religion. New proposals before Congress are targeting redlining violators (insurers and agents) who are withholding insurance protection in certain metropolitan areas. False Claims It is unlawful for an agent to submit a false or fraudulent claim to receive insurance loss proceeds. This includes "staging" or conspiring to stage accidents, thefts, destruction of property, damage or conversion of an automobile, etc. Unfair Business Practices It is a violation in most states for agent/brokers to fail to act promptly and in good faith regarding an insurance claim, fail to confirm or deny coverage applied for within a reasonable time, dissuade a claimant from filing a claim, persuading a client to take less of a claim than he or she is entitled to, fail to inform 63

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and forward claim payment to a client or a beneficiary, fail to promptly relay reasons why a claim was denied, specifically advise a client NOT to seek an attorney when seeking claim relief, mislead clients concerning time limits or applicable statutes of limitation concerning their policy, advertising insurance that the agent does NOT have or intend to sell, use any method of marketing designed to induce a client to purchase through the use of force, threat or undue pressure, use any marketing method that fails to disclose (in a conspicuous manner) that the agent is soliciting insurance and/or that an agent will make contact. Policy Replacement (Specific states only) Agents must clearly disclose in writing, signed by the client, their intention to replace insurance with a new policy and that the existing insurance will lapse, be forfeited, surrendered or terminated, converted to a paid-up or reduced paid-up contract, etc. A copy of this "replacement notice" shall be sent to the existing insurer (by the new insurer). Additional requirements typically include the completion of specific sections of the insurance application where the agent must acknowledge that he or she is aware of the replacement. Privacy Information gathered in connection with an insurance transaction should be confidential and have specific purpose. Clients are entitled to know why information is needed and have access to verifying its accuracy where a claim or application is denied.

Agent Ethics
It is difficult to discuss matters of agent responsibility and reducing liability without exploring ethics. As it relates to insurance agents, ethics go beyond the maintenance of "moral standards". Insurance ethics involves the maintaining of honest standards and judgments that place the client first. To keep it simple, just remember the old adage the customer is king. Someday, it may be real important for a court and jury to hear that you have a history of serving the client without consideration for how much commission you made or how busy you were, i.e., you are a person with good ethics. Take the case of Grace vs Interstate Life (1996). An agent sold his client a health insurance policy while in her 50's. After the client reached 65 he continued to collect premiums despite the fact that Medicare would have replaced most of the benefits of her policy. The court did not look favorably on the agents lack of duty to notify his client. Ethics exist to inspire us to do good. Having high ethical standards, can be more important than being right because honesty reflects character while being right reflects a level of ability. Unfortunately, the insurance industry, like many industries still rewards ability. There are, for example, plenty of "million dollar" marketing winners and "sales achievement awards", few, if any, "Ethics & Due Care" certificates. For some, the very effort to be as ethical as possible brings its own rewards. Consider, for example, the satisfaction that agents realize when the interest of a client has been served by the proper placement of insurance: The capital needs of a family are met by a $1 million life insurance policy when the breadwinner dies prematurely. The estate of an entire family is left intact because an umbrella liability policy sheltered against a major accident claim. A business is able to survive after the death of a partner because a life policy payment provided necessary capital to replace the devastating loss. The retirement plans of a once young married couple are made possible through investments in pensions and annuities. 64

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The owner of income property financially survives a major fire because his liability policy included "loss of income" provisions. A family survives a mother's long term bout with cancer because their health insurance carried a sufficient "lifetime" benefit.

The list can go on and on, but the point is made: The work of an insurance agent often impacts the entire financial well being and future of businesses and families. Ethics place the interest of these clients above an agent's commission. Being ethical is being professional but the gesture goes beyond the mere compliance with law. It means being completely honest concerning ALL FACTS. It means more than merely NOT telling lies because an incomplete answer can be more deceptive than a lie.

Sales ethics involve more than compliance with the law and more than NOT telling lies because an incomplete answer can be just as deceptive as a lie.

Perhaps this whole issue of ethics can be summed up in the very codes of conduct now in place for members of organizations like the American Society of CLU and ChFC, Chartered Property and Casualty Underwriters and the International Association of Financial Planning. Following are some examples: In all my professional relationships, I pledge myself to the following rule of ethical conduct -- I shall, in the light of conditions surrounding those I serve, which I will make every conscious effort to ascertain and understand, render that service which, in the same circumstances, I would apply to myself. In a conflict of interest situation, the interest of the client shall be paramount. Take responsibility for knowledge of the various laws and regulations affecting my services. Avoid sensational, exaggerated and unwarranted statements. Improve my professional knowledge, skills and competence. Maintain a high degree of personal integrity. Maintain a professional level of conduct in association with peers and others involved in the same activities

Instilling ethics is a process that must start long before a person chooses insurance as a career. It is probably part of the very fiber that is rooted in lessons parents teach their children. So, preaching ethics in this book may not be incentive enough to sway agents to stay on track. It may be easier to explain that honesty and fair play could mean cleaner sales and lessen the possibility of lawsuits.

Agent Disclosure
Client Disclosure
In response to frequent and often groundless claims, many agents have resorted to limiting contracts and disclosures for clients to review and sign prior to any purchase decision. It may be common, in years ahead, to attach such statements to each and every policy or even require clients to sign one prior to any insurance discussions, much like doctors have patients sign disclosures in advance of services. The sample on the next page was composed by an agents association and is provided for educational purposes only. Before using any disclosure letter speak to an attorney for approval. Also, know that specific products may require different wording. 65

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Additional attachments to this letter could disclose options the client chose to refuse, such as: The opportunity to seek tax, legal or business advice prior to making any insurance purchase or the availability and cost of various options or riders to a policy that were available and suggested at time of purchase (waiver of premium, higher deductible options, exclusions, etc). Agents have successfully used disclosures to qualify a promise of coverage as in T.G.I. East Coast Construction vs Firemans Fund Insurance (1985). Here, an agents letter to a client regarding future coverage commitments included a very important disclosure: You will be covered subject to our normal underwriting requirements. Of course, when the time came, the client automatically assumed he was covered. However, on the strength of the disclosure, the courts disagreed. Agents may also want to use disclosures to "narrow the scope" of their duties. For example, agents have been held liable for NOT securing "complete" coverage. If an agent is unwilling to assume responsibility and take the time necessary to provide "complete" coverage, it might be wise to disclose that coverage is for a specific property, condition or a specific insurance carrier. Further, it might be appropriate to say that the agent has NOT reviewed client coverage needs concerning leases, contracts, directors, product liability, estate taxes, etc.

Nothing can prevent a lawsuit, but an agent will be ahead to demonstrate client knowledge about product and service by using disclosures.

In Eddy vs Sharpe (1988) an agent proposal included the following disclosure: This proposal is prepared for your convenience only and is not intended to be a complete explanation of policy coverage or terms. Actual policy language will govern the scope and limits of protection afforded. While this seems to cover any omission the agent might make in his proposal, he was found liable for client losses because his proposal also listed eight specific exclusions of the policy. Unfortunately, the one he left out was the peril that damaged the clients policy. While nothing will prevent legal action by a disgruntled client, an agent would be better ahead to be able to demonstrate client knowledge in advance of the sale. Further, some legal advisors recommend inserting a binding arbitration clause to hopefully circumvent the long, expensive process of a judicial proceeding. Only a competent attorney should prepare these types of disclosures and clauses.

Insurer Disclosure
As between agent and insurer, the obligations and duties of both should be fully disclosed in the agency agreement, general agency agreement or explicitly detailed in other written documents. Agents reading these documents should be clear on issues of authority (what the agent/broker can and cannot do), advertising (what compliance is the agent subject to), waivers, venue (governing law of state), materials and records, rules & regulations, supervision, audits, commissions, special conditions, indemnification, termination conditions, etc. As accountability grows, some agent contracts are including aggressive hold-harmless agreements that impose liability on agents for any claims, regardless of fault, while others contain personal indemnification clauses that place an agent's home and personal assets at risk. With ALL these disclosures present, it is a wonder how disputes develop between agents and their insurance companies. The answer lies in the interpretation of these agreements and circumstances that can be quite different for each transaction.

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Sample Agent / Client Disclosure

(Speak to an attorney before using ANY disclosure form) Dear Client: As you know, we are an insurance agency and not an insurance company. Our service to you includes the pricing and presentation of various insurance programs which may fit your needs, and the transmittal of your application to the insurance company. There are, however, limitations to our service, including the following: 1) Premium quotation and coverage are controlled by the insurance company and may be subject to change. We do not warrant or guarantee that a premium or coverage quoted by an insurance company will be identical to the ultimate premiums or coverage of the policy as issued by the company. There is no coverage promised or implied beyond the policy as written and endorsed. Your acceptance of the policy replaces all other agreements, either oral or written. 2) While we are pleased to provide to you and explain the industry ratings of a particular company or alternate insurers, we do not make any independent investigation of a specific company's solvency or financial stability. We do not warrant or guarantee that any insurance company will remain solvent, and we will not be liable to any insurance applicant or insured for the failure or inability of an insurance company to pay claims. 3) Insurance companies rely on the truthfulness and accuracy of information provided in the application. It is your sole responsibility to complete the application accurately, and if the insurance company should deny a claim based on its contention that the application has not been truthfully or accurately completed, we take no responsibility for such inaccuracy. We ask that our client applicants signify their understanding of the foregoing points and their agreement to defend, indemnify, and hold us harmless against any loss or liability which may arise from the applicant's failure to truthfully and accurately complete the application, by signing and dating this letter in the place provided below and returning the copy to us. Kindly do so at your earliest convenience. Accepted by _______________________________ on _____________

Agents and brokers have been sued by their insurers for failure to comply with terms of agency agreements ranging from gross misappropriation of premiums to seemingly small violations involving clerical errors. In many of these cases, the attorney for the defense had to go beyond the written disclosure by defending the agent or broker on the following points of law: Agency Relationship Without specific contractual ties, the agent's only duty to the insurer is to collect premiums and delivery the policy. The extent of any agency relationship between the agent and insurer beyond collecting the premium and delivery the policy is governed ONLY specific agency agreement or binding authority. Proximate Cause & Reliance In cases where the insurer sues a broker for failing to supply correct or complete information on the risk or client, brokers have countered that the insurer would have agreed to underwrite the risk even if he had not supplied correct or complete information. As a practical matter, it is rare to encounter liability 67

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insurance litigation in which the insurer can prove that it would not have provided coverage if better information has been provided. Estoppel An insurer who has had a long course of dealing with a given broker/agent may well have been willing, over the years, to overlook shortcomings in the information a broker provided the insurer. In some cases, brokers are allowed to "bind" coverage and later provide additional information. If the same insurer brings an action against the broker after a loss has occurred, the broker may be able to point to the insurer's past practices as the basis for an estoppel argument. Ratification When an insurer can be shown to have a practice of issuing policies even though the broker has supplied incomplete information, the broker may be able to establish that the insurer has ratified the broker's actions and adopted them as the insurer's own. Ratification of unauthorized acts of an agent can be sufficient in some cases to release the broker/agent from liability to the principal.

Errors & Omissions Insurance

Like other professionals, insurance agents should carry their own errors and omissions insurance. One author suggests that the highest level of agent ethics occurs when errors and omissions insurance is purchased for the protection of clients. While this is indeed a noble gesture, it is more likely that agents purchase these policies for more selfish motives. After all, we have entered an era of high accountability and cannot hope to survive a major claim without this protection. In some states, for example, the punitive awards can be as high as three times the amount of compensatory awards (some policies do not cover punitive damages). Faced with these kinds of actions, insurers, who many times foot the bill for agent mistakes, are less timid about suing their agents and brokers for any malfeasance. Of course, to some extent, the very existence of errors and omissions insurance may be a factor in an agent being named in litigation that he may otherwise have avoided. In a case involving several security salesmen, for example, a pre-trial judge asked for a show of agents who did NOT have errors and omissions insurance. They were excused from the case! This could happen again, or not at all. Who wants to take the chance? There is no standard errors and omissions policy. Most policies are written on a claims-made basis rather than on an occurrence basis. Claims made means the insurer is ONLY responsible for claims filed while the policy was in force. This could represent a problem down the road a few years, if the agent moves or retires. Even death is not an excuse, where a "hot shot" attorney can file his client's claim against the agent's estate!! Policies today also have some very significant limitations, caps, gaps, consent clauses and relatively high deductibles. So many loopholes, in fact, that an agent is likely to feel the financial impact of any litigation almost immediately and under certain conditions may receive NO protection whatsoever. Some older style policies even require the agent to pay the entire claim before the errors and omissions insurer has any obligation at all. These are referred to indemnification policies. In many instances, the choice of a errors and omissions policy doesnt center on the limits or features an agent wants, rather it comes down, for many, to what the agent can afford. Unless agents find a way to finance the huge premiums, through banks or association groups, this often leads to the agent accepting many policy exclusions.

Exclusions
Aside from the primary limits of the policy ($1 Million seems to be the limit of choice for most agents) the cost of defense is the most important exclusion to watch. Does your errors and omission policy include 68

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defense costs as part of the limit? If so, the amount of money available to pay monetary or punitive awards will be significantly reduced. Defense costs can also be limited to a percentage of policy limits. Here, when the number is reached, you start paying for the balance of defense costs. Obviously, the best errors and omission plan will pay for all defense costs in addition to policy limits. The claims made exclusion is the next consideration. If you have one, you will be covered for only the claims that occur while the policy is in force. If so, how will you handle a claim problem that occurs down the road, say at retirement, when you have dropped your policy? Actually, you may have little choice in the matter since most policies today are written on a claims made basis versus an occurrence basis. However, there are endorsements, discussed later, that can help protect you in the down the road scenarios. In addition to the claims made limitation, there are many other important coverage exclusions an agent must consider, such as: insurer insolvency, receivership, bankruptcy, liquidation or financial inability to pay; acts by the agent that are dishonest, fraudulent, criminal, malicious or committed while knowing the conduct was wrong; promises or guarantees as to interest rates or fluctuations of interest rates in policies sold, the market value of any insurance or financial product or future premium payments; activities of the agent related to any employee benefit plan as defined under ERISA; agent violations of the rules and regulations of the Securities Exchange Commission, the National Association of Security dealers or any similar federal or state security statute; violations of the provisions of the Consolidated Omnibus Budget Reconciliation Act (COBRA); discrimination or unfair competition charges, violations of the Racketeer Influenced Corrupt Organizations Act (RICO), and structured settlement placements. In most of the instances above, the standard agent's errors and omissions policy WILL NOT PAY a claim. In the case of an insolvent company that retains client's money or refuses to make good on a claim, the agent WILL NOT even be defended according to specific terms that exist in most policies. Also, be aware of specific limitations . You may not be covered by errors and omissions in the following areas: punitive damages, business outside the state or country; failure to give notice if new employees or agents are added to your staff; fraudulent or dishonest acts of employees or agent staff; negligence may be covered, but bodily injury and property damage may not; judgements -- some policies only pay if a judgement is obtained against you; some exclude contractual obligations in the form of hold harmless clauses (watch them); outside services like the sale of securities, real estate or notary work. Most errors and omissions policies are far from perfect. However, before losing interest in buying this valuable coverage, you should consider the high costs, and lost production time, associated in the defense of even one protected client claim and any subsequent judgement requiring an agent to pay any deficiencies and possible attorney/court fees. The cost of the average errors and omissions policy is cheap when compared to these costs. If you want your errors and omissions to do more, you can pay more and upgrade your coverage. Critical policy options that you might consider include first dollar defense coverage, defense costs in addition to policy limits, adequate liability limits ($1 million minimum), the availability of prior-acts coverage and coverage carrier solvency. Obviously, the concerned agent would do better to avoid malpractice claims at the outset by doing everything possible to investigate safety and solvency of any proposed carrier, acting professionally, keeping current, due care, etc. Further, there is no substitute for operating in a prudent, ethical manner rather than rely only on an errors and omission policy. After all, can there be any point to work and build a practice to lose everything to the dissatisfaction of one client?

Working With E&O Claims

If you feel you have a potential errors and omissions claim, you should first review your policy to follow 69

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the reporting requirements that need to meet. Most E & O carriers want you to report an incident right away. However, it is important to know what your company determines to be an incident. Is it an actual claim? Is it a threat of a claim? If in doubt, you might want to call the company anyway and discuss it with them. Generally, it is in your best interest to cooperate fully with the company by assisting in any evidence gathering and witness lists. However, this same spirit of cooperation does NOT always extend to your client. Most errors and omissions insurers do NOT want you or any staff member to make any voluntary admission of guilt to the client. Never blame the insurance company in any way or make any statement that might lead them to believe that the situation will be cured. While you can be cordial and calm in dealing with the client, be careful NOT to give any advice, legal or otherwise. If you are absolutely positive the claim is wrong, you can deny it, but never offer to settle. If the situation involves a claim between the agent and a represented insurance company, the same precautions must be taken. In essence, you cant afford to prejudice your case in any way. Violating this errors and omissions contractual promise is the sure way for coverage to be canceled. Cooperation also extends to any settlement offer proposed by your errors and omissions company. If your E&O insurer suggests a settlement offer that you do no agree with, and the case ended with a higher judgement that the settlement, you could be held liable for the difference as well as any amounts that exceed policy limits.

Office Protocol
Properly used, an agent's office automation and procedures can help to avoid costly claims or at least control E&O losses. For example, a sound basis for a defense can be established if an agent produces documentation, records of phone conversations regarding binding and specific coverages or records that show a clients decision to reject a recommended coverage. The client would have a hard time proving otherwise. Some liability claims have hinged on a hastily scribbled note confirming that a disputed conversation took place.

The legal purpose of documenting client dealings is to establish evidence. The best evidence gathering results from standard operating procedures.

The legal purpose of documenting client transactions is to establish evidence. Evidence can be parol evidence which is oral (difficult to prove in court), or it can be hearsay evidence (behind the scenes notes) which are written but not generally admissible unless it is collected under ordinary business rules. You should develop standard operating procedures which require the following evidence rules for the best protection possible: Reduce oral agreements to writing as soon as possible and indicate that the written document is the entire agreement. Handle ordinary course of business using an operating manual that is followed consistently, e.g., You offer a special endorsement coverage to everyone and log their acceptance or denial in the client file. Instead of post-it notes and scattered comments in client files make a point to transfer the content of these notes to a formal log kept in every client file. 70

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Following are some areas of office protocol that may make or break a claim against an agent: Automated Equipment Computers and the diary capabilities they present provide up-to-date documentation that can be used to verify an agent's defense. Electronic "date-stamping" can also be valuable as can fax messages concerning any client/agent contact concerning the dispute. We use a program called Maximizer which allows a quick location of a client file and fast entry of the conversation. Retrieval is a snap. Application For Insurance Complete and legible copies of the original application for coverage are extremely important. They presumably show the "intent" of the insured when he took out the policy, what he communicated to the agent regarding his wishes, whether the agent followed his wishes as to coverage requested and whether the insurance company followed the wishes of the agent who requested a policy of insurance pursuant to the wishes of the insured. Also, a material misrepresentation of fact by the insured in his application may cause the policy to be declared void ( American Family Mutual Insurance Co vs. Bowser - 1989) The Agent's File In a legal action involving an agent or his insurer, a client's attorney will always attempt to secure a copy of the agent's file. It will show his knowledge of the insured's intent for specific coverage, communications between the agent and the insured about securing these coverages and the communications between agent and the underwriting department of the insurer. In State Farm Fire & Casualty vs. Gros (1991), lack of notation regarding a client conversation three years before the loss was evidence upon which a jury concluded that the agent misrepresented the terms of the policy to the insured. By law, insurance companies generally have access to your files. So, it would be wise to NEVER make a derogatory comment about a client in these files. Also, when a claim or potential claim situation surfaces, it is always a good idea to check with your errors and omissions insurer before turning over any documents. As the industry edges closer to paper less filing it is important to understand that ALL files (paper, electronic, fax, post-it notes, etc) are considered evidence and can be used on your behalf or against you. Certain documents, such as applications with original signatures still need to be kept in paper form. Correspondence Clients will often say they never received a letter or cancellation notice or it was not in the envelope you sent. Experts suggest that using window envelopes and various methods of proven delivery, like Western Union, Certified Mail or United Parcel will provide you with a tracking record. Additionally, if the insured acknowledges receipt of a window style envelope he cant say there was nothing inside since the address was on the letter showing through the envelope window. E-Mail E-mail messages and correspondence is fast replacing written memos, faxes, phones calls and more. The ease of use, however, may hide liabilities that you need to address. For instance, confidential notes or information can be unintentionally sent without saving a copy, or worse yet, sent to the wrong party. E-Mail users often hit the enter key before they think, and just hitting delete doesnt automatically eliminate a message or derogatory remark. The system may back-up. E-Mail communications are just as binding, admissible and prohibitive in court as other communications. Attorneys are finding damaging information in E-Mail files that they cant find elsewhere. That is why it is imperative to have use guidelines for E-Mail. For liability purposes, all parties who have access to E-Mail in your company should apply good judgment. They should communicate with E-Mail as they would in a public meeting. Sensitive information should be encrypted to protect it from being transmitted via the Internet. For the best protection, use software that requires passwords. 71

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Operations Manual As you read above, standard operating procedures are steps that you follow consistently in selling and serving client. Standard procedures can be critical in establishing your notes and records as usable evidence in a trial. Further, it can be suggested that an agent who is careful to follow set procedures is usually found to be more credible in his own defense. Both are important reasons to document procedures in an operations manual. Some errors and omission insurers are requiring agents to have and see their operations manual before coverage can commence. You should also be aware that in an insurance dispute, the existence of such a manual may be uncovered. From a defense standpoint, the manual and your adherence to it may prove that you are a diligent agent. From a plaintiffs vantage, noncompliance of policy procedures that you establish may work against you.

An operations manual should detail standard procedures to follow in dealing with clients, insurers and special services you offer .

Your operations manual should cover procedures for dealing with client applications, claims, policies and certificates, insurance companies and any special services you plan to offer. The following is a basic outline of information that could be included in your manual. Because agencies and insurances differ widely, you will want to add issues that are specific to your business before implementing any procedures. Client needs and requests should always be noted in the file. Many agents routinely take 5 minutes after a client interview or phone call to document the needs and requests of the client in the file. Even if you have to shut the door and set the answering machine, this is important. The first section discusses many routine questions concerning agent due care and client needs. Always be consistent. If you ask one client to accept or deny a specific endorsement or make sure that you ask the same question of others. Note the date or nature of all correspondence that notifies a client that his application has been accepted or denied. Equally important is logging notification of clients or potential clients that coverage is NOT available. Create a hot list or follow-up file for ALL transactions that require additional review. A contact management or database system is excellent for noting the need to review the client file within 10 days, 20 days or on a specific date to check a renewal, ordered endorsement, etc. Your operations manual should also layout office procedures to be followed for handling and logging phone messages, faxes (copy thermal paper before putting in file), e-mail, photographs, microfilm, proof of mailing receipts as well as how long and where storage and deep storage of records will be kept. Standard procedures using window envelopes (advisable) for all notifications should also be established. As mentioned above, all oral agreements and binders should be reduced to writing and dated in the file. Policies received should be checked against specimen policies to be sure it is the same contract and against the client application to be sure it meets client needs Endorsements should be processed as soon as possible. Make notes that show the policy has been endorsed and create a follow-up system that compares any endorsement papers mailed with the endorsement received from the insurance company. Cancellation procedures should comply with state regulations and policy provisions. Notices to client should be tracked and posted in the client file. Also, be sure that the client does NOT continue receiving a bill after cancellation. Renewals should be sent within a specified time before expiration of the policy (usually 60-90 days). 72

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Experts agree that if you cant reach the client you should order the renewal anyway. Posting and tracking any notices to file is very important. Expirations should comply with state and policy provisions. Always notify client of any expiration. Claims should receive immediate attention and all requests should be promptly sent to the insurer. A follow-up note to the file should be prepared. Dont tell the client that the claim will be paid unless you are absolutely sure. Dont offer any legal advice to the client. Compare claim awards to policy limits accuracy.

CONSUMER PROTECTION ISSUES YOU CANT IGNORE

Rules and regulations vary from state to state. There are, however, widely accepted codes of behavior expected from licensed agents that fall under the category of consumer protection. Conflicts that surface here are usually the result of violations in advertising and deceptive or unfair trade practices. Agents in the real world find it near impossible to know each and every consumer statute, yet a single mistake could jeopardize a career and personal assets. Sometimes, it is the tiny indiscretions in business that create the problem. For example, placing a small and seemingly harmless sub-title on your letterhead that says Professional Services Guaranteed could hold you accountable for more than you bargained. Or, how about sending a withdrawal or surrender of cash value form to an insured to sign and mail back. This seems both efficient and convenient for the client, and a practice familiar with many agents. However, the client signature is not truly witnessed. Will a spouse or surviving family member who did not participate in any cash distribution deny the signature is real? Such is the way that matters of simple mistakes grow to legal conflicts. Knowing what is expected of agents in the consumer protection arena is the best place to reduce and avoid these problems.

Insurance Advertising
Insurance advertising is highly regulated with guidelines that differ from state to state. These guidelines determine what is communicated in an advertising message, how it is communicated, and how it looks. In fact, much of what agents communicate probably falls under the legal definition of advertising. Failure to comply with state laws could require the insurer and agent to cease doing business and incur penalties.

What is Considered Advertising?

Advertising includes all materials designed to create public interest in an insurer, its products, an agent or broker. This may include, but is not limited to: Product Brochures, Prospect Letters, Sales Presentations, Agent Recruiting Materials, Newsletters, Business Cards, Trade Publication Ads, Point-ofSale Illustrations, Print/Radio/TV/Internet Advertising, Stationary, Telemarketing, Telephone Conversations, Yellow Page Ads, Videos, etc. Most insurance companies require agents submit these forms of advertising to compliance departments for approval prior to publishing.

Nearly ALL client contact is considered advertising and subject to strict state guidelines .

Blind ads which do not identify product features or rates are particularly vulnerable to mistakes since they are typically not reviewed by compliance departments, although many insurers will look them over 73

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as a courtesy. Due to violations in this area of advertising, many states now require an agents license number be displayed in ALL forms of communication, including blind ads.

What Isnt Advertising?

Communication used purely for internal purposes and not intended for public use is not considered advertising, as well as policy holder communications that DO NOT encourage policy modifications.

Advertising should identify the insurer, the policy type and be understood by a person of average intelligence.

Advertising Compliance
The consequences of using non-approved advertising are both severe and damaging. Insurance regulators concerned about an advertisements content may require that ALL future advertising for the entire company be submitted for prior state approval. This would be disruptive and time-consuming. Additionally, a violation in advertising may carry fines of $1,000 or more per violation. As an example, 1,000 misleading flyers could be assessed a fine of $1 million ($1,000 X 1,000). To avoid these kinds of conflicts advertising should comply on several fronts: Identity of Insurer or Product If advertising focuses on a specific company it is advised that the FULL NAME of the company be used along with the home office address (City and State). Initials or abbreviations are not acceptable to most companies or insurance regulators. For specific product ads, the policy or contract type should be clearly and accurately identified. Accuracy and Truthfulness As a general rule, the advertising piece, when examined as a whole, cannot lead a person of average intelligence to any false conclusions. These conclusions can be based on the literal meanings of words in the ad and impressions from pictures or graphics as well as materials and descriptions omitted from the advertising piece. In one case (McConnell vs Ehrlich - 1963) the agent lost his license for using prospecting letters that closely resembled official correspondence from the Department of Motor Vehicles.

Words like safety should be supported while terms like legal reserve should be avoided, as should other words that might lead a purchaser to believe he was getting something other than an insurance product.
Specific words like safety should be supported using A.M. Best Ratings, etc., while terms like LEGAL RESERVE should not be used at all. Absolute words like all, never and shall should be avoided, while words such as free, no cost and no extra cost can be included IF actually true and then ONLY if the one paying for the benefit is identified or if the copy indicates that the charge is included in 74

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Words that are not typically used in connection with a policy, like investment, personal pension plan, asset protector, etc., should not be used in a context which leads a purchaser to believe he is getting something other than an insurance product. Illustrations and Quotes There are many proposals by states, professional groups and organizations like the National Association of Insurance Commissioners. Most require that agents disclose all assumptions in the illustration or quote and explain and highlight any guaranteed portions as opposed to anticipated results. Almost as important is whether nonguaranteed elements of the policy are shown with equal prominence and close proximity to the guaranteed elements. Representations concerning withdrawals cannot be made unless reference is also made to any prepayment or surrender charge. Where words like tax free or exempt are used, they should be explained. Comparisons, Ratings and Competition References Comparisons made between policies and investment products, e.g., comparing an annuity to a savings account or a split limit quote to a single limit estimate, must be complete, accurate and not misleading. Agents have lost their license by using solicitations and letters that inferred that insurance is available at lower rates than others because of a special volume plan. All statistical information should be recent, relevant and the source and date identified. Any reference to a commercial rating should be clear in describing the scope and extent of the rating. If an A.M. Best, S&P, Moodys or other rating is advertised, the appropriate disclosures should be given. References to the competition should be factual and not disparaging. Comparisons to competitors products ought to be fair and complete and there should never be a reference to State Guaranty Associations as a means to induce the purchase of an insurance product. Disclosures If you display a rating from a commercial company you should use a disclosure similar to this: A.M. Best has assigned (Company) an A (Excellent) rating, reflecting their current opinion of the financial strength and operating performance of (Company) relative to norms of the insurance industry. A.M. Best utilizes 15 rating classifications from A++ to F. If your agency is located in a bank or other prominent corporate institution, the following disclosure is appropriate: Contracts are products of the insurance industry, and are not guaranteed by any bank or company, or insured by the FDIC. Also, if your product aligns with estate planning, financial planning, taxes or asset protection, you might display the following caveat: Neither (Company) nor any of its agents give legal, tax or investment advice. Consult a qualified advisor. Testimonials and Endorsements Never use or imply an endorsement or testimonial by a person or organization without their approval. Further, if a person or organization making an endorsement or analysis is an employee of or has a financial interest in the Company or receives any benefit, it should be prominently displayed.

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Other Unfair Insurance Practices

While advertising is the most obvious trade practice violation, agents should be certain they are not also participating in other unfair methods of competition or unfair or deceptive act or practice in the course of their daily business, the subject our of next discussion.

Illustrations or proposals must not be misleading. Ratings should be supported and reference to competition should be fair.

Agents in question of unfair trade practice methods are typically subject to a hearing, usually before the State Department of Insurance, to show cause why a cease and desist order should not be made by the appropriate regulatory agency or board. After a hearing, if it is determined that the agent's actions violate the rules of unfair competition and practices, a formal cease and desist order may be served -- a warning. Violating such a cease and desist order is typically subject to various dollar penalties and administrative penalties such as injunctions, loss or suspension of license, and severe civil penalties such as high dollar fines, damage awards, and court fees to the injured parties. In addition to advertising, discussed above, areas of specific importance include:

Identification
Agents should clearly identify themselves as insurance agents promoting or selling an insurance product.

Defamation
Defamation violations occur where an agent is involved in making, publishing, disseminating, directly or indirectly, any oral or written statement, pamphlet, circular, article or literature which is false or maliciously critical of or derogatory to the financial condition of any insurer or which is designed to injure any person engaged in the business of insurance.

Boycott, Coercion & Intimidation

Most states consider it unlawful for licensed agents to enter into any agreement or commit any act of boycott, coercion or intimidation resulting in or tending to result in unreasonable restraint of, or monopoly in, the business of insurance.

False Financial Statements

Restrictions are very clear that an agent violates the law when filing with any supervisor, public official or making, publishing, disseminating, circulating or delivering to any person, directly, or indirectly, any false statement of financial condition of an insurer with intent to deceive. This also includes making any false entry in any book, report or statement of any insurer with intent to deceive any agent, examiner or public official lawfully appointed to examine an insurer's condition or any of its affairs. Willfully omitting to make a true entry of any material fact pertaining to the business of such an insurer in any book, report or statement are similar violations. 76

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Stock Operations
It is considered unlawful to issue, deliver or permit agents, officers or employees to issue or deliver company stock, benefit certificates or shares in any corporation promising returns and profits as an inducement to sell insurance. Participating insurance contracts, however, are excluded from this category.

Discrimination
An agent clearly violates insurance law in making or permitting any unfair discrimination between individuals of the same class and equal expectation of life in the rates charged for any contract of life insurance or life annuity or in the dividends or other benefits payable by such contracts. Similarly, there shall be no discrimination between individuals of the same class and of essentially the same casualty hazard in the amount of premium, policy fees, or rates charged for any policy or contract of accident or health insurance or in the benefits payable under such contracts. Discrimination can also occur where individuals of the same class and of essentially the same hazards are refused renewability of a policy, subject to reduced coverage or canceled because of geographic location.

Rebates
Rebates permitted by law are authorized. Otherwise, it is a violation in most states to offer, pay or rebate premiums, provide bonuses or abatement of premiums or allow special favors or advantages concerning dividends or benefits related to an insurance policy, annuity or contracts connected with any stock, bond or securities of any insurance company. A rebate may also be classified as any readjustment in the rate of premium for a group insurance policy based on the loss or expense experience at the end of the first year, made retroactively only for that year.

Deceptive Name or Symbol

Agents shall not use, display, publish, circulate, distribute or caused to be used or distributed any letter, pamphlet, circular, contract, policy, evidence of coverage. article, poster or other document, literature bearing a name, symbol, slogan or device that is the same or highly similar to a name adopted and already in use.

Deceptive or Unfair Business Practices

In addition to specified insurance codes, insurance agents must answer to generalized consumer protection laws carrying titles such as "Deceptive Trade Practices" or "Unfair Trade Practices". For the most part, these consumer laws apply to insurance and agents because an insurance policy is deemed a "service" and the purchaser of a policy is deemed a "consumer". Therefore, insurance

In addition to insurance codes, agents will be held responsible for violations of state consumer protection laws .

services fall within the meaning of widely adopted consumer protection acts. Agents are also pursued under consumer protection laws because some insurance codes do not specifically address certain 77

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questionable acts by agents where the misrepresentation or fraud occurs outside the limits of insurance business. In such cases, the damaged insureds or policy owners were not considered to be "consumers". By including the purchase of insurance services as a consumer transaction, the additional protection of deceptive or unfair trade practices acts can be invoked. The Uniform Consumer Sales Practices Act was enacted by the federal government and adopted by many states to protect consumers from deceptive marketing practices and establish a uniform policy. The essence of this legislation, as well as local and state laws, is that "buyer beware" is an old attitude now replaced by real laws and enforceable legal limits. The courts frown on oppressive and unconscionable acts and consider it the duty of any sales person and agent to disclose information available to him which gives him an unfair advantage in a sale. False statements constitute fraud, and the fine print in contracts may be construed, under certain conditions, as an intent to conceal.

Unlawful Trade Practices

False, misleading or deceptive acts or practices in the conduct of any trade or commerce are unlawful and subject to action by the appropriate codes of consumer protection. Such acts, which may apply to insurance agents and brokers, include, but are not limited to the following: Passing off services as those of another. Causing confusion or misunderstanding as to the source, sponsorship, approval or certification of services offered. Causing confusion or misunderstanding as to affiliation, connection or association with another. Using deceptive representations or designations of geographic origin in connection with services. Representing that services have sponsorship, approval, characteristics or benefits which they do not have. Disparaging services or the business of another by a false or misleading representation of facts. Advertising services with intent not to sell them as advertised. Advertising services with intent not to supply a reasonable expectable public demand, unless the advertisements disclose a limitation on quantity. Representing that an agreement confers or involves rights, remedies or obligations which it does not have or involve, or which are prohibited by law. Misrepresenting the authority of a salesman or agent to negotiate the final terms or execution of a consumer transaction. Failure to disclose information concerning services which was known at the time of the transaction if such failure was intended to induce the consumer into a transaction which the consumer would not have entered had the information been disclosed. Advertising under the guise of obtaining sales personnel when in fact the purpose is to first sell a service to the sales personnel applicant. Making false or misleading statements of fact concerning the price or rate of services. Employing "bait and switch" advertising in an effort to sell services other than those advertised on different terms or rates. Requiring tie-in sales or other undisclosed conditions to be met prior to selling the advertised services. Refusing to take orders for the advertised services within reasonable time. Showing defective services which are unusable or impractical for the purposes set forth in the advertisement. Failure to make deliveries of the services advertised within a reasonable time or make a refund. Soliciting by telephone or door-to-door as a seller, unless, within thirty seconds after beginning the conversation the agent identifies himself, whom he represents and the purpose of the call. Contriving, setting up or promoting any pyramid promotional scheme. Advertising services that are guaranteed without clearly and conspicuously disclosing the nature and extent of the guarantee, any material conditions or limitations in the guarantee, the manner in which the guarantor will perform and the identification of the guarantor. 78

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Burden of Proof
To recover under deceptive or unfair trade practice acts, it is the claimant's burden to prove all elements of his cause of action and that he is a "consumer" within meaning of the act.

Legal Remedies
Whenever the courts or consumer protection division of an insurance department have reason to believe that any person is engaging in, has engaged in, or is about to engage in any act or practice that may violate a trade or practices act, and that proceedings would be in the public interest, the division may bring action in the name of the state against the person to restrain by temporary restraining order, temporary injunction, or permanent injunction the use of such method, act or practice. In addition, there may be a request by the consumer protection division, requesting a civil penalty for each violation, possibly $2,000, with a maximum total not exceed an established amount (typically $10,000). These procedures may be taken without notification to such person that court action is or may be under consideration. Usually, however, there is a small waiting period, seven days or more, prior to instituting court actions. Actions which allege a claim of relief may be commenced in the district court -- usually where the person resides or conducts business. The Court may make such additional orders or judgments as are necessary to compensate those damaged by the unlawful practice or act. Usually, there is a statute of limitations, typically two years, to bring such action.

Unfair Competition & Unfair Practices by Insurers

Agents should know that the insurance companies they represent are also subject to the insurance and practice rules above, as well as to specific deceptive or misleading acts in the areas of advertising, settlement practices, reporting procedures, discrimination (by race, disability, rates, renewal, benefits), investment practices, reinsurance restrictions, liquidations and more. Violations of consumer protection issues by insurers will be met with an array of fines and penalties ranging from hearings before the commissioner, public hearings, judicial hearings and review, additional periodic reporting (beyond annual statements), investigative audits, dollar penalties, civil penalties to the more severe cease and desist actions and revocation of an insurer's certificate of authority to conduct business. The following are some areas of consumer protection violations by insurers that should alert agents:

Unauthorized Insurer False Advertising

The purpose of consumer protection laws in this area is obvious -- insurers not authorized to transact business in the state should not place, send or falsify any advertising designed to induce residents of the state to purchase insurance. This legislation is usually directed at "foreign or alien insurers" and defines advertising to include ads in the newspaper, magazine, radio, television and illustrations, circulars and pamphlets. Violations can also include the misrepresenting of the insurer's financial condition, terms and benefits of the insurance contract issued or dividend benefits distributed.

Unfair Settlement Practices

Insurers doing business in a state are subject to rules and regulations detailing unfair claim settlement practices such as: Knowingly misrepresenting to claimants pertinent facts or policy provisions relating to coverages. 79

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Failing to acknowledge with reasonable promptness pertinent communications with respect to claims arising under its policies. Failing to adopt and implement reasonable standards for prompt investigation of claims arising under its policies Not attempting in good faith to effectuate prompt, fair, and equitable settlements of claims submitted in which liability has become reasonably clear. Compelling policy holders to institute lawsuits to recover amounts due under its policies by offering substantially less than the amounts ultimately recovered in the suits brought by these policy holders. Failures of any insurer to maintain a complete record of all the complaints which it has received during recent years (usually three years) or since the date of its last examination by the commissioner. This record shall indicate the total number of complaints, their classification by line of insurance, the nature of each complaint, the disposition of these complaints and the time it took to process each complaint.

Discrimination by Handicap
An insurer doing business in a state may not refuse to insure, continue to insure or limit the amount, extent, or kind of coverage available to an individual, or charge an individual a different rate for the same coverage solely because of handicap or partial handicap, except where the refusal, limitation, or rate differential is based on sound actuarial principles or is related to actual or reasonable anticipated experience.

Discrimination by HIV Testing

In recent years, HIVrelated testing in connection with an application for insurance has become commonplace. If an insurer requests or requires applicants to take an HIVrelated test, he must do so on a nondiscriminatory basis. An HIVrelated test may be required only if the test is based on the person's current medical condition or medical history or if the underwriting guidelines for the coverage mounts require all persons within the risk class to be tested. Additional stipulations require that an insurer may not make a decision to require or request an HIVrelated test based solely on marital status, occupation, gender, beneficiary designation or zip code. Further, the uses that will be made of the test must be explained to the proposed insured or any other person legally authorized to consent to the test and a written authorization must be obtained from that person by the insurer. An insurer may not inquire whether a person applying for insurance has already tested negative from a previous HIV test. The insurer may inquire if an applicant has ever tested positive on an HIVrelated test or has been diagnosed as having HIV or AIDS. The results of an HIV test are considered confidential, and an insurer may not release or disclose the test results or allow the test results to become known, except where required by law or by written permission from the proposed insured. Then and only then can results be released, but only to the proposed insured, a licensed physician, an insurance medical information exchange, a reinsurer or an outside legal counsel who needs the information to represent the insurer in an action by the proposed insured.

Discrimination in Rates or Renewal

An insurer may not discriminate on the basis of race, color, religion, or national origin, and, to the extent not justified by sound actuarial principles on the basis of geographical location, disability, sex, or age, in the setting or use of rates or rating manuals or in the nonrenewal of policies.

Benefits Protection
Insurers are duty bound to protect all money or benefits of any kind, including policy proceeds and cash values to be paid or rendered to the insured or any beneficiary under a life insurance policy or annuity contract. In essence, these benefits must inure exclusively to the person designated in the policy or 80

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annuity contract. They must be exempt from attachment, garnishment or seizure to pay any debt or liability of the insured or beneficiary either before or after the money or benefits are paid. They are also exempt from demands of a bankruptcy proceeding of the insured or beneficiary.

Health Policy Benefits

In the health insurance industry, benefit payments are commonly assigned to a physician or other form of health care provider who furnishes health care services to the insured. An insurer may not prohibit or restrict the written assignment of benefits. When such an assignment is requested, the benefit payments shall be made directly by the insurer to the physician or health care provider and the insurer is relieved of any further obligation. Of course, the payment of benefits under an assignment does not relieve the covered person from any responsibility for the payment of deductibles and copayments. Further, a physician or health care provider may not waive copayments or deductibles by acceptance of an assignment.

Contract Entirety
Every policy of insurance issued or delivered within the state by any insurance company doing business in the state shall contain the entire contract between the parties. Furthermore, the application used to secure the insurance is usually made part of the contract.

Insurer Mergers
The conditions and regulations necessary for two insurance companies to merge or consolidate are well documented in state insurance codes. Concerning consumer protection, however, it is important to know that all policies of insurance outstanding against an insurer must be assumed by the new or surviving corporation on the same terms and under the same conditions as if the policies had continued in force with the original insurer.

Reinsurance Assumptions
A method used by one insurance company to insure or reinsure another insurance company is called stock assumption. Most insurance codes do not affect or limit the right of a reinsurer to purchase or to contract to purchase all or part of the outstanding shares of another insurance company doing a similar line of business for the purpose of reinsuring all of the business including the assumption of its liabilities. Despite the practice of assumption reinsurance, some members of Congress in recent years have objected to the process, since there is no requirement to inform policy holders in advance that the insurance company behind their policy is relinquishing responsibility to another company, that is, the reinsurer. The reasoning behind their concern is that policy holders who have purchased coverage based on the financial condition and reputation of one company may suddenly find themselves insured by another company without warning or knowledge of the new company's abilities to pay their claims. To date, however, there is no definitive legislation passed to change reinsurance assumption.

AGENT BLUNDERS & COURT CASES

One of the best schools in town is the experience of other agents. The purpose of this section is to study case examples where agents were held legally responsible or accountable to defend their actions. Knowing the mistakes of others could save you from making them yourself. A few years ago, no one knew what market conduct meant. Today there are class action suits and negligence claims filed against insurers and agents alike amounting to millions of dollars for sales and legal conduct violations. Of course, agent conflict is nothing new. Our research into blunders found 81

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cases dating back to the early 1800's. What is different between cases of today and the ones that occurred years ago is the trend toward fiduciary responsibility. In essence, the courts are viewing agents as more than mere salesmen. Agent responsibility, in the past generation, has evolved from contractual compliance to ethical duty. Recent cases, for example, lean toward the precedent that agents, as insurance professionals, should have known something was wrong compared to years ago where agents were generally held liable for outright negligence in a matter. There is a world of difference between the two that is best explained by the legal precedent theory. In a nutshell, this theory claims that because our legal system makes legal decisions based on precedents it is destined to constantly expand. Each decision in the chain sets the stage for the next step of expansion. This chain reaction is demonstrated in some recent court cases. In Southwest vs Binsfield (1995) the agent should have known that a specific coverage option was important to the business he insured. In Brill vs Guardian Life (1995) the agent breached his fiduciary duty by not using an optional conditional receipt. Clearly, the expansion of agent liability from decadesold negligence issues to these types of fiduciary duties is a trend. In the next chapter, we discuss these controversies and other potential conflicts which may be the next expansion phase, i.e., sales and legal conduct issues of the future.

Due to our expanding legal precedent system, events that were NOT a problem in the past, could now represent agent liability.

In reviewing the following court cases, keep in mind that issues in the past that did NOT result in agent liability might indeed represent exposure today, mostly because of the legal precedent theory and the fact that courts and juries in more recent years show a willingness to sanction this expansion. Further, an agent who escaped liability in a conflict may not have escaped the huge cost of a trial or legal fees. A lot of agents fail to insure for this contingency and errors and omissions carriers can also refuse to cover the claim. Also, dont assume that a casualty court case has no application to you if you sell life insurance and visa versa. Many legal matters concerning duties are fully portable and transferable between classes of agent. Finally, be aware that some court decisions appear to clear the agent of wrongdoing. These decisions can result from issues extraneous to the case or a technicality Aetna of the Midwest vs Rodriguez (1988) ISSUE: Failure to assess clients real need RESULT: Agent responsible Based on a conversation, an agent believed his client was seeking insurance on a conditional sales contract when, in fact, client had purchased a home secured by a mortgage. A claim resulted in lack of coverage and a lawsuit commenced. The courts determined that even though the client used words that could have been interpreted two ways the agent should have investigated the Areal coverage and not simply wrote the policy in a manner that was most legally advantageous to the insurance company. American Pioneer Life vs Sandlin (1985) ISSUE: Misrepresentation of future value RESULT: Agent liable 82

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An agent sold annuity policies to mostly retired clients where the average purchase was about $20,000. The agent typically represented that the principal was available at anytime and the accumulation value of the contracts were guaranteed to grow to certain levels. Both representations were so false so as to prove a fraudulent scheme for which agent was liable. Ahern vs Dillenback (1991) ISSUE: Failure to procure adequate coverage RESULT: Agent not liable but paid big legal fees In 1982, clients were visiting California and purchased an automobile policy which agent said would cover them on an up and coming trip to Europe. Client requested the best policy available and agent assured client that she and her husband would receive full insurance coverage with policy limits that would safely protect them. In 1984, the client was driving in France and was seriously injured in a hit-and-run accident with an unidentified and uninsured motorist. Claims by the client were denied since the following coverages were not in the policy: collision, medical payments and uninsured motorist. Clients lawsuit against the agent was not successful in this case because the courts felt that the general duty of reasonable care that an agent owes a client does not include the obligation to procure complete liability protection. Further, there was NO special relationship with client that held agent to a higher standard of care. Bayley Et All vs Petes Satire (1987) ISSUE: Failure to obtain proper coverage RESULT: Agent liable for current and future losses In an unusual case a client owned a bar/lounge and was assured by the agent that his business was fully covered for alcohol-related lawsuits. In fact, the policy obtained for client contained an exclusion for such lawsuits. The bar was eventually sued for negligence by permitting a minor to leave the lounge while intoxicated and causing an accident. The insurance company cited the exclusion and refused to pay. The client sued both the insurance company and agent for full reimbursement of his costs to settle the accident case. The courts concluded that the insurance company was NOT liable but the agent WAS. Further, because the error was rooted in complete negligence, the agent was held liable for all future alcohol related lawsuits the client might incur. Bedford vs Connecticut Mutual Insurance (1996) ISSUE: Misrepresentation of policy terms RESULT: Agent liable Client purchased a whole life policy from agent under the assumption that coverage would be fully paidup in six years. When it became apparent that the policy would not be paid-up in six years client sued and the courts determined that the special relationship between agent and client was a factor in determining agents fraud. Bell vs OLeary (1984) ISSUE: Failure to notify coverage not available RESULT: Agent liable Agent took an application for flood insurance but failed to notify client that his mobile home was located in unincorporated areas that were ineligible under the National Flood Insurance Plan. A loss occurred and agent was sued. The agent tried to assert the client could NOT have purchased flood insurance from anyone and he could have known coverage was not available because the Code of Federal Regulations regarding flood coverage availability was public information. The courts did not agree rendering that 83

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agent has superior knowledge and failure to notify clients that coverage was unavailable takes precedence over the fact that coverage was not available from any source. Benton vs Paul Revere Life (1994) ISSUE: False statements by agent RESULT: Agent liable Agent sold a disability policy to his client on basis that coverage could be extended for life for an additional premium, when in fact, the policy and rider required a higher level of disability occur before life benefits are awarded. The court was clear to point out that any agent who does not understand the differences between two products he is selling is subject to liability for fraud. Born vs Medico Life (1988) ISSUE: Gaps in coverage RESULT: Agent not liable but paid huge legal bills A client purchased a new health insurance policy from agent with a typical six-month pre-condition waiting period. Client then canceled his old policy but soon developed health problems that were waivered by the precondition waiting period of the new policy. Client sued agent for gaps in coverage but court decided that agent did not have a duty to advise client about maintaining his old policy until the six-month waiting period of the new policy had expired. Also, it was discovered that agent advised client specifically about the six-month waiting period. Brill vs Guardian Life (1995) ISSUE: Failure to advise conditional coverage RESULT: Agent liable A client expressed a desire to obtain life insurance coverage as soon as possible. Agent took clients application but failed to advise client his option to pay a small fee for a conditional receipt which would have provided immediate, although temporary life insurance. Upon clients sudden death, his widow sued the agent and company for negligence in failing to recommend use of the conditional receipt. The court sided with the widow by determining agents negligence was a breach of duty. BSF Inc vs Cason (1985) ISSUE: Inaccurate application by agent RESULT: Agent liable An agent met with a client and filled out an application for homeowners coverage. Client supplied information that indicated he had previous claims and was canceled by another carrier. A loss resulted and the insurance company refused the claim upon learning the true experience of client which was not disclosed on application filled out by agent. The courts determined that the agent was liable for acting outside his scope of authority by failing to record the clients claim and cancellation experience. Boothe vs American Assurance (1976) ISSUE: Failure to notify application not accepted RESULT: Agent liable Client requested flood insurance coverage. Agent accepted a completed application and advance premium payment and led client to believe he was protected. The application was not sent and the insurance company refused coverage which client discovered when he submitted a claim for a flood loss. Agent was sued and found liable for neglecting to follow up on application and notify clients that they did 84

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INSURANCE MARKETING ISSUES not have coverage. Campbell vs Valley State Agency (1987) ISSUE: Agent negligence due to special knowledge RESULT: Agent potentially liable

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The client was a founder and director of a bank that owned and operated an insurance agency. The agent was also manager of the agency and knew that client was a millionaire. Agent obtained automobile coverage for client in the amount of $100,000 per person and $300,000 per occurrence. A major accident occurred which exceed the limits of the policy. The client sued agent for these additional damages. Although the case was scheduled for a new trial the original court found that a jury could have found the agent had a duty to advise the client about his liability coverage needs due to the special relationship that existed. Thus, the agent was potentially liable for the damages that exceeded policy limits. Cartwright vs Equitable Life (1996) ISSUE: Misrepresenting policy terms RESULT: Agent fined $30,000 Multiple clients purchased life insurance policies from an agent on the strength that policies were selfsupporting after only three premium payments. When clients learned that automatic premium loans were reducing face values agent again reassured clients he would take care of the problem. The courts sought $6.1 million in punitive damages from insurance company for failure to curb agent after his conduct was first reported. Agent was fined $30,000 for fraud even though he was retired at the time of the trial. Commissioner vs Grossman (1986) ISSUE: Agent fraud for back-dating application RESULT: Agent subject to fraud conviction Agent received an initial premium from client three months prior to fire that damaged clients home. Upon learning of the fire, agent scurried to obtain insurance he had neglected to purchase by altering his postage meter to give the appearance that he processed the application two days prior to the fire. The insurance company received the application three days after the fire and refused the claim. The insurance commissioner pursued and won a conviction for fraud. Crobons vs Wisconsin National Life (1984) ISSUE: Agent was party to fraudulent signature RESULT: Agent liable Agent sold client a life insurance policy. Client later became very ill and lapsed into a coma. Agent, who was fully aware that client was in a coma, witnessed a change in beneficiary signature that led to a dispute in determining the proper beneficiary of the proceeds. Agent was responsible for his damages by his fraud. Cuismano vs St Paul Fire (1981) ISSUE: Failure to obtain requested coverage RESULT: Agent liable Client clearly informed agent of the need for a specific coverage. The face page of the policy suggested that the client was furnished this coverage. A claim for loss, however, proved otherwise. The court held that the ambiguity of the policy did not require the client to verify coverage, especially in light of agents 85

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INSURANCE MARKETING ISSUES assurance. Negligence here resulted in agent liability. Durham vs McFarland Et Al (1988) ISSUE: Failure to obtain adequate coverage RESULT: Agent liable

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Agent handled most of clients insurance needs for approximately 15 years. Client purchased a new residence boathouse and met agent to discuss transferring the coverages on the old residence to the new boathouse. Ten months after the meeting the boathouse was damaged by a flood and the client submitted a claim. The insurance company did not list the flood peril and denied coverage. The agent was sued and the courts agreed that he had a duty to advise the client about flood insurance on the new residence, especially since it was a covered event for the old residence. Eddy vs Sharp (1988) ISSUE: Failure to obtain adequate coverage RESULT: Agent liable under fiduciary duty Client owned multiple rental buildings requested coverage from new agent similar to old coverage. The agent prepared a proposal describing his coverage as All Risk subject to a list of eight exclusions. Additionally the proposal contained the following disclaimer: This proposal is prepared for your convenience only and is not intended to be a complete explanation of policy coverage or terms. Actual policy language will govern the scope and limits of protection afforded. Client relied on the proposal letter and decided it met his needs. When the policy arrived he did not read it. Client losses resulted from the back up of water through drains and sewers (due to a clogged city drain). This was not covered by the policy but was not listed as an exclusion in agents proposal. The court held that the agent owed his clients a fiduciary duty, a duty of care under agency principals, and a statutory duty to accurately describe the provisions of their policy. Further, when agent described proposed coverage as all risk and clients accepted same, there was a binding contract obligating agent to obtain the promised coverage. Employers Fire Insurance vs Speed (1961) ISSUE: Coverage not obtained RESULT: Agent sued but not liable Agent agreed to obtain fire and extended coverage on clients soon-to-be constructed building. Client was led to believe he was covered but agent failed to do so. Client relied on agent but did not request the name of agents principal (insurance company). Upon a claim for loss, the court ruled that there was no contract for insurance, even though the same client was already insured with six of the eight companies carried by agent on other projects. The agent incurred big legal fees and lost a good client. (Compare this result to Julien vs Spring Lake Agency - 1969). Europeon Bakers vs Holman (1985) ISSUE: Negligence in obtaining adequate coverage RESULT: Agent liable After handling the clients insurance needs for approximately six years the agent proposed that the client change its business interruption coverage to a policy that included a coinsurance provision. The insured accepted the proposal but found that it covered only 28 percent of his loss caused by the interruption of business when an oven accidentally exploded. The agent was sued for negligence by the bakery which was seeking the full amount of the lost business production it suffered. The court held that the agent was responsible since he had a duty to advise the client about its business interruption needs, especially since agent held himself to be an expert in this area and client had relied on him in the past. 86

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INSURANCE MARKETING ISSUES Evanston Insurance vs Fred A. Tucker (1989) ISSUE: Agents broker took premiums without coverage RESULT: Agent responsible for client losses

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The client paid agent almost $75,000 for fishing vessel coverage. Agent requested coverage and sent premiums to intermediary broker who failed to obtain coverage and refused to return premium money. Agents E&O carrier refused to pay claim since his E&O policy excluded any claim for premiums lost. Agent was found liable. Flattery vs Gregory (1986) ISSUE: Agent failed to obtain options he bought before RESULT: Agent responsible for optional coverage Agent had previous business with client where he purchased optional coverage on his automobile. A new policy was purchased, but nothing was said about adding the optional coverage. Naturally, the clients loss involved optional coverage damages which were not included in the new policy. The court ruled that the agents promise to procure optional coverage was implied from the earlier transaction. He was responsible to provide this coverage at his own expense. Foster vs American Deposit Insurance (1983) ISSUE: Agent miscalculated coverage period RESULT: Agent liable Agent sent client a letter indicating that clients automobile policy was paid for 90 days. A loss occurred 89 days from client letter and client submitted his claim. The insurance company denied coverage since 90 day coverage had expired days earlier. Agent was responsible for damages due to his error in calculating coverage. Free vs Republic Insurance(1992) ISSUE: Insufficient policy limits RESULT: Open for future trial Since 1979 agent provided client homeowners coverage and assured same that the policy limits were sufficient to rebuild his home. In 1989 clients home was destroyed by fire and insurance proceeds were found to be less than needed to rebuild. The client brought an action against agent and insurance company in that they failed to inform him of the inadequate limits of coverage despite years of assurance. The courts held that the agent was under NO general duty of care to advise client about the sufficiency of coverage to replace his home, but once he elected to respond to his inquiries he acquired special duty to use reasonable care. Due to some extraneous issues a new trial was to set to establish liability. Gabrielson vs Warnemunde (1988) ISSUE: Duty at purchase greater than on-going RESULT: Agent sued but not liable The particulars in this case are not as important as the result. It was found that an agents duty to inform the client that he had appropriate coverage is greatest at the time of purchase. Agents do not generally have a duty to ferret out, at regular intervals, information which brings a client within provisions of a policy exclusion or waiver. Agents typically acquire this duty by their own admission (refer to Free vs Republic -1992 and Grace vs Interstate Life - 1996).

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INSURANCE MARKETING ISSUES Gauntt vs United Insurance Co of America (1994) ISSUE: Agent refused to tender policy RESULT: Agent potentially liable

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A client requested insurance company pay the accumulated cash value in her life policy. The company refused because the policy had already been converted to another policy without a current surrender. As a result of the dispute, the agent refused to turnover the clients policy. The courts found that even though the policy was rightfully converted, the agents wrongful detention of the policy effectively denied the client the ability to know her policy rights and thus constituted a conversion for which the agent could be liable. Glenn vs Leaman & Reynolds (1983) ISSUE: Failed coverage due to insolvency of carrier RESULT: Agent liable An independent agent obtained coverage for client in the past and was asked to do so again. An application and advance premium payment was made and coverage obtained. Shortly thereafter the insurance company was declared insolvent and clients coverage was prematurely terminated. The courts in this case established that a fiduciary relationship existed between the agent and client and that he did NOT fulfill his obligation to inform client of the premature termination even though he mailed an unregistered letter to clients last known address. For the most part, the court was disturbed that this letter was sent more as a courtesy and not out of any course of action designed to notify client of the insolvency and the procedure to be followed in obtaining a refund of his unearned premium. Agent was liable for losses client incurred. Grace vs Interstate Life (1996) ISSUE: Policy not necessary any longer RESULT: Agent potentially liable Agent obtain a health insurance policy for client who kept it going for almost ten years. Benefits of this policy were substantially replaced by Medicare after age 65 but agent continued to collect premiums. The courts determined that the special relationship that existed between agent and client created a duty for agent to disclose this fact and his silence made him personally culpable in a second potential lawsuit. Great American Insurance vs York (1978) ISSUE: Failure to follow instructions RESULT: Agent liable Agent accepted an application from clients wife without clients knowledge. In addition, a business was operated on the residential property but agent failed to make a personal inspection to discover this. Shortly after submitting for coverage a fire destroyed the home but the insurance company refused the claim since insufficient information was obtained on the application. The agent was responsible for clients damages because he had failed to follow insurance company instructions to submit a completed application, including all signatures. Greenfield vs Insurance Incorporated (1971) ISSUE: Failure to cover specific machinery RESULT: Agent liable Client requested business interruption coverage including mechanical breakdown of an automobile shredder. Agent assured client this coverage was in place but a claim for lost production went unpaid as 88

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uncovered. The courts ruled that even though the client failed to read the policy, he had a right to rely on agents representations as well as years of agent/client relationship. The agent was liable. Gulf Insurance vs The Kolob Corporation (1968) ISSUE: Reasonable time to cancel RESULT: Agent sued and liable in a costly trial For various reasons, an insurance company decided to cancel all of an agents business policies. The agent was asked to collect and send any remaining premiums and cancel policies. Because agent had a large volume of clients to cancel and find replacement coverage, this process was delayed. Cancellation for one client did not occur for six weeks, during which time a claim occurred. The major task before the court was determining what is reasonable time to cancel these policies. Despite evidence of the agents tremendous workload and possible contributory negligence by the insurance company in not following up sooner, the insurance company was forced to pay the client and the agent was ultimately liable to the insurance company for not taking quicker action. Hardt vs Brink (1961) ISSUE: Failure to obtain adequate coverage RESULT: Agent liable Client owned a metal products company and leased space for which agent obtained a comprehensive liability policy. Although the agent never saw clients lease, it included language that excluded the tenant client from any benefits of the building owners coverage. Thus, when a major fire damaged the building, the client was uncovered. In fact, agents coverage specifically exempted the insurance company from liability for damage to the leased property. The agent was sued and the court ruled that even though agent was unaware of the lease provisions, he had breached his duty to advise the client to obtain sufficient coverage under the lease. This duty was solidified through previous dealings with client where client followed all agent recommendations. Agent was liable for damages. Honeycutt vs Kendall (1982) ISSUE: Client not notified about lack of coverage RESULT: Agent liable Client requested automobile coverage by tendering an application and premium payment. Before policy was issued, the insurance company discovered an undisclosed traffic violation and asked for an additional premium payment. Client was not aware of this demand and the policy was shortly canceled. Clients loss claim was denied and the agent was sued. The courts determined that the agent had a duty to provide notice to the client that coverage was not available. Hutchins vs Hill Petroleum (1993) ISSUE: Failure to add additional insured RESULT: Agent found negligent Client owned a maintenance company specializing in oil refineries. Client requested that agent name a refinery as additional insured under his existing policy. An employee of client was witness to the phone conversation where agent was orally instructed to accomplish this. When the agent failed to add the refinery, the clients maintenance contract was terminated resulting in business losses. The agent was sued and the court agreed that the contract termination was, for the most part, the agents failure to add the refinery.

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INSURANCE MARKETING ISSUES INCO Express vs Marketing Insurance (1984) ISSUE: Non admitted company / insolvent insurer RESULT: Agent sued at costly trial but not liable

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This case involved a non-admitted insurance company that eventually became insolvent. When the client incurred losses, the agent and the surplus line broker he used were initially found liable because the agent failed to investigate a low-rated carrier and disclose to client that they were a non-admitted company. On appeal, the surplus lines broker was determined to have ultimate responsibility. Independent Life vs Peavy (1988) ISSUE: Agent fraud RESULT: Agent liable for big punitive damages The specifics of this case are not as important as the lesson. An agent attempted to cheat a client out of $412 in policy benefits. The court was so enraged with this deception that it awarded the client punitive damages in the amount of $250,000 -- thats 606 times the compensatory damages of $412! Jarvis vs Modern Woodmen of America (1991) ISSUE: Preexisting condition and incontestable period RESULT: Agent potentially liable Agent encouraged client to drop an incontestable policy and purchase a new policy even after being advised about clients certain mental and financial problems. Policy was later canceled when these facts were found missing from application. The courts awarded $500,000 punitive damages against the insurance company based on acts of its agent and agents gross, reckless and wanton negligence. Further action by the insurance company against the agent was contemplated. Johnson vs Illini Mutual Insurance (1958) ISSUES: Agent described wrong house RESULT: Agent liable An insurance broker was requested to insure the clients home at a specific address. The agent misdescribed the house number and the building and contents were subsequently destroyed by fire. The insurance company refused to pay the claim and the courts ruled that the broker was liable to his principal (client) for failure to follow instructions. Julien vs Spring Lake Agency (1969) ISSUE: Failed coverage but principal disclosed RESULT: Agent sued but insurance company liable The client was a builder who dealt with agent regularly among a variety of properties. Client requested agent cancel a specific policy and add two others. Although agent noted the request to add two policies, only one was issued. As luck would have it, the uncovered property incurred damages. Since the claim went unpaid the client sued both agent and insurance company. The courts found for the client but denied the insurance company claim for reimbursement from agent on the basis that agent had binding authority and all previous business policies were written with the same insurer. In essence, the courts felt that the principal was adequately known to the client even though coverage was never obtained. (Compare this case to Employers Fire vs Speed).

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INSURANCE MARKETING ISSUES Karam vs St Paul Fire (1973) ISSUE: Failure to obtain adequate coverage ESULT: Agent liable

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Client owned a Laundromat and requested agent obtain as much property damage liability insurance as possible. Agent said that $100,000 was the most he could get. Client approved but through agent error only $10,000 was written. A water heater exploded causing $20,000 of damage. Agent was sued and found liable for the difference between damages and policy limits. The courts felt that the client had no responsibility to read the policy or the bill sent by agent which stated $10,000 of coverage. Kurtz, Et Al vs Insurance Communicators (1993) ISSUES: Dual Agency & Agent Misrepresentation RESULT: Agent liable In 1985, client obtained group medical, life and accident coverage for its employees. Client was not knowledgeable in this area of insurance and relied on agent, who held himself out as an expert in the field. Agent advised client to sign a Certificate of Non-Applicability which essentially exempted client from certain Medicare provisions of TEFRA. In fact, this exemption does not apply to companies with more than 20 employees. Agent informed insurance company that client had only 12 employees when, in fact, he knew they had 30. A serious illness with clients employee was the source of major claims in 1987. The insurance company paid for some of the claims, then informed client that is was not required to pay for the employees treatment because client had violated the above TEFRA provisions. Late in 1987 the insurance company canceled the policy and then demanded that client reimburse it for amounts already paid. A lawsuit was commenced in 1989 by insurance company which believed its coverage to be secondary to Medicare coverage. Client filed a cross complaint against insurance company and agent alleging breach of contract, breach of implied covenant of good faith, fraud, negligent misrepresentation and unfair business practices. The complaints between the client and insurance company were a wash, but on appeal, the agent was found to be liable for negligence and negligent misrepresentation. Lazzara vs Howard Esser (1986) ISSUE: Agent missed split limit gap in coverage RESULT: Agent liable Client requested $1,000,000 automobile coverage. Agent purchased two policies: A primary with $300,000 maximum and an extended policy covering claims in excess of $250,000 up to $1 million. The primary coverage was issued for split limits of $100,000 per person and $300,000 per occurrence, i.e., a $150,000 gap. Upon a loss client sued agent for the gap in coverage. Client prevailed because agent had a duty to act in good faith with reasonable care, skill and diligence. Lewis vs Equity National Life (1994) ISSUE: Agent failure to disclose known information RESULT: Agent liable Client was injured in a car accident and had many heart-related treatments which the insurance company refused to pay after learning that client had a preexisting condition that was NOT disclosed on the original application. Client alleged that agent was the one who filled out the application and failed to list the condition even though it was disclosed to him. The courts awarded contract and punitive damages to client because agent misrepresented information disclosed to him.

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INSURANCE MARKETING ISSUES Lott vs Metropolitan Life (1993) ISSUE: Deceptive sales practices RESULT: Agent and company subject to fines

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Clients employees were sold life policies through a cafeteria plan. Agent mistakingly represented to employees that they must buy life insurance in order the plan to be granted tax savings. Agent and company found liable for undisclosed damages and fines. MacGillivary vs W. Dana Bartlett (1982) ISSUE: Agent failed to disclose insolvent, non-admitted insurer RESULT: Agent liable Agent obtained insurance on clients boat which was later stolen. Insurance company failed to pay claim since it was declared insolvent. Client also found out that this company was not licensed to do business in state. The courts determined that the agents failure to apprise himself of the non-admitted status of insurance company was gross negligence. Magnavox Co of Tennessee vs Boles & Hite (1979) ISSUE: Failure to obtain adequate coverage RESULT: Agent liable The agent set out to provide a construction company complete liability coverage. Agent had done business with client for over seven years and had in his possession the construction contracts used by the client which required client to indemnify his customers damages occurring in connection with his performance. An employee of clients subcontractor died in an accident and all parties were sued for damages, including agent. The courts held that the agent had a duty to advise the client of the need to be covered for the peril and was negligent in failing to investigate this need based on the client contracts he had in his files. Naijmias Realty vs Cohen (1985) ISSUE: Agent obtained wrong insurance RESULT: Agent liable Client builder asked agent to obtain replacement cost coverage for his rental property. Agent instead procured actual cash value coverage. A fire to the building and requirements to meet updated building codes resulted in damages exceeding policy limits. Agent was sued for deficit and the courts awarded same to client due to agents breach of duty to obtain the correct coverage as instructed. Nationwide Insurance vs Patterson (1985) ISSUE: Misrepresentation of policy terms RESULT: Agent liable A trial court concluded that an agent was liable for misrepresentation for not advising client about the stop loss payment feature of his policy when he accepted a revised group health policy proposal. Agent was responsible for the stop loss damages. Osendorf vs American Family Insurance (1982) ISSUE: Agent relationship meant higher care RESULT: Agent liable 92

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Agent handled ALL clients farm insurance business for 10 years. Agent had visited the operation many times during this period but failed to advise client that he needed liability coverage for his employees. An on-the-job injury caused uninsured damages which the agent was liable to cover. Pacific Insurance vs Quarlls Drilling (1988) ISSUE: Wrong coverage with insolvent insurer RESULT: Agent sued in costly trial but not liable Agent and client agreed that crew and employee injuries would NOT be covered under a hull and indemnity policy because it was already covered by another liability policy. Somehow the crew and employee coverage was Abound and written with the hull and indemnity policy. Meanwhile, the insurer for the other policy became insolvent and an employee-related client loss occurred. The client filed his claim with the hull and indemnity company which denied it upon learning that agent and client agreed NOT to include it. Because the agent produced documentation that proved this arrangement, the courts sided with the hull and indemnity company and agent. The clients higher level of sophistication was also a factor in this decision. Padeh vs Zagoria (1995) ISSUE: Inappropriate product recommendation RESULT: Agent potentially liable An investment advisor/agent recommended client invest the proceeds of an investment into a pension plan and purchase additional life insurance for the same purpose. Client launched a lawsuit for reasons that the pension plan was ill-suited for their financial goals and life insurance was inappropriate inside this plan. The courts established that the agent misrepresented claims of the potential benefits and offered negligent advice. Where results of the plan are negative, the agent has a potential liability. Parlette vs Parlette (1991) ISSUE: Agent failed to name beneficiary RESULT: Agent liable Agent sold a life insurance policy to a client, the primary purpose being to benefit the mother of the client if he died prematurely. Despite this knowledge, agent failed to see that the mother was properly designated as beneficiary. Upon the clients death, the mother proved she was the intended beneficiary and sued agent for his negligence in failing to see that it was accomplished. R-Anell Homes vs Alexander & Alexander (1983) ISSUE: Incorrect description of policy coverage RESULT: Agent liable Client advised agent that a new telephone system would be part of his building. Agent indicated that the phone system would automatically be covered under the buildings blanket policy. Damages that occurred to the phone system were denied by the insurance company since it was NOT covered under terms of the policy. The courts found the agent liable for negligently conveying false advice. R.H. Grover vs Flynn Insurance (1989) ISSUE: Agent error and negligence RESULT: Agent liable Client requested a Certificate of Insurance from agent. Agents new employee issued the certificate, 93

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however no coverage was ordered. A claim was presented and denied. The courts held the agent liable to client for his negligence in supervising his new employee. Reserve National Insurance vs Crowell (1993) ISSUE: Agent misrepresented preexisting condition RESULT: Agent liable Client requested Medicare supplement information from agent and disclosed certain preexisting health problems. The agent told client he could receive better coverage under a new policy. After policy was issued, a claim developed which was denied by the insurer upon learning of clients preexisting condition The courts awarded client contract damages and punitive damages totaling 600 times the out-of-pocket expenses based on the agents intentional misrepresentations about the preexisting condition. Saunders vs Cariss (1990) ISSUE: Alleged signature fraud RESULT: Agent liable In 1986 client obtained an automobile policy from agent. The policy included uninsured motorist coverage with $100,000 in limits. The policy was in effect in 1988 when client was seriously injured in an accident caused by an uninsured motorist. When client submitted his claim the insurance company produced Reduction Agreements consenting to reduce uninsured coverage down to $25,000. The agreements purported to bear the signature of Client although he denied signing them. Client sued claiming that agent signed his name without authorization. The court held that the agent was liable where his intentional acts or failure to exercise reasonable care in obtaining or maintaining insurance resulted in damages to the client. Seascape vs Associated Insurance (1984) ISSUE: Agent claim that coverage was available was in error RESULT: Agent liable Agents held themselves out to be professional insurance planners. They had served client for several years. Client came to them to get specific advice regarding seawall insurance. Agents advised client that this type of insurance was NOT available to them. Later, a storm damaged clients seawall and clients learned that seawall insurance could have been purchased. Clients sued agent alleging that their relationship was such that agent owed a duty to exercise reasonable care in rendering advice on insurance matters. The courts agreed. Small vs King (1996) ISSUE: Duty to procure correct coverage RESULT: Agent liable to insurer for client losses The specifics of this case are not as important as the result. Client requested full coverage. In response, agent obtained additional coverage, but the wrong kind. Client losses were attributable to the insurance company who sued agent for reimbursement. The court in this case ruled that the agents duty to provide correct coverage cannot be triggered by a clients request for full coverage because that request is not a specific inquiry about a specific type of coverage.

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INSURANCE MARKETING ISSUES Smith vs National Flood Insurance Program (1986) ISSUE: Improper notification by agent RESULT: Agent liable

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Agent filled out a flood insurance application dated March 31. As typical with this type of insurance, coverage only becomes effective the day after the application IF the payment and application are received within 10 days of application or if mailed certified within four days of application. Agent used regular mail and application was received April 11 (after the deadline). Clients claim for loss that occurred after application mailed was denied. Agent was sued and the courts determined that he was negligent for using regular mail rather than certified mail, the only sure method of fulfilling his duty under provisions of the coverage. Agent was liable for the flood damage of clients home and contents. Sobotor vs Prudential Property & Casualty (1984) ISSUE: Agent as expert / Failure to procure coverage RESULT: Agent liable Client requested the best available auto insurance package from agent. Coverage options for uninsured motorist were NOT discussed and this coverage was NOT included in the policy as issued. Subsequent client losses prompted a lawsuit. The courts sided with the client by determining that even though this was a single insurance transaction between agent and client, a fiduciary relationship existed because the agent held himself out to have special knowledge in insurance and client, who knew nothing about the technical aspects of insurance, placed his faith in agent. Also, by asking agent for the best available package client put agent on notice that he was relying on agents expertise to obtain desired coverage. Southland Lloyds Insurance vs Tomborlain (1996) ISSUE: Fiduciary duty is highest on agents own contracts RESULT: Agent denied coverage Agent made application to insurance company to cover property he personally owned. The property was later destroyed by fire but the insurance company denied coverage based on misrepresentations by agent concerning the propertys age, purchase price and condition. The court held that an agents fiduciary duty to its principal (insurance company) is highest when agent writes his OWN contract insurance. Southwest Auto Painting vs Binsfield (1995) ISSUE: Lack of reasonable coverage RESULT: Agent liable Client requested coverage for his auto painting business indicating his reliance on the advice and ability of agent to obtain appropriate coverage. At no time was employee dishonesty coverage mentioned and it was NOT included in the policy as issued. Later, one of clients employees embezzled over $150,000 of company money. The insurance company refused the claim and agent was sued. Agent was found liable, contrary to previous court cases where agents, who had no special relationship with client, had no duty to advise or recommend a specific coverage. In this case, however, expert testimony helped the court determine that the agent was duty bound to advise client about the relevant types of coverage where this coverage is widely available for this type of business at a relatively low cost. Speir Insurance Agency vs Lee (1981) ISSUE: Replacement coverage not obtained RESULT: Agent liable 95

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Agent agreed to bind comprehensive collision and liability coverage on clients vehicle. Insurance company canceled policy prior to date of collision but agent failed to obtain replacement coverage upon learning of the cancellation. The court felt that the agent acted in bad faith and committed fraud on the client. As such, punitive damages were authorized. State Farm vs Gros (1991) ISSUE: Misrepresentation and lack of agent notes RESULT: Insurer liable / agent sued Client built a home on the side of a hill and carried a standard homeowners policy. The policy contained a common exclusion landslide damage. However, client alleged that agent told him if a landslide made contact with your home, youre covered. Three years later, client filed a landslide claim. Agent advised client he was NOT covered for landslide. Lack of notes in agents file to support earlier conversations with client forced court to hold that the policy was misrepresented when purchased. The insurance company was liable and bound by the agents action. Steadman vs McConnell (1957) ISSUE: Misrepresentations to induce sales RESULT: Agents license suspended for one year Agent sold multiple life contracts called Bank Loan Life Insurance Plans where clients paid the first annual premium on a ten-payment life insurance policy. The policy is subsequently assigned as collateral a bank loan. Proceeds of the loan are applied to payment of the second annual premium. On each anniversary date, a new note is executed in the amount then outstanding. The result of this process was that after ten years the cash values of the policy would be substantially less than the premiums paid. Knowing this fact, agent continued to promise clients that cash values, sufficient to meet their financial planning needs, would be available. They were not. The insurance commissioner accused the agent with misrepresentation, dishonest conduct and other counts which resulted in the suspension of the agents license for one year. Stuart vs National Indemnity (1982) ISSUE: Agent promise to cover / Lack of binding ability RESULT: Agent liable Client requested coverage and tendered initial premium. Agent represented that client had full coverage even though agent had NO binding authority. A loss occurred before application was approved but insurance company denied coverage. The court ruled that an agent who advises client that coverage is bound, with knowledge that the intended insurance company has not yet agreed to accept such coverage, acts as the insurance company until coverage is accepted. The agent was liable for client losses. Tillman vs Short (1973) ISSUE: Agent negligence RESULT: Agent not liable but paid legal costs Client owned a business and purchased a group medical plan. Client sold business but continued to pay his portion of premiums with full knowledge of agent. A subsequent car accident caused client to submit a medical claim which the insurance company denied upon learning he was no longer a full-time employee (a requirement for coverage). Even though the agent seemed to be doing the client a favor client sued agent, but the court ruled that BOTH agent and client were equally at fault. It doesnt pay to cross the line.

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INSURANCE MARKETING ISSUES Todd vs Malafronte (1984) ISSUE: Failure to obtain adequate coverage RESULT: Agent liable

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Client maintained a business insurance policy through agent that did NOT include workers compensation coverage even though the agent knew that client hired a part-time summer employee. The agent had assured client that it was not necessary to cover this employee who was later injured. The client sued the agent for the damages and the courts agreed that it was the responsibility of the agent to be sure the client had proper coverage for this condition. United Farm Mutual Insurance vs Cook (1984) ISSUE: Failure to obtain coverage RESULT: Agent liable Agent and client had a long-standing relationship where the agent exercised broad discretion to serve client needs. Client explained a new project that he wanted agent to insure. Despite having sufficient information to know that he could NOT obtain this coverage, agent said nothing and did not procure coverage. The courts determined that agent was liable for losses of the client since he had the duty to exercise reasonable care to inform client he could not provide coverage. Wal-Mart Stores vs Crist (1988) ISSUE: Agent exceeded authority / insolvent insurer RESULT: Agent not liable but incurred major legal expenses Client (Wal-Mart) asked for bids on workers comp coverage. Agent submitted a $3.5 million premium offer which client accepted. After issuance, the high claims experience did not seem to match the payroll. Then it was discovered that a Wal-Mart employee intentionally misrepresented the payroll amounts to secure a better insurance bid. Thereafter, the insurance company refused to pay claims and demanded Wal-Mart pay premiums that matched its actual payroll. Just about that time, the insurance company became insolvent. A lawsuit followed that involved the agent. Through testimony, the courts determined that the agent and insurance company were equally at fault as Wal-Mart. In essence, all parties had sufficient information to know that the premium deal was too good to be true. No one was liable to the other, but all parties incurred huge legal bills. Ward vs Durham Life Insurance (1989) ISSUE: Failure to disclose information on app RESULT: Agent potentially liable Client purchased a life insurance policy from agent and later died. The insurance company denied benefits because certain health history information was left out of the application. The clients widow sued on the basis that the agent told her and her husband that the missing information did not need to be disclosed on the application. The court ruled a new trial indicating possible collusion between agent and the client where no agent notes of the conversation could be produced. Watts vs Talladega Savings & Loan (1984) ISSUE: Failure to notify premium due RESULT: Agent liable For years agent worked with client by sending notice of payment due for real estate fire insurance coverage. The mortgage company would then draw a check from the escrow account and pay agent. The 97

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policy would automatically renew upon payment. For some reason, agent failed to send premium notice and the policy was canceled, despite a call to the agent by the mortgage company regarding coverage. A claim caused client to sue agent. The courts felt that agent had a duty to notify client that premium was due as he had in the past. A phone call from the mortgage company was further proof of agents negligence. Westrick vs State Farm (1982) ISSUE: Failure to obtain coverage RESULT: Agent potentially liable Client maintained insurance with agent since 1964. The agents office was run by a father and son team. Both shared an office but had different clients. Since they had no employees they would answer the phone for each other when one was out. In early 1977 client inquired about insuring a jeep-type vehicle to be used in his agricultural business. Agent son gave client impression that said business vehicle would automatically be insured for 30 days. Client did not purchase this vehicle. In late 1977 client did purchase a welding business for his son which included a six-wheel welding truck. The day client called the insurance office the father agent was alone. Client asked for son agent and then explained that he purchased the business with two vehicles for which he wanted coverage (clients automobile coverage provided for 30 days of automatic coverage for any newly acquired auto if it replaced an auto already insured with company). Client said he offered the father agent serial numbers but the agent said his son would be in the next day. Client assumed he had coverage and that night the welding truck was involved in an accident. Father agent believed that the truck was NOT insured because client wanted to talk to son agent. Further, it was a commercial vehicle not covered by his policy. Client, however, assumed this type of vehicle was insurable based on his earlier conversation with son agent regarding the jeep-type vehicle (in court the son agent did not remember this conversation). The court originally found in favor of the agents but this was reversed on appeal because it felt that a jury would have ruled negligence on the part of agent. The case was recommended for retrial. White vs Calley (1960) ISSUE: Breach of agent oral promise RESULT: Agent liable Client maintained a builders risk policy covering a rental home that was set to expire on April 16. In March, client requested that agent increase the insurance limits of the rental. Agent verbally agreed that she would take care of increasing the insurance. A few days later the agent delivered to client a routine rider that contained a mortgage clause to be endorsed on the new policy which commenced April 16. When the building was destroyed by fire on March 30, the insurance company paid ONLY the old value. Clients lawsuit to obtain the new value from agent was successful even though agent testified that the clients real intent was to increase limits for the new policy. Williams Agency vs Dee-Bee Contracting (1984) ISSUE: Agent employee promises RESULT: Agent liable Agent discovered that clients apartment building was underinsured. Unable to reach client about this situation agent left on a trip and took no further action. During agents absence, the client also learned about the valuation problem but was unable to reach agent. Agents secretary indicated that the matter would be taken care of. The client took no further action but a major fire destroyed his building. Agent was sued for failure to fully insure the property and the courts determined that agent was negligent.

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INSURANCE MARKETING ISSUES Wood vs Newman Agency (1995) ISSUE: Failure to notify coverage dropped RESULT: Agent liable

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A client maintained a comprehensive business policy with agent for her marina complex. The insurance company notified agent that this policy would no longer cover ice and snow damage but agent failed to advise client of this fact when the policy was renewed. When the next storm hit the area, the client lost 18 covered wooden docks which collapsed under the weight of snow and ice. The insurance company denied coverage and the client sued all parties. The courts determined the agent was negligent and liable for not advising client of this lost coverage even though her knowledge of same might not have changed the outcome, i.e., she would have suffered loss from the damage anyway because NO snow and ice coverage was available from any source. Wright Bodyworks vs Columbus Agency (1974) ISSUE: Dual agency / lack of coverage RESULT: Agent liable Client requested business interruption insurance from agent. Agent agreed to adequate coverage based on agents yearly inspection of clients books to determine premium. Coverage was placed but agent calculated premiums based on clients gross profits rather than its gross earnings. When a major loss occurred the client was underinsured in a big way. The courts determined that the agent assumed a dual agency role because of his special arrangement to audit the books and the fact that agent advertised himself as an expert in this field of insurance. The insurance company paid their limits and the agent was liable for any deficit.

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CHAPTER 2

INSURANCE ON THE INTERNET

When the topic of the Internet arises, the question that many insurance agents ask is. . . should I participate? A better question would be . . . how can I participate? Like it or not, the Internet is here and its use is about to explode. Need proof? A recent survey, by International Data Corp, asked small business owners if the Internet is key to doing business. Almost 40% responded YES! This is double the response of the previous survey. And, by 2000, the World Wide Web is expected to be a significant channel representing $95 billion in product and service activity. Users of the Internet numbered 16 million in 1995, jumping to 34 million in 1996 and anticipated to skyrocket to 163 million by the year 2000.

WILL THE INTERNET REPLACE INSURANCE AGENTS? Experts dont believe this will happen since most insurance is purchased when an agent uncovers a need and encourages the consumer to take action. Further, only a small portion of the population is thought to be self-directed enough to log on and buy insurance without help. For future generations, however, their lifelong association with the computer may stimulate more of them to make remote purchases of goods and services like insurance
In the insurance industry, growth of the Internet is still in its infancy. A recent Booz-Allen & Hamilton suvey of 144 insurance companies found that most had websites, but only a few had a strategic plan for use of the Internet. Sixty-six percent used the Internet for name recognition, whereas only eight percent used it for lead generation and one percent for direct sales. Clearly, there is more potential to be tapped with over 60 million adults using the Internet with desirable demographics: Users have an average annual income of $60,000 and an average age of 35. If we accept a growing consumer enthusiasm for the Internet, the next question is will people use it to buy complicated financial products, like insurance, and will direct access to insurance company websites soon eliminate the need for agents altogether? Both issues are hotly debated. A recent Nielsen Media Research study indicated that there is strong growth in the US and Canada among people who have made purchases on the Web usage jumped 50 percent in a recent six-month period. These sales, however, may not have been made in complicated areas such as insurance or business, but rather in consumer products. So what is the potential for insurance? Experts believe that someday a rather exclusive group of consumers will dial up insurer sites, research policies and fill out an electronic application. Several carriers are already in place to make this happen. The best estimates are, however, that only a small segment of the population will be willing to do this. More likely, most people will find the 100

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task of Internet searches and the analysis of lengthy and complicated insurance policies too intimidating on their own. So, as long as insurance companies do not offer deep discounting as an incentive to buy direct over the Internet there is no reason for consumers not to take advantage of professional guidance from a licensed agent. If the Internet is not an immediate vehicle for widespread direct purchasing of insurance policies what good is it to agents and the industry alike? Currently, there at least a dozen or more great ways that the insurance industry can benefit from using the Internet. Clients and agents can check the status of policies or cash values Clients and agents can check the status of pending applications Premiums can be paid by credit card or electronic transfer Quotes and illustrations can be instantly retrieved Clients can stay in touch directly with their agent using E-mail Agents can be connected to carrier news on new products or learn of commission problems Insurance loss claims can be reported Clients can use an agent website to review benefits of their policy Agents can provide clients with a 24-hour information source using an electronic newsletter Clients will be able to buy insurance using electronic signature technology Agents can inexpensively market their services with their own website or as a member of an insurance mall. Agents can download forms and order underwriting requirements Agents can learn of new regulations and licensing requirements or complete their continuing education Discussion groups (chat rooms) can provide valuable interaction with other professionals about policy benefits and insurance news Independent and employee agents alike can have access to powerful prospecting databases, professional tax and planning reference materials and rating services Agents in the field could log on for sales presentation / quote information Regulators can post consumer-beware bulletins and comb the web for violations and less than ethical insurance dealings. Insurers and agents alike can use the Internet as an inexpensive recruiting tool

Just one of these possible uses should be a reason for the professional agent to get involved and work through the Internet.

Bill Gates, in a recent interview about insurance sales on the Internet, said: Insurance is confusing. I think consumers want advice. Agents who use technology to deliver that advice will do fine.
Experts predict that no major insurer will be without Internet presence in the next couple of years. Given their vast resources and ability to tap into new technology it is likely that the insurance industry will soon maintain a high profile that will not go unnoticed by the many information search services such as Yahoo, Excite, Alta Vista, AOL and Infoseek. As a result, it wont be long before consumers will be offered a stockpile of user-friendly insurance sites and links from related sites in banking, financial planning, tax and retirement planning. 101

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All of above are reasons that agents should now begin investigating the potential use and application of the Internet. To aid in this research you will need to know some background on the Internet and some of the legal and regulatory obstacles to selling insurance on line.

The Marketing of Insurance Over The Internet

In response to the increased use of electronic commerce and the unique regulatory concerns surrounding electronic commerce, the NAIC charged the Market Conduct and Consumer Affairs (EX3) Subcommittee to study and issue a white paper, including recommendations, regarding the sale, marketing and regulation of insurance through the Internet; including, but not limited to, analysis of technology issues such as digital and electronic signatures, electronic fund transfers, electronic applications, privacy and confidentiality issues, contracted policy forms, and agent, broker, producer and company licensing issues. The following section is the White Paper published by the NAIC. Permission for reprinting here is granted by the National Association of Insurance Commissioners.

Internet Commerce
Electronic commerce is the buying and selling of goods via an electronic medium. This is a very broad definition that encompasses the sale of goods from telemarketers to the sale of goods over the Internet. From a consumer's viewpoint, electronic commerce may provide access to more information, faster and economically, and may result in lower product and service acquisition costs with ease and greater cost savings. Electronic commerce can also help organizations meet their goals of enhanced customer service, and the economical dissemination of consumer information and increased sales. Over the last several years, the proliferation of the Internet usage has increased importance of electronic commerce. With the Internet, companies are able to make world wide contact with potential consumers 24 hours a day, 365 days a year. Companies can also maintain this open line of communication with suppliers, independent contractors and any other entity which plays an integral role in the production and distribution of its product.

Potential uses of the Internet

Consumers
The Internet provides a convenient way to learn more about products, sources and pricing. And, since people make most purchasing decisions based on information they receive through manufacturer marketing materials, companies looking for more efficient ways to target their market will find that the Internet will allow consumers to purchase a product, rather than being sold a product. E-mail capabilities allow consumers to communicate with agents and/or companies about changes to their insurance policies and to report and process handle claims. Not only can the Internet cut down or reduce "phone tag," it can help provide instantaneous confirmations that consumers' instructions have been complied with, furnish another option for carrying out correct notification procedures, and provide "hard-copy" (print-out capability) of agents'/companies' instructions (e.g., directions to repair facilities, inspections procedures, etc.) without the need to write down or remember the information.

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Regulators
Regulators in their consumer-protection and consumer education roles could benefit from near-universal consumer access to the Internet. For example, Insurance Departments can post consumer information that would appear more or less automatically in consumers' insurance-related searches. Thus, this information could be disseminated much more cost-effectively and consistently than it currently can be supplied. Many departments already provide this type of information in hard-copy format including general insurance information and premium comparisons, but its dissemination is limited and sometimes expensive because of its hard-copy format The marketing of insurance over the Internet also offers regulators an additional opportunity to actively monitor market conduct. Regulators, like consumers, can "surf" the Web, looking for suspicious solicitation activity. Ordinarily, regulators must wait to be made aware of market conduct problems through consumer complaints (outside normal market conduct audits). The Internet is a more pro-active approach to such audit efforts.

NOT A PART OF THE NAIC WHITE PAPER The Producer Information Network (PIN) and the Producer Database (PDB) are two examples of regulators systems on line that function as central repositories of producer licensing, licensing demographics & regulatory actions, agent disciplinary actions, company appointments, terminations and more!

The ease and speed of Internet communications mean that regulators could more frequently monitor insurer compliance with regulatory procedures and time frames. Once appropriate record keeping requirements are in place, "spot checking," "surprise audits," and other tools could be as simple to implement as an exchange of E-mail. This could instill greater compliance efforts in insurers with chronic service problems.

Industry
Producers and insurers recognize the vast capabilities of the Internet and the ability to provide information to prospective clients, in a format that more closely fit their clients' needs. The Internet allows their

NOT A PART OF THE NAIC WHITE PAPER A recent poll by California Broker the primary reason carriers are interested in having a presence on the Internet is for helping agents make more sales.
information to be easily and continuously available, to post a "presence" that accurately portrays the variety of products and services; and to provide a convenient way for consumers to contact them for follow-up. The relatively low cost of electronic communication, compared to that of hard-copy mailings, telephone solicitations, etc., should provide potential cost savings for agents and companies that use the Internet effectively. 103

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Insurance companies are already taking advantage of the electronic commerce available through the Internet by establishing home pages on the Internet. With these home pages, insurance companies are opening new distribution channels which could eventually incorporate all facets of the insurance transaction, from initial contact with the consumer to collection of premium, issuance of the policy, and the payment of benefits. The Internet is recognized by agents and companies as potentially more efficient than many traditional marketing methods. The Internet allows companies to service existing markets and expand into previously untapped markets. Huge marketing possibilities are more easily possible on the Internet, allowing agents or insurers to post their information in such a way that it will be found by people pursuing related interests, such as crop insurance answering general inquiries. Finally, the Internet offers companies the opportunity to expand its communication with its agents. The Internet offers insurance companies the opportunity to offer these services with greater speed and efficiency and at a lower cost. In addition to sales, insurance companies are finding the Internet a means by which to better educate consumers on the different type of insurance available and the benefits of such insurance. Insurance companies can also utilize the Internet to service current policyholders by offering on-line claim assistance, complaint handling and answering general inquiries. Finally, the Internet offers companies the opportunity to expand its communication with its agents. The Internet offers insurance companies the opportunity to offer these services with greater speed and efficiency and at a lower cost.

Internet Overview
The Internet began in 1968 when the Advance Research Projects Agency (ARPA) at the United States Department of Defense began developing ARPAnet, the first large-scale computer network. ARPANet was designed to give computer scientists at universities and other research institutions access to distant computers, permitting them to use computing facilities which were not available at nearby locations. Before ARPANet, most networks depended on a central server which, if it went down for any reason, jeopardized the entire system. ARPANet used multiple servers and communications lines and protocols so that if any server had a problem, information could be re-routed through remaining servers. In the 1980's, the National Science Foundation (NSF) created five supercomputer centers and made them available for general research purposes. Until this time, access to these supercomputing facilities was limited primarily to scientists, universities and researchers. With the advent of the NSFnet, opportunities for access by others began to open up. Regional networks were developed and interconnected within the NSFnet and these, along with the MILNet, Bitnet, DECnets, and hundreds of Local Area Networks (LANs) made up what has become known as the Internet. A computer network is two or more computers which are connected to each other and can communicate information from computer to computer. Today, the Internet is comprised of thousands of computer networks which are located throughout the world. Common tools used to gain access to this world wide network of computers are e-mail and the World Wide Web. Because this access is available 24 hours a day and is available world wide, the Internet is revolutionizing the ability of individuals to communicate and to obtain information on almost any subject at any time.

Accessing the Internet

Access Through Commercial and Public Internet Service E-Mail, the World Wide Web, Internet Service Providers and computer on-line services are all means by which one can obtain access to the Internet. Electronic mail, similar to conventional mail, allows individuals to send messages to other people. The 104

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major advantage of electronic mail over conventional mail is that electronic mail is delivered immediately, at any time and is paperless. In addition, recipients can retrieve the message at any time and print out the message if the need arises. Another way to gain access to the Internet is through commercial on-line services. These services have electronic magazines, chat rooms, and software libraries that are available to subscribers of the service. They also usually have Internet access via e-mail, newsgroups, and the World Wide Web. A person can also obtain access to the Internet through Internet Service Providers (ISP's). ISP's are organizations that have servers connected to the Internet. ISP's charge a fee to individuals for access to the Internet through their server. Access to the Internet is typically through a fee-based Internet Service Providers or commercial on-line services. For corporate or government entities these may be high-speed, dedicated lines, and for individual consumers they are typically ordinary telephone lines using modems. There is an increasing use of satellite and cable connections, though these are still in a distinct minority. Many people assume that only sophisticated individuals will be using the Internet. However, with the development of low cost, simplified hardware for use exclusively on the Internet or in concert with cable television connections, electronic capabilities will be present in many, if not most, American homes. This means the purchasing of a home computer will not be necessary to access the Internet. Thus, the Internet could offer the promise of improved distribution of products and dissemination of information to households almost everywhere, especially those underserved by current distribution methods. In addition, people may also access the Internet at public libraries and schools. However, unless the cost drops significantly, low-cost home access to the Internet may not soon become a reality for many people. Current prices for equipment necessary to access the Internet via a TV are still beyond the means of many people, and they still must pay monthly Internet access fees. It remains to be seen if these prices will drop sufficiently in the next couple of years. The limited access to the Internet of certain classes of potential insurance consumers could raise some issues for regulators concerning insurance companies, producer marketing and distribution methods. The Internet is relatively new yet its popularity, has grown dramatically in recent years. In fact, reports of the Internet's dramatic growth have seemed common for some time. Still, the essential question for the insurance industry is not how quickly the Internet has grown, but how large and accessible it currently is and how quickly it may grow in the future. The World Wide Web The Internet is actually a variety of technologies including File Transfer Protocol (FTP), Gopher Servers, electronic mail (e-mail), and the World Wide Web. The World Wide Web is the interface familiar to most consumers, and uses Universal Resource Locators (URLs) also known popularly as domain names to identify web sites. This, combined with a user-friendly interface known as hypertext (HTTP) allows users to navigate by clicking with a mouse or other pointing device on select words or phrases, icons, or other graphic images. This is the methodology most people associate with the Internet. The World Wide Web is also where many companies have set up established home pages. A home page can be compared to a company brochure in an electronic format. Like a brochure, a home page will provide basic information about an organization, such as the location of the organization, main area of business and available products. Depending upon the amount of information, an organization wishing to make a home page available may be limited to one page or may expand to include numerous pages of information. In addition, a home page often includes hypertext links to other pages; thus forming a web of information on thousands of subjects.

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Sales and Service of Insurance Over the Internet

To date, current electronic commerce typically involves the sale of goods as opposed to services, such as insurance. This disparity can be tied to a variety of issues, including technology acceptance by consumers, security and regulatory concerns surrounding insurance sales on the Internet. Unlike the sale of a book or article of clothing, the sale of an insurance policy involves complicated contractual language, the transmission of sometimes confidential information and a relationship of good faith on behalf of the buyer and the seller. Current methods by which insurance sales can occur over the Internet are either single source or via insurance malls.

Single Source Sale Sites

Single source sale sites are comprised of a single insurance company marketing its products over the Internet through the establishment of a home page. When developing a home page for a single source sale site, insurance companies can use their home pages as a promotional tool, to direct consumers to their existing agents or as another distribution channel. A survey conducted by the LIMRA International, Inc. revealed that two thirds of the companies use their home pages for name recognition. Eight percent of the companies indicated they use their home pages for lead generation for their agents while only one company indicated direct sales was the main purpose of its home page. A single source sale site is a method of marketing insurance over the Internet which enables the consumer to select and purchase his/her insurance directly from an insurance company. This type of insurance marketing over the Internet will presumably provide the consumer with all the steps necessary to purchase insurance; from filling out an application on-line to payment of the premium and receipt of the policy on-line. Insurers' and producers' home pages can offer marketing and/or educational information about a company and its products. For instance, a home page may explain the benefits of life insurance or explain different auto coverages. In addition to simply providing information, some sites will go a step further and offer on-line requests for quotation (RFQ) forms. Online RFQs typically involve a questionnaire which the consumer must answer in order to obtain a quotation. Once this information is obtained the consumer can obtain an instant quote for insurance. RFQ's allow the consumer to obtain information directly and relatively quickly. If a consumer wishes to obtain more information on a particular product or make a purchase, insurers could provide a list of agents that may be contacted to complete the transaction. In addition to providing a quote to the consumer, RFQ forms provide the company with valuable statistics on the profiles of the individuals visiting the site and the type of insurance being requested. Insurance companies may also develop home pages that work in conjunction with their agents. These sites offer general information on products and help educate consumers about their insurance needs. Similar to sites which provide RFQ's, these sites direct consumers to existing agents in order to obtain quotes, more information about a particular product and to make a purchase. Insurance companies using this arrangement may be selling a more complex insurance product, such as whole life insurance. When referring a consumer to an agent, the typical referral is to the agent's phone number and address. However, some sites may refer a potential consumer to an agent. Just as insurance companies are establishing home pages for single source site sales, insurance agents are likewise establishing home pages for direct sales over the Internet. Currently, these home pages provide general insurance information to the consumer In the future, many of these home pages, along with the single source sites of insurance companies, will presumably offer all of the features necessary to complete the sale and delivery of an insurance policy. 106

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Insurance Malls
Insurance malls are sale sites that offer the products of more than one seller. Vertical insurance malls offer the products of multiple sellers from the same industry, while horizontal malls offer the products of multiple sellers from multiple industries. Because of the diversity of products offered at both types of malls, these malls attract a wide diversity of consumers and have the potential to become true electronic markets. One of the key features of insurance malls is their ability to provide consumers with access to a wide variety of products and comparisons of these products. These Insurance malls are designed to provide consumers with one or more purchase alternatives by matching consumer profiles against company underwriting criteria and present a list of alternative companies from which the consumer may selects. The consumer can then review policy information, pricing, and other aspects of various offerings from companies participating in the mall. Apart from being wholly geared to focusing on cost comparison and sales, many sites are educational. Insurance malls also present information about the different types of insurance available, insurance companies, and ratings of these companies. Such malls may also provide a brief description of insurance terms and information on state insurance laws. A third category are malls which combine sales-oriented information with consumer-oriented information. These sites provide the consumer with the same information available in a site geared to consumer education; however, they also provide the consumer with the ability to fill out complete RFQ forms. In addition these insurance malls may also offer a list of agents as well as hyperlinks to the home pages of these agents or to other insurance Internet resources on the Internet.

Service of Insurance Over the Internet

The more transactions a consumer has with a company via a certain medium, the more bound the consumer becomes to the company and the medium of communication. Unlike consumers in other industries, consumers who use the Internet may have increased interaction with their insurance companies -- with noted benefits. A typical insurance consumer, without Internet service, only interacts with his/her insurance carrier on four occasions: 1) when he/she purchases the insurance policy, 2) when he/she pays the insurance premium, 3) when he/she makes a claim on the policy, and 4) when he/she changes coverage or other contract provisions such as a beneficiary. Consumers may, therefore, be more likely to use this medium to make their initial purchase of insurance if all facets of the insurance transaction are available over the Internet. Many websites are already increasing the interaction insurance companies have with consumers by offering educational information. It has been stated that these types of interactions not only increase the general public's understanding of insurance but also create a familiarity and level of comfort in terms of a company's on-line services. Another method of increasing consumer familiarity and confidence in a company's on-line services might be its provision of complaint and claim services over the Internet. Because the processing of claims, complaints and policyholder services is probably the most important aspect of the insurance transaction for consumers, providing them on-line might be an added benefit. The increased use and demand for services over the Internet should be a constant reminder to insurance companies and regulators that an increasing number of consumers have a strong desire to access more information that is relevant to their individual interests and needs, insurance services being among them. Once all facets of the insurance transaction are available over the Internet, consumers may begin to use this medium to make their initial purchase of insurance. And as capabilities increase, so should insurance commerce on the Internet.

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Company/Agent Communications
The Internet also is a tool which could enhance company and agent communication. With the use of the Internet, agents can have a continuous line of communication to their insurance companies. This could enhance the educational level of agents and thus enhance the information agents pass on to consumers during the sales process. In addition, the Internet has the potential to permit the electronic transmission of policy forms; thus cutting down on the cost of the application and policy issuance process.

Elements of Insurance Transactions

The insurance contract - i.e., the promise by the insurer to perform at a future date, coupled with the policyholder's promise to pay premiums - is a fundamental principle of to the business of insurance. To better understand this principle, it is essential to understand the elements of a contract. We can then examine the elements of an insurance transaction.

Elements of an Insurance Contract

Insurance policies generally contain the above elements. However, the process of achieving a fully executed insurance policy may vary based on a number of factors, including among others things, the type of insurance (e.g., personal lines property and casualty vs. life vs. health vs. commercial/business, etc); the type of policyholder (e.g., group, individual, corporate); and, as we are seeing, the method for memorializing the agreement (written vs electronic signature and/or other methods). Even though differences may exist among the various types of insurance, the following steps typically represent the general means for achieving a binding insurance policy: Offer - the act of a person applying for coverage. Acceptance - an insurance carrier applying its underwriting standards and issuing the policy is commonly considered the act of acceptance. In those instances where a risk is not acceptable to the underwriter, but coverage could be provided at a higher premium, the issuance of a policy at the higher rates or for different coverages would be considered a counteroffer which could be rejected or "accepted" by the consumer. Consideration - in an insurance policy, consideration is obtained by the policyholder paying premiums in exchange for the insurer agreeing to pay benefits at some future date (if certain conditions are met). Legal Purpose - pursuant to the regulatory power of the respective state, insurers cannot enter into insurance contracts for products or services which are unlawful. (For example, business interruption coverage for a drug dealer would be illegal.) Legal Competency of the Parties - the above basic rules as to legal competency generally apply in the context of the insurance contract.

Legal Effect of Electronic Commerce on Insurance Transactions

From the consumer's standpoint, the primary issue is not whether all of the elements of a contract exist. Rather, the consumer primarily seeks to know one thing at the time of sale: "Is my coverage effective?" Typically, with an insurance policy, there are several methods for validating the "binding effect" of coverage following completion of the application process by a consumer - e.g., a conditional receipt may be given or the insurance policy or contract may be issued immediately. However, to achieve this validation of coverage, the consumer typically signs an application form indicating an offer to purchase insurance and 108

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a general understanding of the terms of coverage. Today, electronic commerce - i.e., computer-generated, online applications - poses a number of problems for insurers and consumers seeking to ensure the validity of the "binding effect" of the insurance transaction. Among other things, an acceptable method for verifying the identity of the applicant and recording the applicant's intention to purchase the insurance product must be found. Electronic signature technology currently does exist to address these problems and many states are passing electronic signature laws to address control them. However, the question still remains whether electronic signatures affixed to an electronic application and/or policy will be legally sufficient to form an enforceable insurance contract in the remaining states. Very few court decisions exist on the use of electronic signatures. However, as discussed below, a number of states have moved forward to either enact or propose legislation on electronic signatures. Additionally, general principles of contract law offer some latitude on the use of non-traditional signatures. For example, the Restatement (Second) of Contracts ~Section 134, states that "the signature to a memorandum may be any symbol made or adopted with an intention, actual or apparent, to authenticate the writing as that of the signer." The accompanying comment is also states relevant: The traditional form of signature is of course the name of the signer, handwritten in ink. But initials, thumbprint or an arbitrary code sign may also be used; and the signature may be written in pencil, typed, printed, made with a rubber stamp, or impressed into the paper. Signed copies may be made with carbon paper or by photographic process. The published law on the use of non-traditional signatures is, as stated above, very limited in this area. From an insurance regulatory standpoint, the state of Iowa has provided us with some precedent. In Wilkens v. Iowa Insurance Commissioner, the Utah court of appeals examined whether the computer-generated signature of an insurance agent met the requirements of a signature under the applicable insurance code provision. Ultimately, the court upheld the validity of the agent's signature, ruling that: "The fact that the signature is computer-generated rather than hand-signed does not defeat the purpose of the act. The issue is not how the name is placed on the sheet of paper; rather, the issue is whether the person whose name is affixed intends to be bound." 457 N.W.2d 1 (Iowa Application. 1990) Even though the issue in Wilkens pertained to an agent's signature, the court's reasoning would seem applicable to policyholders. That is, the primary question is: "Did the applicant intend, by signing -whether by pen or other means -- to be bound by the terms of a particular contract?" Considering that the technology now exists for electronic signatures, the next question is: "What are the methods for properly securing and validating those signatures?"

Electronic Signatures: The Technology and the Law

Technology There are two primary forms of electronic signature: (1) digital signatures and (2) stylus signatures. Digital signatures are based on "public key cryptography". Through this, the signer uses a "private key" that transforms the data into unintelligible form and the recipient uses a public key to decipher and verify the data. Digital signatures protect the security and privacy of on-line transactions. On other hand, stylus signatures work in the following manner: the signer moves the stylus (or pen) across a computer screen, which displays an image that traces the movement of the stylus. The signer sees his or her signature as it is being captured by the computer, just as a signer sees his/her signature on paper. Upon completion, the signature is encrypted and sent electronically to its destination. Law Several states have adopted digital signature statutes or regulations. For example, the state of California 109

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has adopted the following statute enacted California Government Code Section 16.5 which provides: (a)In any written communication with a public entity, as defined in Section 811.2, in which a signature is required or used, any party to the communication may affix a signature by use of a digital signature that complies with the requirements of this section. The use of a digital signature shall have the same force and effect as the use of a manual signature if and only if it embodies all of the following attributes: (1) It is unique to the person using it. (2) It is capable of verification. (3) It is under the sole control of the person using it. (4) It is linked to data in such a manner that if the data are changed, the digital signature is invalidated. (5) It conforms to regulations adopted by the Secretary of State. Initial regulations shall be adopted no later than January 1, 1997. In developing these regulations, the secretary shall seek the advice of public and private entities, including, but not limited to, the Department of Information Technology, the California Environmental Protection Agency, and the Department of General Services. Before the secretary adopts the regulations, he or she shall hold at least one public hearing to receive comments. (b) The use or acceptance of a digital signature shall be at the option of the parties. Nothing in this section shall require a public entity to use or permit the use of a digital signature. (c) Digital signatures employed pursuant to Section 71066 of the Public Resources Code are exempted from this section. (d) Digital signature means an electronic identifier, created by computer, intended by the party using it to have the same force and effect as the use of a manual signature. Under the above referenced law, the California legislature intended that the "force and effect" of the digital signature would be established by the intention of the party using the digital signature. (Utah has enacted similar legislation. See Utah Code Annotated . ~Section 46-1-3-107., et seq.) Security of Electronic Signatures One may ask; is digital signature technology "secure?" Can it be altered by other individuals, such as an agent or an underwriter? Is the transmission confidential? In general, digital signatures provide at least two levels of security integrity (i.e., validation that the signature was transmitted in an unaltered state) and authenticity (i.e., validation that the signature is true and correct). These two levels of security are obtained in large measure by the use of unique "keys" which are inputted into the computer program: one by the party generating the electronic document, the other by the signing party. Changes to the underlying electronic application will render the electronic signatures invalid. Thus, the integrity of an electronic document is protected by these safeguards. Stylus signatures offer similar safeguards, i.e., there are several encryption steps. The process uses secret keys and, to a certain extent, the process is highly resistant to alteration or unauthorized access and use. Perhaps most important for insurers, the information set forth on the application is "locked" along with the signature of the applicant (and probably agent). The fact that the application itself is more secure may reduce the possibility that information on that application will be altered. Other Considerations for the Insurance Industry Due to demands on commerce within the various states, state legislatures are moving forward to draft and enact legislation on electronic commerce, electronic signatures, etc. Further, banks and other financial institutions are developing business systems to fully leverage the capabilities of electronic commerce. (Apparently, even the Uniform Commercial Code is being revised to address the issue of electronic commerce -- UCC Article 2B.) These and other events may cause the insurance industry to be left "on the sidelines," watching as other industries and regulatory agencies take the initiative to create new law 110

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on electronic commerce. Given these circumstances, insurance regulators need to examine these new technologies and their application to the business of insurance now.

Advantages and Disadvantages of Insurance Sales and Service Over the Internet
Consumer Advantages
Consumers already have the ability to search the Internet for life and auto insurance quotes on the Internet via numerous home pages and other Worldwide Web Sites provided by or on behalf of insurers and agents. Some Internet sites are interactive and permit the consumer to provide certain information and allow the agent or insurer to determine eligibility for coverages. In addition to obtaining quotes, consumers currently have the ability, from at least one auto insurer, to complete the entire transaction on-line. Another auto insurer provides consumers the opportunity to complete the application on-line and then forwards the application to an agent located near the consumer to complete the transaction. Consumers may also browse the Internet to locate agents and insurers in their area. This provides consumers the ability to narrow their search for a particular agent, insurance company or specific type of insurance coverage. In many cases, agents advertise the names of insurers they represent and the types of coverage they most commonly provide. A particular advantage to consumers appears to be accessibility. Often times, consumers may not have the time nor the opportunity to shop for insurance during normal work hours. The Internet increases the opportunities for these consumers to shop after hours and in most cases, a quote can be received within minutes or the next day. The quote arrives electronically, which eliminates the need to personally interact with an agent, which some consumers prefer. Consumers using the Internet for the purchase of insurance have the ability to contact their agent or insurer 24 hours a day. Depending on the Internet site's capabilities and response time, this is likely to substantially enhance consumer service by eliminating the delays in obtaining policy information and service. While some insurers already provide 24-hour servic e via telephone, the Internet has the potential to increase this practice. Consumers already have the ability from at least one company to review their account status to determine when and how much they need to pay for their existing policy. After checking how much is due, they can make a payment to the company online. This service eliminates the two step process of calling the company to find out how much is owed and then mailing a payment. Online payment could potentially prevent cancellations as this can be done at any hour of the day without the delay of the postal service. Many major insurers have indicated they will be able to deliver insurance products and services via the Internet in a more cost-effective environment. This may result in lower a overall lower cost of premiums to all consumers if a substantial number who are willing to purchase coverage and interact with an agent or insurer electronically.

Consumer Disadvantages
The most significant disadvantage to some consumers may be the lack of personal interaction with an agent. Agents are generally trained to assist consumers in determining the type and amount of coverage that should be purchased to adequately insure their needs. Some consumers may focus on how much 111

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coverage they want to purchase, rather than how much coverage they actually need. Since many consumers may not be well versed in the purchase of insurance, they may end up "ordering" insurance, rather than purchasing insurance that fits. Unfortunately, "ordering" insurance is not a practice that would be unique to Internet sales. Many consumers are not acquainted with insurance laws and regulations. This includes, but may not be limited to familiarity with the requirements for insurer and producer/agent licensing, producer appointment, policy form filing and approval for products sold in the admitted market, and qualifications for sales in the surplus lines and reinsurance markets. Because the location and actual identity of the producer and/or agent is not always obvious, consumers may not in all Internet transactions be able to determine whether they are doing business with regulated producers and insurers, or are purchasing insurance products that have been approved by state regulators. Or worse, could learn they purchased a fictitious policy. This could result in a variety of consumer issues where the desired level of regulatory protection may not be available to consumers. Some consumers lack the financial ability to purchase computer hardware or software, and access the Internet. Even in today's environment where accessing the Internet is becoming increasingly more affordable, the lowest cost access can be unaffordable for some consumers. If insurers offer lower premiums to Internet access users, certain consumers will not benefit from those savings unless they have Internet access from another source such as a Public Library. Inadequacies in the telecommunications infrastructure also limits some consumers access to the Internet, especially in the rural areas of the country. Even though Internet marketing of insurance products and services is growing at a rapid rate, there are only a limited number of insurers presently offering electronic quotes. At least for now, this may limit the number of comparisons or quotations a consumer may obtain electronically.

Regulator Advantages
Industry and consumers will have electronic accessibility to those regulators who have a presence on the Internet. This will permit regulators to respond to inquiries or consumer complaints in a quicker fashion and more efficient manner. Regulators can provide the insurance industry with electronic access to compliance information; guidelines; license applications and fees, information bulletin boards; e-mail; and, of course, faster response time to industry requests for information. Those state regulators with Internet access will have the ability to directly monitor Internet sales and solicitation activity. There are approximately 35 state insurance regulatory agencies currently on-line, along with the National Association of Insurance Commissioners (NAIC). The NAIC has an extensive Web site at http://www.naic.org that serves as a communication link between insurance regulators, consumers and the industry. The site also provides links to all 35 of the state insurance regulatory agencies that have active Web sites, providing users with direct access to insurance regulators in each jurisdiction. Many agent and insurer home pages currently contain a hyper-link to the NAIC and State Insurance Departments. This provides consumers with electronic access to those regulators and in turn, will provide those regulators with a better ability to respond to industry and consumer needs in a more timely and manageable manner. The insurance industry has recently gained Internet access to the NAIC Producer Data Base (PDB) through the Insurance Regulatory Information Network (IRIN). For those states participating in PDB, industry will have electronic access to agent licensing information. This will substantially reduce the number of phone calls and written requests state insurance departments currently receive from industry for verification of good standing and/or licensing status and prior administrative actions. Time previously spent by regulators responding to these requests may instead be spent issuing licenses in a more timely manner. 112

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In addition, the Internet has the potential to permit the electronic transmission of policy forms; thus cutting down on the cost of the application and policy issuance process.

Regulator Disadvantages
Some state regulators do not currently have adequate Internet access making it very difficult to monitor electronic commerce or investigate consumer complaints related to Internet insurance sales and service or monitor unlicensed activity. This impairs the ability of state regulators to provide adequate consumer protections. It may become very difficult for regulators to monitor potentially increasing unlicensed activity. This severely impairs the ability of state regulators to provide adequate consumer protections. Someone intending to commit insurance fraud could create an Internet presence, and complete a number of sales (collecting premium) and subsequently terminate the illicit Internet presence. In these cases, regulators may have difficulty obtaining sufficient evidence that a violation of state law has occurred in order to take and/or prosecute for fraud. Unless there is a specific tie to an insurer and/or licensed agent, it may become very difficult to restore policy benefits.

Industry Advantages
The most significant advantage of the Internet to industry is the ability to communicate and transact business electronically which could substantially reduce administrative costs, and increase profits and bring more innovative and less expensive services to a wider audience. Insurers will also have the ability to communicate and deliver marketing materials to their producers electronically, including rate manuals, underwriting guidelines, applications, company procedures and advertising guidelines. to name a few. Consumers who commonly use the Internet or similar electronic providers for the purchase of other products and services could search for competitive insurance quotes and seek out an agent or insurer that best fits their personal needs. Consequently, the Internet could substantially enhance marketing potential for those agents and insurers willing to be on the cutting edge of this new marketing opportunity. Automation vendors are currently designing web sites that are integrated with agency management systems. This will permit policyholders to access their agent or insurer electronically to examine their premium billing status, determine the type and amount of coverage, make changes on their policy, request quotes and obtain information about other coverages. The insurance industry views this as an opportunity to operate a "virtual" insurance agency that is accessible to policyholders and consumers 24 hours a day. The industry will also be able to electronically access most state insurance regulators to obtain compliance information such as license applications and guidelines, applicable fees, interpretation of certain state laws, communicate by e-mail with insurance department staff and respond to consumer complaints in a more timely manner. There are those in the insurance industry who believe the Internet will enhance their ability to improve regulatory compliance and reduce exposure to potential market conduct violations. Agent and insurer access to the NAIC Producer Data Base will allow on-line verification of the license status of agents on a state-by-state basis, as well as access to producer demographics, lines of authority, prior administrative actions taken by insurance and NASD regulators and NASD exam results. In the near future, industry will also have access to agent appointment information and will have the ability through the Producer Information Network (PIN) to electronically appoint and terminate agents or producers. This should enhance the ability of the industry to comply more efficiently with various state agent licensing and appointment requirements. 113

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The National Council on Compensation Insurance, Inc. (NCCI) currently provides, via its Web site, carriers, agents, employers and regulators alike with worker's compensation related safety and educational materials as well as information on its products and services. NCCI's Web site will be expanded to facilitate access to key NCCI products and services. NCCI's Web site will also provide the door through which applications and deposit premiums can be submitted to the worker's compensation residual market in NCCI plan administered jurisdictions. In the current paper environment, agents and insurers have expressed frustration and concern regarding the binder or effective date of coverage. Those agents who choose to transmit residual market applications electronically will receive immediate notification and verification that coverage is bound per the requested effective date. The NCCI system will also facilitate electronic payment of premiums.

Industry Disadvantages
An issue for the insurance industry is remaining in compliance with insurance regulations while engaging in Internet-based sales and services. The Internet is global, and therefore insurance offerings can appear anywhere, including states or countries where the insurance company or agent may not be authorized to do business. Thus the insurance industry needs to be cognizant of state regulatory requirements in regards to licensing of agents and insurers, approval or filing of insurance products. In most states, insurers may only issue a policy through a licensed agent. Insurers, are expressing concerns that their producers may be offering policies in states where they are not approved, Insurers, therefore, need to make particularly sure that their web sites clearly disclose where their products are intended to be offered, to insure they are only soliciting business or making representations where they have authority to transact business. Based on recent surveys conducted by the NAIC, most states consider electronic solicitation of insurance no different from solicitation through any other media. Therefore, in most states, agents and insurers must first be authorized or licensed to transact business before soliciting insurance to consumers in that state. In using the Internet, there may be some question as to where an insurance transaction may have occurred. When an agent or insurer solicits insurance electronically, does the transaction occur in the state in which the agent is located, or in the state in which the consumer is located? The majority of states have indicated in recent NAIC surveys that they believe the transaction occurred in the state in which the consumer resides. Some in the insurance industry have also expressed a concern that without an agent present in a face-to-face contact with the consumer, it may become more difficult to qualify the applicant for insurance. Inadequate medical records and other sources of information about the consumer may impair an underwriter's ability to determine eligibility without actual contact and verification by the agent. The rapid growth in development of Internet web sites for agents leaves some insurers with concerns regarding specific state advertising laws and regulations. Agents may be advertising specific insurance products and services without authority from the insurer and in violation of these laws and regulations. Furthermore, in a recent NAIC survey of state insurance departments, Internet advertising is considered subject to regulatory approval in many states. Because agents must be licensed and in most cases appointed by insurers in those states in which the agent transacts business, licensing costs will increase for some insurers who permit their agents through the Internet to solicit business in all states.

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Problems With Selling Insurance Over The Internet

Requirement of an applicant's signature
Most state laws currently require an applicant's signature on an application for insurance. An applicant's signature is generally required to certify a sworn statement of the insured. Both the insurance industry and state regulators are expressing concerns that it may be difficult to prove misrepresentation or fraud on the part of an applicant without a sworn and properly signed statement. At least twelve states have already enacted legislation authorizing the use of digital signatures in private communications. These statutes generally provide that a digital signature will have the same force and effect as a written signature as long as the electronic signature is unique to the signer, its authenticity can be verified, and it is valid only if the data in the document has not been altered. Once a legal framework is established and a reliable certification authority is in place, an application signed with a digital signature will be just as binding on the signer as a written signature. Systems are currently in use (and will be design-enhanced in the future) that will allow for an electronic signature of the applicant. Sufficient security measures must be taken to assure that the applicant's electronic signature is valid and verifiable. The most serious unanswered question is what may be acceptable to courts as evidence of an electronic signature.

Requirement of Blood or Urine Samples for Life Insurance

Depending on the level of coverage requested in a life insurance application, most insurers require a blood and/or urine sample for underwriting purposes. Sample Kits are currently delivered to the applicant by the agent or insurer; and the applicant is then required to visit an authorized medical provider or administrator to provide the required samples for testing purposes. The medical provider or administrator then forwards the samples to either the insurer or a medical test laboratory. Test results are then provided the insurer for underwriting purposes. These tests are essential to determine certain health conditions of the applicant, such as HIV. In an electronic transaction, the agent would not be present to deliver the test sample kit, and therefore, the insurer would be left with no other alternative than mailing the Kit or have it delivered by a third party. Another alternative would be to schedule a visit with a healthcare provider or administrator for the applicant and advise accordingly. Regardless of whether the was taken by an agent physically present at the point of sale or an electronic application was sent to an agent or insurer, the blood and urine test must be completed. Without the presence of an agent during the sale, the insurer will need to develop alternative procedures to ensure that the proper medical tests are performed. This change in procedure might result in some increased underwriting costs to the insurer which need to be weighed against the costs of having an agent present during the sale.

Unlicensed and Unauthorized Companies and Producers.

The problem of providing ready access to consumers of entities which are not licensed or regulated by the states' insurance authorities is a major concern. Further, while most states provide for "direct access" by insureds to unauthorized insurers in their surplus lines, rules typically do not extend the use of surplus lines market to less sophisticated commercial or personal lines insurance buyers. Persons, whether resident or not, acting as a producer without a license would be subject to action by most states although enforcement might be a problem for regulators. Regulators need to, therefore, consider a strong consumer education effort encouraging people to check out Internet offers and verify that the source of an Internet insurance offer is regulated by their state 115

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insurance authorities. An NAIC model could require entities licensed in any jurisdiction to provide appropriate disclosure in solicitations that will be available to Internet users.

Fraudulent Sales
It is only a matter of time before a major Internet insurance scam appears on the evening news. The insurance industry and insurance regulators are concerned that inadequate regulatory protections currently exist for this market. Regulating electronic commerce, especially the Internet, will require cooperation from all interested parties. The insurance industry, interested consumer groups, insurance regulators, and others should work together in designing reasonable regulatory solutions that result in the proper protections while at the same time allowing the market to develop without unreasonable administrative burdens from industry or state insurance departments. Insurance fraud in America already adds approximately $900.00 in additional insurance premiums each year. Thus, it is essential that investigators in state insurance departments be permitted access to the Internet and be provided training necessary to investigate and prosecute fraudulent electronic commerce. Fraudulent sales can be expected to proliferate on the Internet because of the ease of access and difficulty of tracing the source of the fraud. Consumers should be encouraged to contact their state insurance departments to determine the authenticity of those doing the business of insurance over the Internet.

Regulatory Issues
Impact on State Insurance Departments
For the insurance industry to fully capitalize on the Internet's potential, it means changes -- some subtle, some more dramatic -- to the standard operations currently employed by the industry. Recognizing that a host of regulations already exist that: (i) are based on existing operational procedures; and (ii) may fail to recognize the Internet's borderless nature, it is likely that some adjustment to the current system is necessary to allow insurers to realize, and consumers to reap the benefits of, the Internet's full potential. It is important to note that, for these adjustments to be successful, they must come from both insurers and regulators alike. With its ability to efficiently transfer documents with audio, video, text and hyperlinks embedded together, the World Wide Web portion of the Internet presents the best opportunities for electronic commerce on the Internet. In its December 1996 issue, "Internet World" reported that, there are currently over 10,000 Web sites dedicated to music. In fact, the music industry was among the first to explode onto the World Wide Web and utilize electronic commerce to conduct business. According to "Internet World," the top 350 music distributors sell more than 25,000 Compact Discs per day via the Internet. Using the generally accepted estimate that there are currently 25 million Internet users worldwide, "Internet World" reported that a full 10 percent report using the Internet to shop for goods and services in place of going to their favorite local shopping mall. Attempting to capitalize on this increase in the Internet's usage, both the travel and financial services industries have recently begun using the World Wide Web to transact business as well. With respect to insurance, current on-line sites consist mostly of static insurer sites, insurance producers, quote providers, a few ancillary services, insurance regulators and trade associations. Insurer sites currently provide varying levels of information about their insurance products, premium levels and insurer or producer contact information for consumers interested in purchasing coverage. Some 116

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insurer sites link potential customers to a nearby agent, others ask the consumer to contact the insurer directly. Several insurance producers are advertising their services on-line, particularly insurance brokers, to assist consumers with locating the desired coverage. Some producer sites even have on-line forms for consumers to submit basic information, assisting the agent or broker with their search producer to provide the requested or alternatively appropriate products and services to consumers. If coverage is located, the consumer is contacted and underwriting usually proceeds via normal traditional channels. Other sites of interest to consumers are those posted by quote providers. These sites allow consumers to compare the premiums of several insurers. Typically free to the consumer, quote providers also attempt to link potential customers with insurance carriers, usually by providing a hyperlink, telephone number. or e-mail address. For those who really want the nuts and bolts of premium calculations, there are also sites that provide insurer rates, for a fee, in a downloadable format. The rates only apply to states with prior approval requirements and, as one might expect, are usually difficult to understand. These types of rating services are typically visited only by insurance professionals, though they are available to anyone and the fees are reasonable. Lastly, there are 35 state insurance regulatory agencies currently on-line, along with the National Association of Insurance Commissioners (NAIC). The NAIC has an extensive Web site at http://www.naic.org that serves as a communication link between insurance regulators, consumers and the industry. The site also provides links to all 35 of the state insurance regulatory agencies that have active Web sites, providing users with direct access to insurance regulators in each jurisdiction. As an example, lets look in more detail at the California Department of Insurance's (CDI) Web site, located at http://www.insurance.ca.gov. The site, launched in April of 1996, currently contains over 860 separate documents, linked together with nearly 15,000 embedded hyperlinks, that are available to anyone with Internet access. Documents can be printed, downloaded for later use or simply read on-line. No interactivity beyond sending electronic mail to the site administrator is currently available, though extensive plans have been made to add a number of various interactive features over the next two years. In its current state, the site is similar in design to many other current state insurance regulatory agencys sites. Even in their infancy, these regulator sites seem to be fairly popular with the insurance industry and consumers. Activity on CDI's Web site has increased virtually every month since it launched. The site registered approximately 10,000 hits during it's first month on-line (April, 1996). Just one year later, in March of 1997, the site registered over 70,000 hits per month. The number of documents downloaded has nearly tripled to over 210 per day. Other states are developing personnel policies that define acceptable uses of the Internet as a tool to assist with job performance, just like policies developed in years past defining how to appropriately use a computer or telephone to complete job assignments. The essential elements of the policy note that: Internet access is provided by the employer for the purpose of completing a job; Any personal use is incidental and must not interfere with job performance; and management has the right to monitor and restrict usage should the employee fail to adhere to the agency's policy. Agencies may require all new hires to sign a copy of the Internet usage policy for placement in a personnel file, indicating that the employee was indeed furnished with, and read, the policy. Some agencies are also incorporating Internet, electronic mail and voice mail policies into one overall communications policy. To be used effectively, Internet access must be seen as a communication tool, just like a telephone, computer or typewriter. Very few people would seriously consider operating a business without a telephone. Today, that notion is more commonly being extended to Internet access as well. Once a regulatory agency has access to the Internet, additional tools may be necessary to effectively 117

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participate in and monitor insurance-related activity on the Internet. For example, a regulatory agency wishing to launch its own Web site will either need the knowledge and capability to create a Web site in-house, or the resources to contract with a vendor to provide the service. Once created, the Web site will need to reside on a server that is dedicated to the Internet, and, the agency will need to create the necessary infrastructure to maintain the site, as static Internet sites quickly become on-line ghost towns. The regulator's Internet infrastructure may be as simple as hiring or training a site administrator to periodically update the site as directed. Or, the infrastructure may be as complicated as obtaining web development software and appointing staff to maintain the content on various portions of the site, sending updates to a web administrator responsible for the technical aspects of site maintenance. Additional items, like a system firewall and other security measures may be necessary as well, depending upon the sensitivity of information being requested from insurers, producers and consumers that is made available by the agency on-line. Tools like Web analysis software that provide automated and customized statistical reports of Web site traffic may also be necessary to determine what information is useful, what is not and what portions of a site give users the most trouble.

Applicability of Current Statutes and Regulations

Insurance regulation is based on geographic boundaries. However, the Internet, by its very nature, does not recognize geographic boundaries as traditionally viewed. This does not mean, however, that the geographic boundaries upon which state insurance regulation is based are invalid. It is this fluid portability of the Internet that makes it a desirable medium for electronic commerce, or "Internet commerce." The threshold question of whether an Internet insurance transaction is an insurance transmission regulated by the states pursuant to the McCarran-Ferguson Act or is a commercial electronic transmission that is regulated by the federal government under the Commerce Clause has not been resolved. There is, however, no ground swell demanding that Internet insurance transactions be regulated by the federal government. Many state insurance regulators view the Internet (which consumers must "go to") only as a new communications medium, like the television, fax machines or electronic mail (which "go to" consumers). They therefore believe it would not be necessary to alter the current treatment of insurance as a business that is regulated by the various states. Insurance regulators have not yet reacted to this new technology by mandating procedures that would be difficult (if not impossible) to enforce. Due to inconsistencies in state regulation, Internet insurance sales can not always be conducted in a uniform manner. Still, the concerns of insurers, producers, regulators and legislators are similar. For example, it is not certain that electronically transmitted insurance applications, policies and related forms are the legal equivalent (in the eyes of most regulators and the courts) of approved paper-based forms. Additional concerns include the following, which are discussed in more detail elsewhere in this paper. Licensing By transmitting information over the Internet, it is a simple matter to enter into potential sales situations in any and every state (and internationally) regardless of whether the insurer or insurance producer is properly licensed where the consumer is located. Accordingly, does an Internet insurance transaction occur in the state in which the consumer is located or in the location from which the electronic message originated (which may not necessarily be where the insurer or the producer is physically located and licensed)? Most likely (based on a traditional "doing business" analysis), the transaction would be deemed to occur in the state where the consumer is located. Advertising and Disclosure As the insurance industry becomes more comfortable with the concept of "commerce on the Internet", more Internet transactions will go beyond simple advertising and agent referral programs. However, the laws and regulations that pertain to advertising (and life insurance illustrations) would always be 118

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applicable. For example, insurance advertising rules generally prohibit deceptive or misleading statements about an insurer's or a competitor's product. Yet, with Internet advertising it will be difficult to always know who made a derogatory statement about an insurer's products or services and whether and to what degree the statement caused damage to the targeted insurer. Insurer information transmitted over the Internet constitutes an advertisement that is regulated by state insurance laws. For example, the NAIC Model Rules Governing the Advertising of Life Insurance define "advertisement" as material designed to create public interest in life insurance or annuities or in an insurer, or an insurance producer; or to induce the public to purchase replace or retain a policy including (a) descriptive literature of an insurer and published material, audiovisual material and descriptive literature of an insurer and; (d)] prepared sales talks, presentations and material for use by insurance producers. An insurer's Web site should constitute an advertisement under the NAIC model because the site is likely designed to "create public interest in the" insurer and "to induce the public to purchase" insurance. Web site marketing efforts could also trigger quote illustration regulation requirements. Marketing insurance products on the Internet involves a "presentation or depiction" that could be subject to the NAIC Insurance Illustrations Model Regulation. Thus, an Intent presentation that includes "non-guaranteed elements of life insurance over a period of years" is not excluded from the definition of "illustrations" and must satisfy all relevant regulatory requirements. Transaction Situs Determination of the transaction situs for an insurance sale can impact the insurance product sold. For example, common contract choice of law, premium taxation, guaranty fund applicability, insurance policy termination, continuation of coverage, cancellation and nonrenewal laws vary among the sates. Signature Authentication Contracts of insurance that are "bound" over the Internet require a form of signature made with the intention of authenticating the document. Because electronic signatures on their face lack the indicia of trustworthiness, procedures have been devised and are now being tested to authenticate signatures. To date the deployment of this electronic signature technology has been hampered by different emerging technologies and a lack of consistency of laws being passed by states validating this technique. Some states, like California, have passed laws authorizing the use of digital signatures, but regulations have not been approved to govern exactly what can be considered a valid electronic signature and when its use may not be authorized. Obstacles like the notarization of digital signatures remain to be overcome. Some states may consider abolishing "wet" signature laws, recognizing that the Internet's many security features may be sufficient substitutes to physical signatures on an application form. Privacy To initiate an insurance transaction, a consumer is often asked to disclose personal information. Along with a decision to divulge personal information comes a consumer expectation of privacy and secrecy. The traditional insurance sales process typically involves communication either in person or over the telephone between the insurer or its agent and the consumer, which methods of communication provide commonly accepted assurances of privacy and anonymity and should over time be extended to Internet transactions. Collection of Premium by Credit Card An insurer or producer marketing directly to consumers over the Internet must be willing to accept payment of the initial premium via credit card, and consumers must be willing to divulge their credit card information over the Internet. Legitimate concerns exist regarding access to credit card information on the Internet. Thus, establishing a secure "credit card environment" is vital to the success of insurance sales over the Internet. Financial transaction safeguards should make consumers more secure when making credit card 119

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purchases over the Internet. However, it is also necessary to verify that the insurance laws of the various states do not prohibit making premium payments by credit card. States that permit insurance premium payments by credit card have varying requirements. The most common include: (i) credit card usage may not increase the premium or incur a separate fee (conversely, policyholders paying by cash or check may not be offered a discount); (ii) the credit card issuer may not cancel a policy if a cardholder fails to pay balances due that include insurance premiums; (iii) premium refunds must be made directly to the cardholder; and (iv) offers of an extension of credit for premium payments made through a particular credit card facility are prohibited. It may be that new regulations may need to be considered, or existing ones amended or rescinded, to ensure that regulations recognize the Internet's borderless nature and work in concert to respond to operational changes that the Internet may produce. For example, if insurance agents and brokers are required to post their license number on business cards and printed advertisements, does that include advertisements posted electronically to the Internet? Do current regulations cover that contingency? As growth occurs in the marketing of insurance products and services over the Internet, and as the industry strives to develop innovative methods to create consumer awareness of these products, issues regarding compensation structures will need to be addressed. While some entities may find that the most efficient mechanisms for delivering products and services involve relationships with third parties and various marketing hierarchies, these efficiencies and avenues for growth will only reach full potential to the extent that regulators permit creative and flexible compensation structures. This will be fostered to the extent that compensation and licensing are only linked as necessary for the protection of the consumer, and to the extent that licensing requirements are limited to parties having contact with consumers or their funds. Regulators should consider the extent to which a benefit is derived from restrictions upon compensation to an individual or entity having neither contact with the consumer nor a role in the actual sale of the product of service, and the extent to which such restrictions might unnecessarily impede the growth of both Internet and traditional commerce. Benefits will accrue as the regulation of product and service delivery, including regulations concerning the compensation structures appurtenant to the various delivery systems, becomes more simplified and uniform. The underlying point is that regulators need access to the on-line world before they can become familiar with, and monitor, Internet activity. Regulators must also need to be able to monitor their own Web sites so they can share meaningful information with other regulators about their own on-line experiences. It is this sharing of information across borders that will begin the process of casting a web to monitor the boundless activity of the Internet. With or without the presence of insurance regulators, businesses from all industries will continue migrating to the on-line world as a standard means of conducting business. It is in no one's best interest for those agencies charged with regulating the insurance industry to stand idle while the rest of the world charges ahead.

Security and Privacy Issues

Security
Consumers and insurers may be hesitant to engage in insurance transactions over the Internet due to concerns about security. While numerous security safeguards are currently available for use on the Internet, they have not been widely assimilated and used. One reason is their perceived limited reliability and a general lack of insurance industry and consumer confidence in the overall security and reliability of Internet transactions, particularly with regard to using credit cards (and other payment systems) over the Internet. Current security safeguards also have a limited scope of use due to a lack of industry standards. Many of these safeguards are not currently supported by the various popular applications, servers, web browsers, and e-mail systems. However, as will be discussed below, the computer industry 120

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Because of the rapidly advancing nature of Internet security safeguards, it may be too early to think about regulation of Internet transactions with regard to security concerns in any substantive way. It is an emerging technology, and how it will develop cannot be totally predicted. Thus, it can be argued that regulation should not be unduly burdensome lest it impede the innovation and growth that has been seen thus far achieved. At the same time, however, it is important for regulators to weigh consumer protections while not impeding innovation as they consider what regulatory role needs to be played regarding security over the Internet. There are three primary points in Internet insurance transactions in which security is an issue. 1. The privacy and confidentiality of personal information transmitted between an applicant and an insurer. 2. The alteration of information provided by the consumer/applicant by a third party such as the agent or another party with access to the file. 3. The tampering by unauthorized individuals with insurers' home pages which may affect the accuracy of information consumers receive regarding insurance sales over the Internet. Security concerns are multi-faceted. One aspect refers to the concern that information transferred from the applicant to the company or agent could be read and misappropriated by a third party. This concern includes misappropriation of personal information and credit card (or other payment system) information. Another dimension of security is authentication, ensuring the identity of the sender and the recipient. A third aspect is data integrity, ensuring that information transmitted is not altered in the transmission process by third parties or accidentally altered by some anomaly in the transmission process. Security concerns will likely be resolved by technical solutions from developed by the computer industry. The various players in the computer industry are cooperating to develop industry standards and protocols. Most producers of Internet products, such as servers and web browsers, are upgrading their products to be compatible with the various security standards and protocols being developed. Security measures currently in use by the Internet community include firewalls, encryption technologies, and good management practices (passwords, digital certificates, tokens, etc.). A discussion of these topics is outside the scope of this paper, though its importance cannot be overstated. Anyone seriously considering availing themselves of the opportunities provided by electronic commerce would be well advised to learn as much as possible about these issues, and to deploy the best techniques and technologies available. Encryption is probably the most efficient and potentially universal method of Internet security. Its purpose is to ensure privacy by keeping data from being read if it is intercepted by an unintended third party. Any message that is encrypted must be decrypted (i.e. transformed back into its original intelligible form) before it can be read. Encryption and decryption require the use of secret information shared between the parties to the message, usually referred to as a key. Most people are familiar with the method of encryption referred to as secret key or symmetric encryption. Secret key encryption involves both the sender and the receiver using the same secret key to encrypt and decrypt a message. Public key encryption is a slightly more complex method. Both the sender and the receiver get a pair of keys, one referred to as a public key and the other referred to as a private key. Each party's public key is published while the private key is kept secret and not published. This is significant because the need for the sender and receiver to share or transmit secret information is eliminated since only the public key is ever transmitted or shared. For example, if a consumer wishes to send information to an insurer, the consumer looks up the insurer's public key and uses it to encrypt his or her private information before transmitting it to the insurer. The insurer then uses its private key to decrypt the consumer's information. Even if the consumers encrypted information is intercepted or copied, only the insurer can decrypt it. At this time, there does not appear to be an established industry-wide standard for public key encryption. 121

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The security concerns regarding compromise of the transmittal process between the applicant and the insurer or agent can be broken down into two elements: (1) authentication, defined as the verification of the identity of the sender and receiver and (2) data integrity or the alteration of information during the transmission process. Data integrity addresses both concerns of intentional alteration by the insurer, agent, or a third party and accidental alteration that might have an impact on the insurance application process. It should be noted that the transmission process will likely consist of information being sent and received by both parties. Thus, we are also concerned with company information sent to the consumer being altered. For example, a quote of $200 per month could be received as $20 per month, either intentionally or accidentally. The computer industry is also developing technical solutions to address authentication and data integrity concerns. These technical solutions are referred to as "digital signatures" and "digital certificates." Used in tandem, they allow the person receiving a message to be confident of both the identity of the sender and the integrity of the message. A digital signature is used to "sign" a transmitted message to be transmitted. To create a digital signature for a message to be transmitted on the Internet, the sender creates a message digest using a hash function. The message digest serves as a "digital fingerprint" of the message. The message digest is then encrypted using the sender's private key to become a digital signature. The digital signature is transmitted attached to the encrypted message data. The receiver can decrypt the message digest using the sender's public key and apply the same hash function to verify the message's integrity after transmission. Thus, the receiver knows that the message has not been altered in transmission and data integrity is ensured. The receiver also knows that the message was sent by someone with access to the private key that purports to be that of the sender. To verify that the digital signature is in fact sent by the sender, and not some third party who has obtained a public-private key pair through some form of fraud or other means, the digital signature can include a digital certificate. A digital certificate irrevocably binds a person's or entity's identity to a public key or group of public keys. In effect, it becomes an electronic equivalent to a driver's license, passport, or other evidence of identification. A digital certificate is issued by a "certificate authority." A certificate authority is a trusted third party that provides secure mathematical computations that result in unique individual digital certificates that cannot be duplicated. A certificate authority has the burden of verifying the identity of a person or entity requesting a digital certificate. Once a person's identity is verified, the certificate authority can issue a digital certificate. The typical digital certificate is issued by the certification authority and signed with its private key. The certificate will verify the owner's name, public key, expiration date of the public key, name of the issuing certification authority, serial number or register number, and the digital signature of the issuing certification authority. In any given consumer insurance transaction, the consumer would have a digital certificate, along with the insurer, the server, and a financial intermediary (if any). Thus, the identity of each of the parties that would have access to the message can be verified and authentication of the identity of the parties is ensured. Other security concerns involve agent and industry tampering with an insurer's home pages, affecting the consumers perception of the reliability of the information presented, and subjecting the insurer to possible legal exposure should the changes be made to policy language and the like. A separate security concern for Internet sales is that unauthorized individuals will tamper with insurers' home pages. For example, an unaffiliated third party could add a hypertext link to an insurer's homepage. When a consumer clicks on that link, he or she will leave the insurer's domain and any text or information presented will be provided solely by the unaffiliated third party. If security measures, such as those discussed above, are in place, the possibility of entering into bogus transactions with an unaffiliated third party engaging in this practice becomes unlikely. Clearly, if the practice of tampering with home pages becomes common, it will affect consumers' perception of the reliability of insurance information provided over the Internet. After discussing this problem with a number of individuals from the industry, the solution 122

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seems to rest with developing technical security measures and continuous homepage monitoring by the person or entity maintaining the homepage.

Privacy
The first step in analyzing privacy concerns regarding personal information transmitted from an applicant to an insurer is to define the scope of the personal information that might be transmitted. Generally, the following information is requested from an applicant: (1) name; (2) address; (3) sex; (4) date of birth; (5) type of product to be purchased; and (6) payment information (i.e. credit card number or other payment source). Depending on the type of insurance being solicited, other information could include: (1) detailed health information; (2) detailed financial information; (3) type of automobile(s) applicant owns, applicant's automobile financing arrangements, and the applicant's driving record; (4) family information; and/or (5) specific information regarding property owned by the potential insured (i.e. home, boat, recreational vehicles, jewelry and other valuables). The privacy concerns deal with how information is used once it has been received by the recipient, presumably an insurer or agent. These concerns are present with all types of insurance transactions; however, privacy concerns are heightened with Internet sales due to the aggregate dissemination of data that is facilitated by the efficient and interactive nature of the Internet. Since privacy is not limited merely to Internet sales, it will not be addressed in this section paper.

Conclusions and Recommendations

The following are conclusions and recommendations by NAIC regarding insurance marketing on the Internet:

Advertising
Some jurisdictions require insurers to maintain at their home office complete files with specimen copies of each advertisement used by the insurer and its agents. To comply with this requirement, insurers typically retain "tear sheets" of print advertisements and tape recordings or a script of radio and television advertisements. However, although in "hard copy" printouts of Web site program information, advertisements displayed on Web sites may be ephemeral and capable of being altered and/or originated by unauthorized persons, making the monitoring of all advertisements difficult for both insurers and regulators.

Marketing
Marketing insurance products on the Internet involves a "presentation or depiction" that could be subject to the NAIC Life Insurance Illustrations Model Regulation. Thus, an Internet presentation that includes "non-guaranteed elements of life insurance over a period of years" is not excluded from the definition of "illustrations" and must satisfy all relevant regulatory requirements.

Privacy
To initiate an insurance transaction, a consumer is often asked to disclose personal information. Along with a decision to divulge information comes a consumer expectation of privacy and secrecy. The traditional insurance sales process typically involves communication, either in person or over the telephone between the insurer or its producer and the consumer. For the Internet methods of communication that provide accepted assurances of privacy and anonymity are yet to be fully explored.

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APPENDIX
Hearing Information
On Nov. 15, 1996, the working group issued a public hearing notice. Four individuals responded that they intended to make a presentation to the working group at this meeting. In addition, written comments were submitted by Selwyn Whitehead (Economic Empowerment Foundation) for inclusion in the record of the public hearing. The first presentation was made by Arthur J. Chartrand (Attorney representing Block Financial Corporation). Mr. Chartrand submitted a written statement for the hearing record (Attachment B). After making his presentation, Mr. Chartrand was asked by Mr. Blair if he endorsed making changes in statutes with regard to commission sharing with unlicensed agents and intermediaries. Mr. Chartrand responded that he sees this as one way to compensate technical services providers, and that regulators might consider removing impediments to companies sharing commissions with those that are participating in the sales process. He emphasized that he did not see a down side to commission sharing. Dudley Ewen (Md.) asked Mr. Chartrand what Block Financial Corporation does on the Internet. Mr. Chartrand responded that Block Financial Corporation is a web site access provider and not an insurance company or an insurance producer. He stated that his clients' company provides a web site that can bring information together in one place and provides gateways to other companies that want to get their information on the web. Mr. Ewen asked whether the company refers potential customers to licensed agents to purchase insurance. Mr. Chartrand stated that Block Financial Corporation provides web site for licensed insurance agents to provide information and that they are compensated based on the data flow that is transacted across the web and not on the production of premiums. Mr. Ewen questioned whether these web pages provide a disclaimer. Mr. Chartrand stated that both the insurance agent and the jurisdictions where the agent is licensed are identified up front. He emphasized that disclosure of this information should be done early and often. Richard Rogers (Ill.) asked Mr. Chartrand to explain what in his view were the regulatory issues related to insurance sales on the Internet. Mr. Chartrand stated the issues included disclosure requirements, electronic signature requirements, multi-jurisdictional and commission sharing issues, and licensure requirements. Mr. Rogers asked whether Mr. Chartrand was suggesting that the provisions against fee schedules would have to be relaxed. Mr. Chartrand stated that he believed the Internet will push this issue into the forefront because people will want to pay for services based on the results obtained. Mr. Chartrand added that many issues related to consumer protection will have to be considered and much like issues related to relaxing countersignature laws have evolved, so too will other laws related to payment of commissions and other consumer protection issues have to be reevaluated as the Internet evolves. Troy Pritchett (Utah) stated that regulators have tried to clarify the distinction between intermediaries and producers and questioned whether Mr. Chartrand was suggesting to regulators that they need to blur the distinction between services provided by intermediaries and those provided by producers. Mr. Chartrand responded that it is likely that the distinction would need to be reconsidered, and that regulators may need to step away from the traditional approach which has been taken with regard to sharing of commissions. Mr. Pritchett then asked Mr. Chartrand if he felt that other statutes would need to be promulgated to specifically address insurance sales and marketing on the Internet. Mr. Chartrand stated that he was not in favor of more regulation, but that it will likely be an issue of adjusting the current laws to the types of activity that will occur. He added that insurance companies and technical services provider see a great potential for improvements in the distribution of services and products to consumers on the Internet, and suggested that most consumers will be able to adapt but that they would want to be able to identify the entities that that they are dealing with on the Internet. Bruce Ramge (Neb.) asked whether there would be any advantages to creating a limited lines producer license for those solely doing business on the 124

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Internet. Mr. Chartrand stated that he would not suggest such a license and that regulators should begin by evaluating the applicability of current statutes and regulations. He reiterated that disclosure is one of the most important aspects and that it should be done early and often. J. Robert Hunter (Consumer Federation of American CFA) provided a written statement to the working group in which he identified some potential problems to insurance sales on the Internet including privacy, security, non-licensed sales, misleading consumers, improper advertising and fraud. Mr. Hunter proposed that the NAIC establish a sales web site where qualifying insurers would be able to have their own page that meets NAIC standards for format, minimum information, solvency, etc. He stated that the requirements for coming under the NAIC umbrella could be worked out with the industry, consumers of insurance and other interested parties, with the members of the NAIC having the final say on design and other aspects. He stated that in so doing the NAIC would become the "good housekeeping seal" for insurance shopping on the Internet (Attachment C). Don Koch (Alaska) observed that Mr. Hunters' recommendation might run into political obstacles, particularly competing against the private sector providers of such services. He asked Mr. Hunter to comment on this prospect. Mr. Hunter responded that he did not see a political conflict because under his proposal the NAIC would become a web site that consumers could access and have confidence that the companies they were doing business with were adhering to specific standards. He added that the NAIC already competes with other information providers on the sale of various types of data, including financial data, and so this would not be an entirely new undertaking for the NAIC. He added that individual state information could also be incorporated into the NAIC site and that he believed it would have a positive impact on the industry. Mr. Rogers stated that in his comments Mr. Hunter had suggested that states require filing of a computer disk containing pricing information in order to provide a price comparison service. He stated that Illinois has struggled with such an idea and that to have a complete price comparison system is difficult. He observed that one of the problems with such a system is that it encourages people to just shop for price when other issues such as an insurer's quality of service, claims handling ability, and service quality are also important aspects that consumers may wish to consider. Mr. Hunter responded that one of the niceties about technology is that in enables consumers to look at everything: service information, company rating information and price information and then make intelligent and informed decisions with regard to purchases. Mr. Blair asked Mr. Hunter what his position was with regard to the types of disclosure that should be incorporated into web sites. Mr. Hunter stated that he believed that the name of the company, licensing information, and insurance company service levels should be provided at if at all possible. Commissioner Kerry Barnett (Ore.) asked Mr. Hunter what he believed should be a regulators' responsibility for technology companies that have provider information on their Internet sites and then later the company is found not to be licensed in the jurisdiction where they were selling insurance. He asked Mr. Hunter whether he would agree that regulators should find ways that impose requirements on those gateway companies so that they do not host sites that are not legitimate. Mr. Hunter responded that the U.S. Federal Trade Commission (FTC) has been doing a great deal of work with regard to fraud on the Internet and that the NAIC should work closely with the FTC with regard to provider legitimacy issues. He added that the NAIC should also work with credit card companies on security issues. Commissioner Barnett questioned whether there should be an affirmative enforcement mechanism. Mr. Hunter responded that he believed such a mechanism was necessary because those companies would then be within reach and that it would not be as difficult as trying to enforce requirements upon those companies which are not within reach. Reginald Berry (D.C.) asked Mr. Hunter if he believed having such requirements would result in more informed consumers. Mr. Hunter stated he believed it would and that there are already some sites that are excellent sources of information and products on the Internet. He mentioned that, for example, there are already programs that can help you calculate your life insurance needs. Mr. Hunter added that he further believed that electronic technologies including the ability to collect information, to collect electronic signatures, and to enable instant sales of products and services will be beneficial to consumers. Mr. Ewen observed that the NAIC recently adopted model consumer information reports and asked Mr. Hunter if he believed it would be advantageous to have those reports adapted to being provided over the Internet. Mr. Hunter responded that the believed it would be a valuable source 125

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of information, but summary formatting of the report might be needed before it could be delivered over the Internet. Ron Kuhnel (Insweb) stated that the NAIC Fall National Meeting in Anchorage, Alaska, he conducted an on-line presentation to show what types of information, products and services are available on the Internet. He said that the question often arises as to what is Insweb. He stated that Mr. Chartrand did a good job of describing what information technology companies do. He said that there was a fine line between the types of services offered over the Internet between insurance companies and information technology provides, and that there are fine line decisions that regulators will need to deal with regarding activities of such providers on the Internet. Mr. Kuhnel then gave a detailed presentation to the working group (Attachment D). In conclusion, Mr. Kuhnel observed that the NAIC provides a great deal of data through its Internet site and suggested that while private sector web companies such as Insweb are already providing links to the NAIC home page, that the NAIC should also developing links to private sector web pages as well. Commissioner Barnett asked Mr. Kuhnel how many insurers rent space from Insweb on their cybermall. Mr. Kuhnel stated that there are more than 50 companies and tens of thousands of agents and brokers that have links through the Insweb site. Commissioner Barnett asked Mr. Kuhnel to explain how Insweb ensures that the information provided on its site meets standards and whether Insweb would allow companies to provide a side-by-side pricing comparison with a competitor on their site. Mr. Kuhnel responded that Insweb provides a secure physical space, but that companies are free to do what they want in that space. Commissioner Barnett questioned whether Insweb actively promotes its site to consumers. Mr. Kuhnel respond that active promotion is conducted. Commissioner Barnett asked whether Insweb conducts any due diligence on the companies and agents that want to get on Insweb. Mr. Kuhnel responded that he believed that certain steps are taken to ensure that a company doing business through the Insweb site is a legitimate company. Commissioner Barnett then questioned whether Internet service providers, such as Insweb, should have an affirmative duty to act as a screen to keep the bad guys off the Internet. Mr. Kuhnel responded that just like newspapers and the Yellow Pages ,Insweb does not control the information that is provided through its site. Commissioner Barnett expressed concern and observed that if Insweb promotes its services as a beneficial location on the Internet for consumers to get valid information on insurance, then they should not have a responsibility to those consumers accessing the site to ensure that the companies or agents are legitimate. Mr. Kuhnel responded that this was a good question and that it would be a good idea to look into this issue further.

STATE SURVEY
Barbara Stewart (Stewart Economics, Inc.) stated that her company is a consulting business that specializes in insurance and insurance regulation services. She then provided a written presentation to the working group below. At the conclusion of her presentation, Mr. Rogers questioned whether Ms. Stewart was suggesting that regulators should look at a more general issue of agent licensing rather than just how those concerns apply to agents providing services over the Internet. Ms. Stewart responded in the affirmative and indicated that she was not suggesting deregulation, but rather that regulators need to rethink the purposes of agent licensing and seek ways to simplify the process. She stated that regulation should not be seen as obstructing the ability of agents to sell insurance regardless of where it is sold. She added that her consulting firm has learned a great deal about licensing and Internet marketing as a result of a study they conducted for United Services Automobile Association (USAA). She added that it is important to look at other ways of collecting licensing revenues as well as encouraging a cooperative effort by the states with regard to multi-jurisdictional licensing. In conclusion, Ms. Stewart observed that activity with regard to the Internet is moving quickly and that actually middlemen (very specialized ones) will form and that there will be an ability to distinguish the good players from the bad players. (The survey of state insurance departments by Stewart Economics is not shown). Citation of Californias Digital Signature Statutes California Government Code Section 16.5 (1995). On October 4, 1995, California enacted this statute 126

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which governs only electronic signatures affixed to communications with public entities. The Act provides that an electronic signature (called a "digital signature" in the statute), shall have the same force and effect as a manual signature if: (1) it is unique to the person using it; (2) it is capable of verification; (3) it is under the sole control of the person using it; (4) it is linked to data in such a manner that if the data are changed, the digital signature is invalidated; and (5) it conforms to regulations adopted by the Secretary of State. Digital Signature Regulations. On May 23, 1997 the Secretary of State released California's proposed Digital Signature Regulations for comment. The proposed regulations provide for the following: 1. Digital signatures must be created by an acceptable technology, as specified in the regulations. 2. The criteria for determining if a digital signature technology is acceptable for use by public entities is set forth in the regulation (and essentially includes the five requirements set forth in the statute, plus a requirement that the technology must create digital signatures that are able to satisfy California's requirements for introducing writings into evidence). 3. The regulations provide that acceptable technologies are: (a) Public key cryptography (b) Signature dynamics 4. The regulations provide a procedure for adding new technologies to the list of acceptable technologies. With respect to digital signatures, the regulations impose upon a person who holds a key pair a duty to exercise reasonable care to retain control of the private key and prevent its disclosure to any person not authorized to create the subscriber's digital signature. The regulation also establishes an approved list of certificate authorities authorized to issue certificates for digitally signed communications with public entities in California. Finally, the regulations does not address liability concerns because the Secretary of State deemed that it did not have the authority to do so through California State regulations. It anticipates that some of the liability concerns can be addressed contractually with the service providers, but recognize that other issues need to be addressed by the legislature. Public hearings on the regulation were held on July 15, 1997. A final regulation has not yet been adopted. (Statutes for other States are not shown) Proposed UCC Article 2B SECTION 2B-202. FORMATION IN GENERAL. (a) A contract may be made in any manner sufficient to show agreement, including by conduct of both parties or actions of electronic agents which reflect the existence of a contract. (b) If the parties so intend, an agreement sufficient to constitute a contract may be found even if the time when the agreement was made cannot be determined, one or more terms are left open or to be agreed upon, or the standard form records of the parties contain varying terms. (c) Although one or more terms are left open, a contract does not fail for indefiniteness if the parties intended to make a contract and there is a reasonably certain basis for giving an appropriate remedy. Uniform Law Source: Section 2-204, modifies (b). First Appeared: 2-203 (Prototype) SECTION 2B-205. ELECTRONIC TRANSACTIONS: FORMATION. (a) In an electronic transaction, if an electronic message initiated by a party or its electronic agent evokes 127

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an electronic message or other electronic response by the other or its electronic agent, a contract is created when: (1) the response is received by the initiating party or its electronic agent, if the response consists of furnishing information or access to it and the message initiated by that party did not preclude such a response; or (2) the initiating party or its electronic agent receives a message signifying acceptance. (b) A contract is created under subsection (a) even if no individual representing either party was aware of or reviewed the initial , the response, the reply, the information, or the action signifying acceptance. Electronic messages are effective when received even if no individual is aware of its receipt. Uniform Law Source: None. First appeared: Section 2-2202 (Sept. 1994) Selected Issues: a. Should subsection (a)(1) require that the initial message invite performance as a response? b. Is the exclusion of any requirement of human review appropriate?

NAIC Notes:
1. The changes in this section parallel earlier changes in that they introduce a concept of electronic agent, rather than intermediary. That concept is narrowed to clarify that the programmed activity that can bind a party is an program accepted, developed or programmed to take action by the party itself. In reviewing this, reference needs to be made to the terms of the section in part 1 dealing with attribution of messages and performances to a party. 2. An electronic transaction is as "a transaction in which the party that initiates the transaction and the other party, or their intermediaries, contemplate that the creation of an agreement will occur through the use or electronic messages or an electronic response to a message." Section 2B-102. This definition does not require that the parties also intend performance to be electronic. 3. The principal application of this section lies in the growing realm of electronic commerce. The section sets out standards for determining when and whether a pure electronic contract can be enforceable. Note that electronic-related language consistent with this section is also included in sections on offer and acceptance as well as formation rules. 4. A principal contribution is in subsection (b) which indicates that a contract exists even if no human being reviews or reacts to the electronic message of the other or the information product delivered. This represents a modern adaptation away from traditional norms of consent and agreement. In electronic transactions, preprogrammed information processing systems can send and react to messages without human intervention and, when the parties choose to do so, there is no reason not to allow contract formation. A contract principle that requires human assent would inject what might often be an inefficient and error prone element in a modern format. 5. The information industry increasingly uses electronic "intelligent agents" and database products generally available on the Internet or other electronic networks. This entirely automated means of utilizing information as a commodity creates a number of uncertain contract law issues some of which this section attempts to answer in a manner that facilitates the development of this branch of commerce. 6. Subsection (a) contains a nonexclusive statement of how a contract may be formed, giving the parties some guidance on how to structure messages to create or avoid contractual obligations. It hinges the 128

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creation of a contract on the response to an electronic message. If the response consists of furnishing the performance, the contract exists at the time that they are made available at a place and in a manner allowing the initial party (or its computer) to have access to or use the information. Notice that this response might occur without there being any decision by any individual involved with the responding to "accept" the offer. If the response consists of creating an opportunity (or offer) to make access to the information available, the contract exists if the initial party signifies acceptance by taking advantage of the opportunity created or by indicating that it intends to do so. 7. Former subsection (c) dealing with "receipt" has been moved to the definition section. In commentary to the September Draft, a number of people suggested that the original version did not deal well with the case of a delivery in the absence of a prior designation of a particular information system by the recipient and was not sufficiently open-ended to deal with changing technology. SECTION 2B-310. ELECTRONIC TRANSACTIONS: TERMS. (a) In an electronic transaction, the terms of a contract are: (1) terms agreed to by the parties as applicable to the transaction prior to the exchange of the electronic messages; (2) terms on which the electronic messages and electronic records of the parties do not conflict and terms on which they substantially agree; (3) the supplemental terms incorporated under any other provisions of this article as to issues not otherwise made part of the contract by paragraphs (1) and (2). (b) If terms included in a contract under subsections (a)(1) and (2) conflict, terms included under subsection (a)(1) control unless the electronic transaction involved review of the electronic message by an individual representing the party against whom the term is asserted and that individual manifested assent to the term contained in the message. (c) Except as otherwise provided by terms included under subsection (a)(1) or (a)(2), if the subject matter of an electronic transaction is information content, neither party is entitled to consequential damages in the event of a breach by the other. Uniform Law Source: None. First Appeared: Section 2-2202 (Licenses, September). Selected Issue: a. Should the terms of a form to which the licensee manifests accent over-ride the other form?

NAIC Note:
1. Subsection (a) creates presumptions regarding the applicable terms. Its effect parallels that of the section on conflicting standard forms and the treatment of single standard form contracts. Essentially, the negotiated terms of an agreement control areas they cover, but beyond that, the electronic transactions is treated as a standard form transaction. 2. A negotiated agreement involving individuals who represent the companies controls. Next in order of priority are terms on which the electronic messages agree. Finally, the supplemental terms of the UCC apply.

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Example: A agrees to make its database available to B with charges to be computed based on the type of information requested. The contract provides that B need not pay for information that is more than one week old. Later, B's computer initiates an electronic inquiry for data on the price of cotton. Its preprogrammed terms require information require a guaranty of accuracy. It does not mention price. A's computer provides the data in a message containing no contractual terms. The contract exists when the data are furnished to B's computer. The guaranty of accuracy does not become part of the contract, but supplemental UCC warranty rules apply. B need not pay for data more than one week old. 3. Subsection (a) provides a coordination concept between this section and the sections on standard form records (mass market and non-mass market). In essence, form provisions in an electronic transactions must comply with the terms of this section. After that step is completed, the conflict or priority resolutions sections of (b) apply. 4. Subsection (e) excludes consequential damages unless contracted for by the parties. This is based on analogy to the treatment of wire transfers in Article 4A. The electronic contracting for information and data is an industry that is growing and that thrives on efficiency and low cost of distribution. The exclusion of consequential as a basic premise here creates a base from which this low cost growth can continue. Furthermore, in most cases, the vendors of this type of data are insulated from liability for content errors under general policy standards applicable to information industry participants. See Daniel v. Dow Jones & Co., 137 Misc. 2d 94, 520 NYS2d 334 (NY Civ. Ct. 1987). SECTION 2B-322. INTERMEDIARIES IN ELECTRONIC MESSAGES (a) A party who engages an intermediary to transmit, make available for access, or log electronic messages or data electronically, or to perform like services is liable for damages to the other party arising directly from the intermediary's errors or omissions in the performance of such services to the extent that such errors or omissions caused reasonable reliance on the part of another party. (b) A party who sends an electronic message through or with the assistance of an intermediary providing transmission or similar services is bound by the terms of the message as received despite errors in the transmission unless the party receiving the message should have discovered the error by the exercise of reasonable care or the receiving party failed to employ an authentication system agreed to by the parties before such transmission. Uniform Law Source: UNCITRAL Draft Model Law on EDI. Revised. First appeared: 2-213 (prototype) Selected Issues: a. What treatment should be given to unknown or gratuitous intermediaries such as will be involved in transactions occurring through the Internet?

NAIC Notes:
1. This section deals with one form of the issues caused by an error or mistake in a transaction involving electronic contracting. The basic issue centers on responsibility for error by a third party (intermediary) brought into the transaction. Essentially, the party bringing the intermediary into the deal has responsibility for any errors that the intermediary makes. 2. This section does not deal with the intermediary's liability, leaving that issue to other law. The Committee may wish to consider whether this is appropriate. 3. Current law makes a distinction must be made between mutual and unilateral mistakes. See Restatement (First) of Contracts 503. As a general common law principle, unilateral mistakes do not absolve compliance with a contract based, in part at least, on the assumption that each party should protect its own position in reference to the handling of errors and the like. This relatively ancient common 130

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law principle has been frequently readjusted in modern case law to hold that the unilateral mistake allows an avoidance of the contract if enforcement against the party making the mistake would be oppressive and recision of the contract would impose no substantial hardship on the other party. See 3 Corbin on Contracts 608. See also Calamari & Perillo, The Law of Contracts 9-27. 4. This formulation suggests the circumstances under which a mistake by the sender of an offer or an acceptance might avoid its mistaken consequences. Avoidance of those consequences comes most readily in cases where the receiving party had reason to know of the error or that party did not rely to its detriment on the mistaken message. The principle is simple enough. If the mistake caused no harm and was either discovered before reliance occurred or was so egregious that the other party could not in good faith not recognize it as an error, the person making the error should not be liable for it. This element of the doctrine is incorporated here. 5. A relevant consideration deals with whether the mistake was caused by error of the sender or whether the mistake came in an error caused by the provider of a service that served as an intermediary. As between buyer and seller, in cases involving errors by telegraph companies, the majority approach is that the sender of the message is liable for errors created by the intermediary it chose to communicate the message unless the other party should have known that the message was mistaken. See discussion in Calamari & Perillo, The Law of Contracts 2-24. See also 1 Williston on Contracts 94. A minority position exists, holding that no contract exists in such a situation because the sender is not responsible for the actions of an independent contractor. Restatement (Second) of Contracts 64, Comment b. 6. In Article 4A, in contrast, the UCC defines the intermediary for this purpose as an agent. The fundamental rationale for this approach to the problem comes from the fact that neither the sender nor recipient may have been at fault in creating the problem, but that some loss occurred and must be allocated to one or the other. In such a case, the proper choice is to place the loss on the sender unless the recipient was in fact at fault in not recognizing that an error existed. 7. In computer-based systems, as between the primary parties, there does not appear to be a current common law principle requiring the adoption and compliance with a security system to detect errors or fraud. Arguably, however, the failure to electronically discern an obvious mistake in a transmitted message may cause a court to conclude that the recipient "had reason to know" of the mistake and that its reliance on the verbatim electronic terms was not reasonable or protected. More generally, engaging in transactions requires, as a matter of prudent business conduct, the creation of an effective means to discover and prevent errors and fraud in the transactions. 8. Contractually, the parties can and should deal with both how the risk of error should be allocated and what type of security or other system should be in place as a means to detect and prevent mistake. One fully appropriate contract rule is to define a commercially acceptable security procedure and to then indicate that either party's failure to conform to the procedure shifts loss to that party in compliance with the procedure would have prevented the risk from occurring. This is the result created in UCC Article 4A. A. Offer SECTION 2B-203. FIRM OFFERS. An offer by a merchant to enter into a contract made in an authenticated record that by its terms gives assurance that the offer will be held open is not revocable for lack of consideration during the time stated. If no time is stated, the offer is irrevocable for a reasonable time not to exceed three months. A term of assurance in a record supplied by the offeree is ineffective unless the offeree manifests assent to the term. Uniform Law Source: Section 2A-205; Section 2-205. Selected Issue: a. Should this section be limited to offers by merchants?

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NAIC Notes:
1. This section follows draft Article 2 language. Issues dealing with firm offers have not been presented to the courts in reference to information contracts, but the section may be important since it applies in cases of multiple level contracts as in development agreements. 2. This section does not limit the length of the firm offer. It requires a record. If a repeal of the statute of frauds occurs, the Drafting Committee may wish to revisit the policy rationale for requiring this type of an offer to be in a writing. 3. Article 2A requires that the term of assurance on a form supplied by the offeree be "separately signed by the offeror." The language here supplants the signature requirement with the concept of authentication and manifestation of assent. SECTION 2B-204. OFFER AND ACCEPTANCE. (a) Unless otherwise unambiguously indicated by the language or circumstances: (1) An offer to make a contract invites acceptance in any manner and by any medium reasonable under the circumstances, including a definite expression of acceptance that contains standard terms varying the terms of an offer. (2) An order or other offer to buy, license, or acquire information for prompt or current transfer invites acceptance either by a prompt promise to transfer or by prompt or current transfer. However, a transfer involving nonconforming information is not an acceptance if the transferor seasonably notifies the transferee that the transfer is offered only as an accommodation. (3) A response by an electronic agent that signifies acceptance or that commences performance constitutes acceptance of an offer even if the response is not reviewed or expressly authorized by any individual. (b) If the beginning of a requested performance is a reasonable mode of acceptance, an offeror who is not notified of acceptance and who has not received the relevant performance within a reasonable time may treat the offer as having lapsed before acceptance. Uniform Law Source: Section 2A-206; Section 2-206. Selected Issue: a. Is the treatment of an electronic response appropriate? NAIC Note: 1. Authentication replaces signing as the applicable expression of the party to be bound. Also, as in other sections, this section was modified to change "intermediary" to "electronic agent", a defined term, that clarifies that a party is bound by electronic preprogrammed operations only if it programmed its available system to make such responses. 2. This section generally follows draft Article 2. It adds subsection (a)(3) to deal with electronic acceptances. Otherwise, the draft assumes that the general reference to enabling a response in any form reasonable under the circumstances adequately covers the analysis of whether an electronic offer invites an electronic response. 3. Subsection (b) has been modified from existing law to expressly reflect that there is no need for 132

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notification where the party receives actual performance within a reasonable time. This is significant in electronic performance where virtually instantaneous responses are possible (e.g., electronic transfer of data). Requiring notice in such contexts is not appropriate.

BIBLIOGRAPHY
Gora, Jean Crooks; The Internet and Online Services: Opportunities for Insurance and Financial Service Companies; LOMA Research Division, 1995 Liefer, David M. & Stevens, Marybeth G.; The Net, The Web And Other Emerging Technologies, Don't Get Caught Without Knowing The Legal Issues; American Council of Life Insurance, 1996. THIS ENDS THE NAIC WHITE PAPER

Whos Who on the Internet

The following is by no means an all inclusive list of insurance and/or related websites. Rather it is a sample of what is already in use. By analyzing existing sites, agents can gather ideas and strategies to build better sites themselves. www.quotesmith.com Life insurance comparisons, company information and underwriting guidelines for a variety of life insurance products. www.iix.com The Insurance Information Exchange offers insurance news, resources, business tools and consumer / agent information with a heavy emphasis on Internet consulting, website planning and on line resources. www.insurancejrnl.com A scaled-down electronic magazine for the property-casualty industry. Insurance Journal West features regional and national insurance news. A recent article pointed to the underinsuring of the Nations 43 million home based businesses. www.irin.org The Insurance Regulatory Information Network is a public-private partnership for the development of leading edge products and services for the insurance industry. IRIN is a non profit affiliate of the National Association of Insurance Commissioners (NAIC) offering the Producer Database (PDB) and Producer Information Network (PIN). PDB is a central depository of producer licensing information (appointments, terminations, disciplinary actions, etc). PIN is an electronic communication network that links state regulators with entities they regulate to facilitate the electronic exchange of producer information. Standards are being developed for the exchange of license applications, license renewal, appointment and termination information for faster turnaround and reduction in paperwork. www.accord.com Accord Software specializes in development kits that help agents generate Internet applications and more. Using agent websites, customers use Accord software to check their account balances, pay premiums by credit card and report losses. At all times, the agent logo and identity remains on the screen. www.acord.com Acord (different from above) is a well-known nonprofit insurance association dedicated to increasing the efficiency of agency distribution systems using standardized forms. The company is developing many new electronic data exchange systems for use on the Internet.

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www.4insurance.com This company offers a ready-made method for agents to participate on the Internet even if they don t own a computer. Consumers who locate the site fill out a request for a quote and then select agents in their area. The quote requests are faxed or emailed directly to the agent within 24 hours. The agent responds with a quote which can be emailed or faxed to the consumer. www.ibsassn.com The Insurance Benefits Service Association offers expert advice, glosseries, AM Best ratings, lead generation and marketing services. www.vistanet.com Vista Net is a general agency with full Internet support for member agents. Online quotes (mostly employee benefits and 24 hour care) and free websites are two of the perks. www.insurance.ca.gov The California Department of Insurance Home Page is one of the shining examples of how regulators can use the Internet. This website includes newsletter type information, industry news, educational articles, agent and consumer beware notices and direct access to the entire California Insurance Code. The California Senate Home Page at www.sen.ca.gov is an excellent source for tracking new legislation. A search feature permits indexing by any topic ; insurance, retirement planning, financial planning, taxes, etc. www.iiaa.org The Independent Insurance Agents of America site offers a multitude of services and information for agents, consumers and members. Services includes current events, an agent locator and a list of state associations. www.insure.com This is the Insurance News Network offering general and state-specific information about auto, home and life insurance. It is a free provider of insurance ratings from Standard and Poor s and Duff & Phelps, and also offers extensive variable annuity information and performance data from Morningstar. www.insweb.com InsWeb is a centralized interactive interactive resource center for the insurance industry. Services include agent listings, tax updates and other helpful directories. InsWeb also offers agencies and companies a high visibility outlet to sell policies over the Internet. www.ircweb.org The Insurance Research Council(IRC) offers abstracts of the Council s research studies and news releases which are oriented toward the property casualty industry. www.inlinea.com Insurance Inlinea is an information website targeted to the insurance industry offering on-line quotes to consumers. But, site founders say its primary purpose is to help insurance professionals integrate the Internet into their business. The service will direct clients and prospects to agent home pages through both off and online promotions and advertising. www.insureinfo.com The Insurance Resource Center works exclusively with the insurance industry helping both the small agent and the large insurance companies discover online solutions. www.ambest.com The AM Best Company website is a true resource tool where agents can find traditional rating and analysis on line (Bests Agent Guide, Best Averages, Best Company Reports, Bests Insurance Reports, Bests International Rating Guide, Bests Managed Care Report, Bests State / Line Reports). In addition, 134

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the companys new Resource Center provides Internet users a place to turn for insurance information. Examples include the World Wide Insurance Directory (a database of 7,000 insurance companies address, website, AMB and NAIC number), directories of insurance associations, government regulators, insurance news stories, stock quotes for publicly traded insurance companies and link access to search engines for locating other subjects. www.realquote.com Auto insurance ratings for at least a dozen companies. www.800insureme.com A private referral network

Miscellaneous Sites
Notable company websites to visit include Blue Cross / www.bluecrossca.com Safeco / www.safeco.com Nationwide Insurance / www.bestofamerica.com Zurich Kemper / www.zurichkemper.com Metlife / www.metlife.com Prudential / www.prudential.com Vision Service / www.vsp.com Cigna / www/cigna.com Lifeguard Health / www/lifeguard.com

How to Get Connected to the Internet

In a recent article in California Broker, Bruce Salmon offers some solid advice on getting connected. The most practical way to get on the Internet is to contract with an Internet Service Provider (ISP). There are many generic providers like AOL or The Microsoft Network and their are industry providers, some of which are mentioned above. A major component of each of these services is e-mail. When you sign on, you receive one, two or three e-mail addresses to connect to your clients and others. Choosing an ISP is the hardest decision. Ask and expect answers to the following questions: How many subscribers do they have? (Ask for referrals). How many modems do they have and what is the speed of the modems? Youll want to know their subscriber to modem ratio. Anything higher than 20:1 is too high and youll likely experience connection problems. Also, if they dont have fast modems 33.6 or higher, youll spend a lot of time waiting for data to transfer. Ask them about the type of connection they have to the Internet. TI or ISDN are typical high-speed connections. Remember, it doesnt pay to have fast access to their system if their access to the Internet is slow. Ask them if they monitor their usage and how often they upgrade equipment. If they are continuing to sign on new subscribers but dont upgrade regularly, their service will likely become bogged down. Get specific details on what charges you are paying for and what is included in the fee. Companies may charge you on a monthly basis and include a certain number of hours with the basic charge. Find out what you pay when you exceed the basic hours. The current trend, however, is to offer an unlimited time for a flat fee. Ask if there are benefits to signing up for several months. Also, find out if there is a discount for multiple IDs. You may have several individuals in your office that may want an e-mail address. What kind of software does the service provider include? They should provide you with the TCP/IP 135

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software, electronic mail package and a WWW browser. This should all be included in the monthly charge and not an extra fee. Finally, ask about support. Who will provide support? What are the hours? Is there a local telephone number you can call if there is a problem? As competition for website hosting grows so will your options. There are, for example, hundreds of independent server companies who specialize in inexpensive web hosting. Some examples are Host Save ($6.95 per month), EnetValue ($5.95 per month), Ecommerce ($14.95 per month). While some of these may be lacking in bells and whistles, they allow you a cost-effective way to have an internet presence.

Website Design
There are volumes of manuals and books written on this subject and just as many companies willing to design and host sites for you. In his Weekly Guerilla Newsletter, Charles Rubin exposes six myths about website planning: Myth #1 - You will reach millions of customers. Having a site on the Web doesn't mean you'll automatically reach millions of customers, any more than having a book in publication means you'll automatically reach millions of readers. There may be millions of people capable of accessing Worldwide Web pages right now, but you'll have to promote your site through discussion group participation, ads, announcements, directory listings, e-mail, links on other sites, and off-line publicity before you'll attract a lot of visitors. Myth #2 - You can set up a site and forget it. Web sites aren't like print or broadcast ad campaigns, where you're married to a particular design and information package for months on end. When I see a site that hasn't changed in months, I wonder whether or not the company is still in business. There are too many new Web sites appearing every day for me or most Net surfers to return again to sites that never change. Your Web site had better change at least weekly. It should announce its changing features right at the top of the home page so even the most casual visitor knows he or she will see something new on the next visit. Plan for change when you plan the site, and think through the process of how it will be updated (and who will do that), and you'll end up with a site that people will visit again and again. Myth #3 - Hits = Visits. High hit counts contribute to the grossly inflated notions of the Web's magical ability to reach people. But your site will always get far more hits than it does actual human visitors.

Make sure your website is compliance ready. The NAIC is actively regulating the Internet in areas such as disclosures ,, forms, rates, replacement requirements, claims settlement, records retention and security. An unsecured site that passes confidential client information can subject you to licensing penalties and a client lawsuit.

Myth #4 - The more graphics, the better. When graphic designers take over a Web site, looks often triumph over accessibility. The prettiest site on 136

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the Web is useless if visitors with non-graphical browsers can't tell what it is or how to navigate in it. Too many sites are unfathomable even to graphical browser users who view them without loading the images. And even interested visitors won't wait to see what you're offering if they have to stumble over too many minute-long downloads as images load. Use small image files . Offer a text-only option at the top of your home page. And let visitors know how large big image files are so they can make an informed decision about whether or not to display them. Myth #5 - Malls make shopping more convenient. Web mall operators say that locating on their site is a plus, because their collection of stores attracts Web surfers. But while a physical mall brings in people because it saves time, Web malls don't offer nearly the same time-saving benefit. It takes no more time for me to jump from one Web site to another than it does to jump from one mall store to another. A mall that's a hodgepodge of companies is less interesting to me than one that features businesses or resources focused around a certain topic of interest, such as the Realty Net, Book Zone, and TV Net. There's enough disorganization and chaos on the Web as it is without having to go to a generalized mall to see more of it. Myth #6 - Sounds and video are simple. You will hear lots of hot air about the multimedia nature of the Web, but Web sites have a long way to go before they resemble your TV set or even a CD-ROM playing on your PC. If you're expecting to point and click to listen or hear multimedia clips, you'll be disappointed. When software developers and content providers completely integrate video and sound player capabilities and overcome the lack of standards and bandwidth constraints for modem connections you might be able to use multimedia. But until then, video and sound files have to be downloaded, and they require a player utility in order to perform on your PC. Video files in particular can be multi-megabyte affairs that take many minutes to download. Further, there are different players for different PC platforms. The best Web sites that offer sounds or video also offer a selection of players you can download to ensure that you'll be able to experience the sound or movie on your PC, no matter what kind it is. More good advice comes from the Schmidt Marketing Group (www.geoprofit.com): Create a Customer-Centered Website. Such a site creates a desire for your products and services while helping you build long term relationships. In essence, your site evolves around your customers needs. To create one, you need to re-package your knowledge into a resource for clients to use. Create an Electronic Commerce System. Using E-commerce, your business is transacted electronically via e-mail, fax, already paid by credit card. Customers can query your products or services online giving them instant gratification. Create a Web Marketing Plan. Such a plan tells you what to do with available technology. In the eyes of your customers, you become an expert, a problem solver resulting in return visits to your site again and again. Once your site is developed you will need to hyperlink to truly capture the power of the Internet. The philosophy is simple: Your potential visitors should be able to find you from many different angles. To do this, experts advise that you establish a moderate number of high quality links to related websites: Sites that share similar subject matter. Linking to these sites can be harder than it seems since you will asking other site owners to advertise your website inside their domain. If customers are interested enough in your information, they can leave the host link and visit your site. Perhaps they will return, or maybe they wont. To make your own site more of a resource tool for customers, you may also want to link your site to others. The general consensus is that you may link to other sites without asking permission provided you are not claiming their site as part of your own. However, there can be benefits to requesting permission before linking to someones site: It is a good way to initiate a contact to ask them to hyperlink their site to yours. 137

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Netiquette
While there are no Internet police, it is important that insurance agents using the net abide by standards of ethics and reason. In the insurance industry this is known as consumer protection; on the Internet, it is referred to as netiquette. A good foundation in netiquette can be gleaned from Arlene H. Rinaldis book called THE NET: USER GUIDELINES AND NETIQUETTE. Following are some important points presented in this work: the 10 commandments of using the Internet 1. 2. 3. 4. 5. 6. 7. 8. 9. 10 Thou shalt not use a computer to harm other people. Thou shalt not interfere with other people's computer work. Thou shalt not snoop around in other people's files. Thou shalt not use a computer to steal. Thou shalt not use a computer to bear false witness. Thou shalt not use or copy software for which you have not paid. Thou shalt not use other people's computer resources without authorization. Thou shalt not appropriate other people's intellectual output. Thou shalt think about the social consequences of the program you write. Thou shalt use a computer in ways that show consideration and respect.

Basic Internet Guidelines

It is essential for each user on the network to recognize his/her responsibility in having access to vast services, sites, systems and people. The user is ultimately responsible for his/her actions in accessing network services. The "Internet" or "The Net", is not a single network; rather, it is a group of thousands of individual networks which have chosen to allow traffic to pass among them. The traffic sent out to the Internet may actually traverse several different networks before it reaches its destination. Therefore, users involved in this Internetworking must be aware of the load placed on other participating networks. As a user of the network, you may be allowed to access other networks (and/or the computer systems attached to those networks). Each network or system has its own set of policies and procedures. Actions which are routinely allowed on one network/system may be controlled, or even forbidden, on other networks. It is the users responsibility to abide by the policies and procedures of these other networks/systems. Remember, the fact that a user can perform a particular action does not imply that they should take that action. The use of the network is a privilege, not a right, which may temporarily be revoked at any time for abusive conduct. Such conduct would include, the placing of unlawful information on a system, the use of abusive or otherwise objectionable language in either public or private messages, the sending of messages that are likely to result in the loss of recipients' work or systems, the sending of "Chain letters," or "broadcast" messages to lists or individuals, and any other types of use which would cause congestion of the networks or otherwise interfere with the work of others.. Permanent revocations can result from disciplinary actions taken by a panel judiciary board called upon to investigate network abuses.

Electronic Communication Dos and Donts

Under United States law, it is unlawful "to use any telephone facsimile machine, computer, or other device to send an unsolicited advertisement" to any "equipment which has the capacity (A) to transcribe text or images (or both) from an electronic signal received over a regular telephone line onto paper." The law 138

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allows individuals to sue the sender of such illegal "junk mail" for $500 per copy. Most states will permit such actions to be filed in Small Claims Court. This activity is termed "spamming" on the Internet Never give your userID or password to another person. System administrators that need to access your account for maintenance or to correct problems will have full privileges to your account. Never assume your email messages are private nor that they can be read by only yourself or the recipient. Never send something that you would mind seeing on the evening news. Keep paragraphs and messages short and to the point. When quoting another person, edit out whatever isn't directly applicable to your reply. Don't let your mailing or Usenet software automatically quote the entire body of messages you are replying to when it's not necessary. Take the time to edit any quotations down to the minimum necessary to provide context for your reply. Nobody likes reading a long message in quotes for the third or fourth time, only to be followed by a one line response: "Yeah, me too." Focus on one subject per message and always include a pertinent subject title for the message, that way the user can locate the message quickly. Don't use the academic networks for commercial or proprietary work. Include your signature at the bottom of Email messages when communicating with people who may not know you personally or broadcasting to a dynamic group of subscribers. Your signature footer should include your name, position, affiliation and Internet and/or BITNET addresses and should not exceed more than 4 lines. Optional information could include your address and phone number. Capitalize words only to highlight an important point or to distinguish a title or heading. Capitalizing whole words that are not titles is generally termed as SHOUTING! *Asterisks* surrounding a word can be used to make a stronger point. Use the underscore symbol before and after the title of a book, i.e. _The Wizard of Oz_ Limit line length to approximately 65-70 characters and avoid control characters. Never send chain letters through the Internet. Sending them can cause the loss of your Internet Access. Because of the International nature of the Internet and the fact that most of the world uses the following format for listing dates, i.e. MM DD YY, please be considerate and avoid misinterpretation of dates by listing dates including the spelled out month: Example: 24 JUN 96 or JUN 24 96 Follow chain of command procedures for corresponding with superiors. For example, don't send a complaint via Email directly to the "top" just because you can. Be professional and careful what you say about others. Email is easily forwarded. Cite all quotes, references and sources and respect copyright and license agreements. It is considered extremely rude to forward personal email to mailing lists or Usenet without the original author's permission. Attaching return receipts to a message may be considered an invasion of privacy. Be careful when using sarcasm and humor. Without face to face communications your joke may be viewed 139

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as criticism. When being humorous, use emotions to express humor. (tilt your head to the left to see the emotion smile) :-) = happy face for humor Acronyms can be used to abbreviate when possible, however messages that are filled with acronyms can be confusing and annoying to the reader. Examples: IMHO= in my humble/honest opinion FYI = for your information BTW = by the way Flame = antagonistic criticism

Discussion Groups
When posting a question to the discussion group, request that responses be directed to you personally. Post a summary or answer to your question to the group. When replying to a message posted to a discussion group, check the address to be certain it's going to the intended location (person or group). It can be very embarrassing if they reply incorrectly and post a personal message to the entire discussion group that was intended for an individual. When signing up for a group it is important to save your subscription confirmation letter for reference. That way if you go on vacation you will have the subscription address for suspending mail. Use your own personal Email account, don't subscribe using a shared office account. Occasionally subscribers to the list who are not familiar with proper netiquette will submit requests to SUBSCRIBE or UNSUBSCRIBE directly to the list itself. Be tolerant of this activity, and possibly provide some useful advice as opposed to being critical. Other people on the list are not interested in your desire to be added or deleted. Any requests regarding administrative tasks such as being added or removed from a list should be made to the appropriate area, not the list itself. Mail for these types of requests should be sent to the following respectively:

The World Wide Web

Do not include very large graphic images in your html documents. It is preferable to have postage sized images that the user can click on to "enlarge" a picture. Some users with access to the Web are viewing documents using slow speed modems and downloading these images can take a great deal of time. It is not a requirement to ask permission to link to another's site, though out of respect for the individual and their efforts, a simple email message stating that you have made a link to their site would be appropriate. When including video or voice files, include next to the description a file size, i.e (10KB or 2MB), so the user has the option of knowing how long it will take to download the file. Keep naming standards for URL's simple and not overly excessive with changes in case. Some users do not realize that sites are case sensitive or they receive URL's verbally where case sensitivity is not easily recognizable. Infringement of copyright laws, obscene, harassing or threatening materials on Web sites can be in violation of local, state, national or international laws and can be subject to litigation by the appropriate law enforcement agency. Authors of HTML documents will ultimately be responsible for what they allow users worldwide to access. 140

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CHAPTER 3 THE STRENGTH BEHIND THE SALE

As a professional insurance agent, you already know that you are selling more than an insurance policy to your client. You sell security, peace of mind and freedom from financial worry in the event of a major catastrophe, death or disability. Your clients expect that the coverage you provide them is placed with a financially reliable insurer the strength behind the sale. As you will see in this chapter, there are many facets of this strength you need to know before any contract is signed and delivered. Even if you believe that the company you represent is beyond reproach, you assume personal liability for not being familiar with and monitoring its financial well being in the event of a problem, or worse; a liquidation. There are many tools in this chapter that can help you. Ultimately, however, you must make the final decision to place your client. When you do, be sure to document your motives. Finally, dont make any sale until you believe in the product your selling and you believe in the company that stands behind it.

INSURANCE REGULATION
Why Regulate Insurance?? Insurance??
In his book Insurance Risk, Howard Blanchard suggests three reasons for the need to regulate the insurance business: 1) The value of an insurance contract is only as good as the insurer's ability and willingness to fulfill the promises of the policy contract -- today and possibly decades away; 2) a system of insurance requires public confidence; and 3) insurance is a technical subject which requires skills and specific knowledge beyond the grasp of most people -- many individuals running insurance companies are attorneys, and attorneys have been accused, by some, of complicating simple issues and routine procedures. Blanchard cites several good examples of why regulatory intervention is important. A whole life policy, for example, may conceivably be in force for 80 years. If the insurer is sound and competently managed when the policy is first approved, its financial condition and management could, in the absence of safeguards, change during the remaining tenure of the policy. Also, in large measure, the continued solvency of an insurance company depends on the quality of its investments. If insurers are not held to some course of action that will continuously enable them to meet their obligations through sound investment practices, policy holders could suffer. Without any form of regulation or self policing, less than honest insurance managers might succumb to the temptation to seize present profits without concern for future solvency. Further, one must allow for the fact that most insurance contracts are written for the benefit of third parties, some of whom have little or no direct voice in the choice of an insurer. An example might be workers compensation or liability policies contracted through a broker. Many consumers who purchase these policies receive protection but may not even know the name the carrier, much less its financial condition. Obviously, their positions are improved where some form of insurer regulation is in place. In addition to these considerations, it is common knowledge that insurance is difficult to understand and the operations and locations of insurance companies are distant, complicated and highly specialized. Also, many state regulators are attorneys. As such, they are in a better position than most to represent the general public and penetrate the maze of financial accountability that insurers must heed. Of course, none of this adulation for regulation should be construed to mean that state regulators are perfect. But, between their efforts and the work of industry groups, the industry has been relatively successful in maintaining a historically high level of solvency and done much to protect the public from 141

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a few schemes that might, in their absence, be nothing short of racketeering. Events before the days of strict regulation are evidence enough of such possibilities.

The History of Insurance Regulation

Before 1850, insurers operated with little formal or direct regulatory supervision in the United States. The power of insurers was defined in their charters. In 1851, the New Hampshire Legislature created a full-time board of insurance commissioners. Massachusetts and Vermont enacted similar legislation in 1852, New York in 1859 and Rhode Island in 1865. As the number of companies expanded, the need for regulation grew -- especially around the time of the Civil War. During this period, incompetency and dishonesty caused many insurer failure. Policy owners were devastated and the entire industry became suspect. An 1869 United States Supreme Court decision,(Paul v.Virginia) held that insurance was NOT interstate commerce, and therefore not subject to the control of the federal government. That decision left insurance regulation in the hands of the various states. In the late 1800's, however, the Supreme Court ruled on many "public interest" cases which later, in 1914, resulted in legislation that established the right to regulate an industry where the public good was involved. While this could have paved the way for some form of federal regulation, the states still controlled. Policyowners at the time, however, were wise to limit their business among century old companies like Lloyds of London or deal only with fraternal organizations who offered protection for members only. In 1905, Congressional began an investigation of the life insurance industry ( The Armstrong Report) due to some serious financial reporting abuses with no resulting legislation. A related audit of nonlife insurers in 1910 (The Merrit Committee) found unchecked price competition abuses among fire and casualty companies. Inadequate rates, in turn, resulted in many insurer insolvencies. Still, however, the prevailing sentiment was that state administrators should be responsible for fair competition and public protection in the affairs of insurance. Each state went about establishing its own system of licensing insurers. In the years preceding the Great Depression, financial conditions of insurance companies improved, primarily because the investments backing insurers prospered by huge leaps in value. Starting in the late 1920s, however, the effects of depressed conditions and declining security values started taking their toll. Insurance companies, particularly in the fire and casualty area, were failing at unprecedented rates. Life insurers, with their assets invested primarily in bonds and mortgages, were less affected by the rapid decline in security prices. Concerned state regulators, at a 1932 National Convention of Insurance Commissioners, recommended that companies set up voluntary "contingency reserves". Despite a general acceptance of this idea by individual companies, failures continued. Fortunately, recovery of the market in late 1932, afforded new assurances to regulators and the public. It was about this same time that multi-state insurance companies became more prevalent. These and other major insurers had avoided closure, and proved able to absorb the adverse effects of deflation, at least for limited time frame. Insurance managers of this era, hopefully realized their mistakes, due largely to an inflation psychology. State regulators narrowly escaped widespread collapse and gained a degree of confidence in their ability to garnish industry support for some form of solvency standards. Bolstered by their ability to handle these early brushes with insolvency, state regulators maintained a front seat in controlling the industry. This position was not questioned again until 1944. Though previous Supreme Court decisions repeatedly held that regulation of insurance was not within the power of the federal government because insurance was NOT commerce, on June 5th of that year, the Court reversed itself (United States v. South-Eastern Underwriters Association), declared insurance to be commerce and therefore subject to federal regulation to the extent that it was interstate in character. While ALL members of the Supreme Court agreed that insurance was subject to regulation under the commerce clause of the Constitution, a majority decided that the Sherman Act, non-insurance related legislation already on the statute books, was more applicable. The Sherman Act established that the making or setting of prices, premium rates in the case of insurance, was illegal and since this was a function fundamental to the operation of most insurance companies. With the Supreme Court again decided, Congress showed no desire to takeover regulation and, in fact, passed the McCarran-Ferguson Act in 1945 which, in effect, formally invited the states to 142

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preempt the federal antitrust laws by regulating the business of insurance. In response to this Congressional invitation, individual states again prevailed as the responsible regulator for insurance business within their own jurisdictions. The result is that each state now maintains its own insurance department organized under the supervision of a commissioner, director or superintendent who is appointed or elected. Currently, twelve insurance regulators are elected. Throughout much of the 1950s, 60s and 70s it appeared that the insurance industry was not a major legislative subject, although the business of insurance continued to grow more complex. However, as the 1980s beget progressive "interest sensitive" products as well as an aggressive tort system, the strain on the industry began taking its toll. Insurer safety and solvency regulation became morning news again. No doubt, history will also view the late 1980s and early 1990s as watershed years in solvency regulation. This experience, however, is easily surpassed by the disturbing upheaval in other financial services institutions, regulated by the federal government. Namely, the number of bank failures during this time frame climbed to between 200 to 300 anually! This compares to only 80 to 90 insurance company failures during the same time frame.

The Objectives of Insurance Regulation

The regulation of the business of insurance is fundamentally a task of consumer protection. The primary goal of the regulator is to protect the interest of consumers -- whether as policy holders, potential insurance claimants, or taxpayers -- from the financial loss associated with insolvency. This means that regulators must closely monitor companies and, where possible, take action designed to prevent an insurance company's insolvency. It may also mean, where an insolvency is unavoidable, as is sometimes the case in a competitive free economy such as ours, regulators must take action to assure that losses to consumers resulting from the insolvency are minimized. Another objective of regulation is to assure the sense of fair play. Many people mistakingly interpret this to mean the control of free competition. Actually, it involves systems to be sure that insurance is available to the public on a fair and even basis. Inner city applicants should not be denied access to insurance or be "redlined" for simply living in a higher risk area. Another more recent example of fair play regulation is the State of Florida's moratorium to keep insurers from canceling homeowner policies en masse or hiking rates to recoup major losses experienced from Hurricane Andrew. Regulators are also around to assure equity. This refers to policy holder fairplay regarding equal treatment between one policy holder and another as well as equal treatment where participating policies must impartially distribute earnings back to policy holders without discrimination of any kind.

The Role & Process of State Regulation

Court cases have established that the federal government has the power to regulate insurance but has elected to remain silent. Over a period of 100 years, ending in 1945, there have been many pieces of legislation (discussed above) leading to the current day presumption that the regulation and taxation of insurance is, for now, the domain of the states. Congress has let it be known, however, that if state regulation becomes ineffective or deficient in serving the public, the federal government maintains the right to takeover. During times of great economic stress and larger than normal insurance company failures, such as that experienced in the early 1990s, the threat of the federal intervention is routinely revived. Regulation of insurance was at first the duty of state legislators. Their role was to help control insurer solvency, regulate rates, apply rules of fair play, oversee agent licensing, supervise company reporting and evaluate insurer finances in the areas of valuation of assets, investments, surplus, etc, as well as assume the prominent role as "executor" in the liquidation of troubled companies. However, because many of these areas require specialized knowledge, most states have found it necessary to establish their own departments of insurance. Insurance laws are still the jurisdiction of state legislators who depend on their respective departments of insurance to develop and evaluate proposed laws which are typically drafted with the aid of the state attorney general. The official in charge of insurance regulation 143

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is the commissioner, superintendent or director. He is usually appointed by the governor and is considered a powerful force in determining the direction and intensity of insurance regulation. Insurance departments have the authority to make and enforce rules. The authority to make these rules is known as administrative law. However, rules of the commissioner can be challenged or regulated through state judicial review or state insurance authority. Also, court rulings will reinforce or change state insurance regulations. Today, it is staggering to learn, there are almost 6,000 different insurance companies being regulated in the United States, collecting over $600 BILLION in premium per year (Insurance Information Institute). According to author Wesley Smith "...This amounts to 12 percent of the disposable income in the United States. Americans pay more for insurance (direct and indirect) than they pay for federal income taxes, not counting Social Security. Obviously, the task of regulation is a mammoth undertaking. Yet, the size of state insurance departments' staffs varies from a dozen to over 1,300, with a national aggregate staff of just under 9,000 (1990). Similarly, the budgets for these departments cover a range from a low $750,000 to $67,000,000, with a national budget of over $458 million (Government Accounting Office report to the Senate Subcommittee on Policy Research and Insurance, July 29, 1991).

Other Regulatory Efforts

Like other systems of authority, the regulation of the insurance business by state agencies has been the subject of criticism. The issues include poor enforcement, lack of attention, lack of uniformity between states. Early attempts to create uniformity were primarily undertaken by private industry groups like the South-Eastern Underwriters Association (SEUA). At one time, this organization controlled 90 percent of the fire insurance within its stated jurisdiction. The SEUA established underwriting guidelines, agent requirements and other strict procedures until in 1942, the U.S. attorney general accused it of violating the Sherman Antitrust Act. Among other charges, the SEUA was eventually indicted for restraining interstate trade and monopolizing insurance business. The longest surviving organization for promoting universal standards is the National Association of Insurance Commissioners. The remaining portion of this chapter is dedicated to the efforts and inner workings of this group and its attempt to create a "model system" among all state departments of insurance. Suffice to say, the group's efforts have been more successful than any agency in unifying state cooperation. In spite of this, however, model laws are still not in force in every state. Specific "model laws" that are working in many states are generally believed to be effective. Further, nonparticipating states, under recent threat of federal intervention, are under more pressure than ever to comply with NAIC "model acts". Examples of the type of NAIC model acts in wide use include standards and rules concerning standard annual reports, uniform liquidation procedures, product improvements such as easy to read policies, indexes for price comparing insurance rates, model laws for regulating insurance rates and the availability of coverage, authority to revoke licensing of unauthorized insurers, risked based capital requirements, proposed model investment laws, etc. Still at discretion for state regulators are the rules and business procedures such as: agent licensing and continuing education, agent rebating, agent misrepresentation, agent discrimination, unlicensed insurers ( nonadmitted companies), capital and surplus requirements, loss reserve ratios, policy owner dividends and state guaranty funds.

The National Association of Insurance Commissioners & Insurance Regulation

A Brief History of NAIC
The National Association of Insurance Commissioners is a voluntary organization composed of the insurance commissioners from each state. Its primary purpose is to create uniformity in state insurance laws. The organization has grown from a simple advisory role into a constructive participant in legislative 144

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issues and major creator of "model laws" now in use by a majority of states. The National Association of Insurance Commissioners' involvement in solvency regulation dates back to its formation 120 years ago. In fact, the NAIC was created specifically to address a series of insurance company insolvencies in the late 1860s and early 1870s. Since then, state regulators have worked together, through the NAIC, to coordinate protection of the consumer from financial and personal loss that can result of the insolvency of an insurance company. The resulting system of insurance regulation provides a high degree of uniformity in the supervision of interstate companies, yet is sufficiently decentralized to provide responsiveness to insurance consumers and a sensitivity to the regulatory needs of a diverse nation. In 1875, the NAIC adopted the predecessor the Annual Statement Blank which, since then, has served as the uniform financial reporting form for all insurance companies. Thirty-four years later, in 1909, when changing, and sometimes fraudulent, investment practices by insurers threatened the stability of the industry, the NAIC established the Securities Valuation Office (SVO) to provide uniform valuations of insurers' securities. In the 1930s and 1940s, multi-state insurance companies became more prevalent. The NAIC responded, first by establishing the "zone examination system" for the regional examination of multi-state companies, then by publishing the NAIC Examiners Handbook to standardize zone examination procedures. During the 1960s and 1970s, as the business of insurance continued to grow more complex, the NAIC responded with a host of improvements in solvency regulation. These enhancements included the adoption of model guaranty association acts and the institution of a centralized database and Early Warning System to help identify and prioritize troubled companies. This system was later expanded to become what is now known as the Insurance Regulatory Information System (IRIS). Further standardization of solvency regulation was achieved with the release of the statutory accounting manuals for life and property/casualty companies and the Troubled Companies Handbook.

What Does NAIC Do?

The NAIC plays an integral role in the insurance regulatory framework, a role which is being significantly enhanced as increasing demands are placed on state regulators. NAIC coordinates and assists state solvency efforts in a number of ways, including: maintaining an extensive insurance database and computer network linking all insurance departments; analyzing and informing regulators as to the financial condition of insurance companies; coordinating examinations and regulatory actions with respect to troubled companies; establishing and certifying states' compliance with minimum financial regulation standards; providing financial, reinsurance, actuarial, legal and computer and economic expertise to insurance departments; valuing securities held by insurers; analyzing and listing non-admitted alien insurers; developing uniform statutory financial statements and accounting rules for insurers; conducting education and training programs for insurance department staff; developing model laws and coordinating regulatory policy on significant insurance issues; and conducting research and providing information on insurance and its regulation to Congress, government agencies and the general public. These activities facilitate state regulators' oversight of a complex industry extending across state and national boundaries while also enabling them to better respond to the concerns and unique aspects of their particular jurisdictions. The NAIC has grown rapidly in recent years to be able to expand its services to state regulators and the general public. The NAIC currently has a highly trained, professional staff of 142, representing a 240 percent increase since 1982. The NAIC's budget has grown almost four-fold over the last ten years to $16.2 million to support increases in staff, new programs and maintenance and enhancement of its expanded information systems. To talk about all of the NAIC's activities in depth would take several chapters, but it is useful to outline several of those activities in greater detail.

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1. DATABASES & INFORMATION SYSTEMS -- The NAIC has amassed the most extensive financial database available on insurance companies accessible to state insurance departments through an advanced computer information network. The NAIC database contains five years of detailed annual and quarterly financial information on-line for approximately 5,400 insurance companies, in addition to data maintained off-line to the mid-1970s. The current database, systems and technology reflect a four-year $17.6 million investment to provide state regulators and NAIC staff with a "state-of-the-art" information facility. The processing of annual statement data alone for 5,000 plus companies is a massive effort as each filing runs a gauntlet of 13,000 cross-check edits and careful review by a team of data quality specialists. Development of the database is closely integrated with the NAIC's development of the annual statement blank and accounting rules as well as the related specifications for diskette filings, which now comprise 90 percent of all filings. The NAIC database serves as the core of the solvency surveillance and other analysis activities of state insurance regulators and the NAIC. State regulators and NAIC staff access the database through a variety of sophisticated application systems which allow them to access data on specific companies, generate "canned" reports on a group of companies, or generate custom reports to suit their specific needs. Every state department has at least one personal computer, provided by the NAIC, plugged into the NAIC network and 19 states have host-to-host connections allowing them to tie in other terminals. More than 500 insurance department users have direct access to the NAIC system and the number continues to grow. This national insurance database also has been provided to the GAO, federal agencies, academies, rating organizations and various other users. In addition, the information contained in the database is made available to the public in a variety of statistical reports and special studies. The NAIC maintains a number of other databases which state regulators and NAIC staff utilize for financial analysis and other regulatory functions. The Alien Reporting Information System (ARIS) provides financial reports that show reinsurance ceded to alien insurers, along with identifying any invalid federal employer identification numbers (FEINs), alien numbers or company locations. The on-line Valuation of Securities (VOS) system provides a complete VOS manual listing of securities held by insurers, along with historical data beginning with 1989, for financial review purposes. This database also contains individual portfolios of the 275 subscribing companies that maintain their stock/bond portfolio on the NAIC computer system. The Omnibus Budget Reconciliation Act (OBRA) reporting system permits states to satisfy Medicare supplement insurance reporting requirements. Companies that write Medicare supplement insurance are instructed to send a completed OBRA reporting form to the NAIC. The NAIC then produces the required reports on behalf of each state and files them with the Health Care Financing Administration (HCFA). The NAIC maintains other special databases containing information on regulatory actions against insurers and agents, the Regulatory Information Retrieval System (RIRS), and information on entities of regulatory concern, the Special Activities Database (SAD). RIRS, in existence since 1983, and SAD, initiated in 1990, greatly enhance regulator's ability to share information on individuals or companies possibly involved in illegal or questionable activities and prevent their infiltration into new areas. The RIRS database contains information on more than 49,000 agents and companies against which some regulatory action has been taken. State regulators and NAIC staff also use an electronic mail system on the NAIC's computer network to communicate rapidly and coordinate with each other on examinations, regulatory actions, troubled companies, entities of regulatory concern and a variety of other matters. In addition to maintaining databases and systems, NAIC staff frequently provide consulting services to state insurance departments seeking assistance in enhancing their information systems. 2. FINANCIAL ANALYSIS & SOLVENCY SURVEILLANCE -- Financial analysis and other solvency surveillance are also major areas of activity for the NAIC. The NAIC has long served a vital coordinating function in the event that a single large, multi-state company experiences financial difficulty. Since the early 1970s, the Insurance Regulatory Information System (IRIS) has served as the NAIC's baseline 146

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system for monitoring insurers' financial condition at a national level and identifying those insurers requiring further regulatory attention. Companies are first processed through a statistical phase consisting of a series of eleven financial ratios followed by a series of additional screening criteria. Companies showing unusual results are then analyzed further by a select team of state financial examiners who recommend further investigation by the companies' domiciliary regulators, if necessary. Companies deemed to be "high priority" are followed up by the NAIC's Examination Oversight Task Force which takes action if the domiciliary state fails to do so. Insurers' IRIS ratio results also are available to regulators over the NAIC network and to the public in a hard copy report. Although the IRIS has and will continue to be an important financial analysis tool for regulators, as explained earlier, the NAIC is constantly developing new solvency analysis systems. NAIC will use these systems and other kinds of quantitative and qualitative information to identify companies which may be in financial difficulty. 3. OTHER NAIC FUNCTIONS -- The NAIC supports the insurance regulatory process in a number of other ways. In the financial area, the NAIC's reinsurance experts advise state regulators on reinsurance transactions and contracts and reinsurance reporting issues. These experts also develop reference manuals that will assist regulatory examiners and analysts in evaluating reinsurance agreements. This section also operates ARIS and produces a series of special reports on companies' reinsurance activities and problems. The NAIC's Computer Audit Specialist assists insurance examiners in using special audit software and automated procedures to perform more comprehensive and efficient examinations. A number of special examination routines have been developed including analysis of insurers' securities, reinsurance ceded and assumed and loss reserves. In 1987, the NAIC purchased a master license for several audit software products which are now being used by 35 states. To further facilitate this activity, the NAIC's computer audit specialist has developed an Automated Examination Procedures Manual, publishes a quarterly newsletter, and conducts several regional training sessions each year to increase regulators' knowledge of the audit software and automated techniques. The NAIC's Securities Valuation Office (SVO) determines uniform accounting values of insurers' securities investments which include government, municipal and corporate bonds, and common and preferred stocks. The SVO database contains approximately 185,000 securities for almost 32,000 issuers. Each security in the database is reviewed and valued annually and published in the Valuation of Securities Manual. The Non-Admitted Insurers Information Office (NAIIO) maintains a Quarterly Listing of Alien Insurers which states may utilize to determine surplus lines carriers eligible or approved to operate in their jurisdictions. To qualify for the listing, an alien must submit financial information, pass a financial and operational review, meet certain capital and surplus requirements and establish a U.S. trust fund. The NAIC's Special Services Coordinator tracks and advises regulators concerning the activities of individuals, agencies and companies that are causing or have the potential to cause regulatory problems within their jurisdictions. He also assists regulators in investigating and coordinating insurance fraud cases with local, state and federal law enforcement authorities. In addition, the Special Coordinator publishes Special Report, a bimonthly newsletter to provide information on companies, individuals and practices that could affect insurers' financial stability. Market conduct activities also have expanded significantly at the NAIC to better support the states' extensive activities in this area. In addition to maintaining the RIRS and SAD system, the Market Conduct Coordinator is supporting the development of a new nationwide complaint database and a system for tracking basic profile data on entities involved in the insurance business. Information from the complaint database will be used to target companies for market conduct and financial examinations. These systems will further enhance state regulators' efforts to ensure that consumers are treated fairly in the insurance marketplace and that their claims are handled properly. 147

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The NAIC's Education and Training Department conducts programs, workshops, seminars and other educational activities that deal with insurance issues and regulation for commissioners, their professional regulatory staff members and others concerned about the regulatory aspects of insurance. In addition to regular commissioner and staff programs, a special program developed for financial examiners has won a national award and other workshops have been conducted on solvency, health insurance and legal issues. Finally, the NAIC serves an important research and information function for state regulators, Congress, federal agencies, the industry and the general public. The NAIC's Research Division and other divisions generate a number of standard, as well as custom, statistical reports and conduct special studies on industry investments, competition and profitability. The NAIC's Research Library maintains an 8,000 volume specialized insurance regulatory collection, conducts research for state insurance departments and answers numerous questions about insurance and insurance regulation from a variety of sources.

Recent NAIC Accomplishments

There are several key areas where NAIC has taken an active role in solvency regulation. These efforts culminated in the 1989 NAIC Solvency Policy Agenda which has five main components: The Financial Regulation Standards Improved reinsurance evaluation A more effective financial examination process Improved solvency analysis support Enhanced capital analysis & requirements

1. FINANCIAL REGULATION STANDARDS -- In this environment, in which troubles in the federally regulated financial institutions have shaken consumer confidence in all financial institutions, the NAIC has moved aggressively to enhance what has long been a sound system of insurance regulation by beginning the process which led to the 1989 adoption of the Financial Regulation Standards. These minimum standards establish bottom line requirements for state solvency regulation in three areas: laws and regulations, regulatory practices and procedures, and organizational and personnel practices. In order to provide guidance to the states regarding the minimum standards and an incentive to put them in place, the NAIC adopted a formal certification program in June 1990. Under this plan, each state's insurance department will be reviewed by an independent review team whose job it is to assess that department's compliance with the NAIC's Financial Regulation Standards. Departments meeting the NAIC Standards will be publicly acknowledged, while departments not in compliance will be given guidance by the NAIC on how to bring the department into compliance. Furthermore, beginning in January 1994, accredited states will not accept reports of examination from non accredited states, providing further impetus for states to adopt the minimum standards. We expect that, as the standards are enhanced and more states enact them, greater pressure will be placed on other states to become accredited. In fact, the NAIC Executive Committee has endorsed a Model Act which would provide a powerful incentive for adoption of the NAIC's minimum standards. The Model Act, which is still under consideration, would sanction companies domiciled in non accredited states by requiring them to meet the solvency regulations of every accredited state in which they do business, as "designated by the department in a regulation adopted pursuant" to the Act. As a result of these and other contemplated sanctions, being domiciled in an non accredited state will increasingly become a liability, inducing states to meet the standards or witness the redomestication of their companies. Furthermore, the heightened scrutiny of such companies by the accredited states will provide added protection for insurance consumers. Another element of the Financial Regulation Standards looks at the resources available to state insurance 148

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departments to enforce the laws and regulations imposed on insurance companies. The last several years has witnessed a dramatic increase in resources, both economic and human, that states have brought to bear upon insurance regulation. From 1985 to 1990, funding for state insurance departments increased by 96.7 percent. Similarly, from 1986 to 1989, the aggregate staffs for state insurance departments increased by 23.2 percent. This growth in personnel and resources has resulted in a 12.4 percent increase in the number of insurance department staff per company. Finally, one reason that total department funding has increased faster than staff levels is that insurance departments are making substantial investments in computer technology for improved solvency surveillance. 2. IMPROVED REINSURANCE REGULATION -- Regulation of reinsurance activity, by which insurers spread their own risk to other companies, is of particular importance to state regulators. In order for insurance consumers to be confident that their own insurance companies can make good on their promises, consumers must be confident that their insurer's reinsurer is willing and able to keep its promises. The regulatory challenge posed by reinsurance is made more complex by the fact that many reinsurers are based overseas and, therefore, are not subject to the direct regulation of either the state or federal governments. Several decades ago, state regulators devised a method of protecting U.S. insureds by regulating the degree to which the primary insurer may reduce the liabilities on its balance sheet by taking credit for the reinsurance ceded by the insurer. In 1984, this concept was codified in the Model Credit for Reinsurance Act , which allows such a reduction of liabilities only if the reinsurer is licensed in the state, is accredited, qualifies under either the so-called Lloyd's or ILU provisions, or establishes either an acceptable trust, letter of credit, or cash deposit. Through the direct impact this treatment has upon the balance sheet of the primary carrier (the "ceding insurers"), state regulators can exercise a formidable influence over reinsurers, whether licensed to do business in a state or not. Perhaps the most dramatic changes in the regulation of reinsurance have come about in the area of reporting requirements. The most notable of these is a new detailed requirement which gives primary carriers a financial incentive to assure that their reinsurance companies pay promptly. Furthermore, by incorporating the rule into the NAIC Annual Statement Blank, it has become a uniform reporting requirement in every state. Finally, the rule allows regulators across the nation to quantify the extent of overdue reinsurance and identify slow-paying reinsurers. Another important development in the realm of reporting requirements is the creation of a more refined, computerized NAIC reinsurance data base. Beginning with the 1989 Annual Statement, reinsurers are now identified with a unique identification number. As a result, regulators can track the reinsurance operations of all companies in the U.S., including reinsurance ceded to virtually any company worldwide, and thus are able to evaluate the ripple effect of potential reinsurance insolvencies upon the rest of the industry. This ability to spot potential land mines that lie in the path of an insurer's financial health will better equip regulators to avoid or minimize solvency problems. Also, regulators are able to quantify reinsurance ceded to alien reinsurers and identify insurers which are highly leveraged by reinsurance transactions. For some time, American regulators have been concerned about their lack of authority over reinsurance intermediaries and brokers. The potentially dangerous practice by some insurers of turning over critical management decisions to intermediaries, and the resulting improprieties encouraged by this practice, led the NAIC to craft the Reinsurance Intermediary Model Act. This act mandates licensing for brokers and managers of reinsurance and establishes minimum requirements for the relationship between ceding insurers, intermediaries and reinsurers. For similar reasons, the role of managing general agents has come under scrutiny leading to the September 1989 adoption by the NAIC of the Model Managing General Agents Act. A managing general agent is an agent who either handles the reinsurance contracts for an insurer or manages all or part of its insurance business, and underwrites premiums in the amount of at least five percent of the company's net worth. Like the Intermediaries Model, the MGA Act prescribes limitations on the 149

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relationship between insurers and MGAs. These limitations are designed to weed out the improprieties that led to the abuse of the MGA function in some of the more conspicuous insolvencies of recent times. Both of these models are included in the NAIC=s solvency standards and will be necessary for accreditation. Furthermore, the National Association of Insurance Commissioners are allocating additional resources within the NAIC to assist state insurance departments in interpreting reinsurance contracts and evaluating reinsurance companies. When combined with our recent creation of a reinsurance database, this will do much to strengthen the ability of regulators to regulate this important sector of the industry. 3. MORE EFFECTIVE EXAMINATIONS -- Another key component of the NAIC Solvency Policing Agenda for 1990 was an overall assessment of examination processes. The concept of effective regulatory examination involves several components: (1) a system by which regulators are warned in a timely fashion that an examination of a particular company is called for, allowing for a targeted allocation of examination resources, (2) a financial reporting system upon which regulators can place substantial reliance, (3) on-site examinations that are timely and targeted toward those companies most in need of examination, and (4) high quality examinations. While state regulators and the NAIC have operated under an examination system that has proven over time to be quite effective, there has been substantial activity to improve that system. The NAIC is dedicated to improving the system by which regulatory efforts are focused on those companies most in need of close scrutiny. They have created a centralized financial analysis unit within the NAIC which is developing additional statistical measures to the IRIS financial ratios so that they continue to be useful to insurance consumers, regulators and others. This unit also is developing a series of computerized analytical routines which will be utilized by state insurance departments to enhance their financial analysis and solvency monitoring activities. Furthermore, they also have developed computerized and other financial analysis techniques to support the activities of the Potentially Troubled Companies Working Group in its oversight role. Additionally, the NAIC will continue to assist states in developing and improving financial statement analysis capabilities and techniques. Of the various planks of the solvency platform adopted in December 1990, one of the most important was the requirement that insurance company financial statements be subject to an annual audit by a Certified Public Accountant (CPA). This requirement was adopted both as a Model Regulation and as an amendment to the Annual Statement Instructions. The significance of the incorporation of the CPA audit requirement into the instructions is that it takes effect immediately in all 55 jurisdictions. The NAIC also adopted a multi-faceted proposal which requires that the mandatory actuarial opinions regarding the adequacy of a property/casualty insurer's reserves comment specifically upon items which might materially affect reserves, such as discounting, reinsurance collectibility, financial reinsurance, loss portfolio transfer, and salvage/subrogation. Perhaps as important a change was the requirement that the actuarial opinion address both gross and net reserves, a modification that will give regulators a clearer picture of a company's total potential liability, if reinsurance agreements were to fail. Recently, the NAIC adopted a Model Law on Examinations which represents a conceptual change with respect to the frequency and scope of on-site financial examinations of insurers. By authorizing the Commissioner to conduct examinations whenever it is deemed necessary, and no less frequently than every five years, it is designed to direct department resources toward the examination of companies most likely to encounter financial trouble. This conceptual change can be accomplished because of the recent addition of new financial regulatory tools -- such as independent CPA audits, opinions on insurance reserves by actuaries, computerized annual financial statement analyses, and quarterly reporting by insurers, among others -- which mitigate the need for frequent comprehensive periodic examinations of all companies. 150

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At the 1990 Winter National Meeting, the NAIC also received a report from the Examination Processes Committee which included 17 recommendations regarding the examination process. One of the more important recommendations involves improving the Examiners Handbook, incorporating the American Institute of Certified Public Accountants' generally accepted auditing standards, tailored where appropriate for the regulatory perspective, and establishing a system for annual review. Other recommendations of the Examination Process Committee involve the creation of an NAIC Education and Research Foundation and the upgrading of qualifications of financial examiners. One of the challenges facing regulators is expanding the pool of financial examiners, auditors, and regulators with the necessary knowledge to perform complex insurance regulatory activities. 4. IMPROVED SOLVENCY ANALYSIS SUPPORT -- In recognition of the need to enhance the NAIC's solvency analysis support to the states, the NAIC has bolstered its budget. The NAIC's staff of financial analysts has been increased in order to better track insurance department handling of companies that are facing solvency problems. Analysts also have developed an additional computer based financial solvency analysis system. The NAIC serves a vital coordinating function in the event that a single large, multi-state company experiences financial difficulty. The NAIC's approach to such situations is based upon two fundamental premises: (1) that a smooth flow of information, always important to the effective regulation of the industry, is even more critical when a company gets into trouble, and (2) that a peer review process involving independent state regulators with common and interdependent interests can provide greater protection for consumers than is available from unitary systems of regulation. This philosophy can be seen in the operation of the NAIC's Potentially Troubled Companies Working Group. Created two years ago to deal specifically with large, potentially financially troubled insurance companies, the Working Group is a multi-state committee of state regulators supported by the staff of the NAIC's Division of Financial Analysts. When the Working Group identifies, through a sophisticated form of financial analysis based on the results of key financial ratios, a company that may be facing difficulties, the NAIC Member in whose state the company is domiciled is contacted by the NAIC and asked to report on that state's regulatory responses to the difficulty. Should the NAIC Member refuse to respond or provide a response that, in the opinion of the Working Group, is an inadequate regulatory response to the company's predicament, the Working Group prepares a coordinated interstate plan of action for implementation by the non-domiciliary states most likely to be affected by any problems that might arise. 5. ENHANCED CAPITAL ANALYSIS & REQUIREMENTS -- For nearly four decades, state regulators have utilized a form of risk based capital regulation for stocks and bonds held by insurers. Life and health companies are required to establish reserves for their investments in securities, the size of which are based upon the quality of the assets. For example, a low grade bond in an insurer's portfolio might require the establishment of a reserve that is twenty times higher than that required for a high quality bond. Similarly, property/casualty companies may carry high grade bonds on their books at their amortized value, but must carry their lower grade bonds at the lesser of market value or amortized cost. However, like their counterparts in the banking regulatory community, state insurance regulators realize that a more comprehensive risk based approach to capital requirements -- one that addresses asset risk for all assets, e.g., insurance risk, interest rate risk, and business risk -- will improve solvency regulation. The NAIC charged two working groups to develop the now enacted Model Act on Risk Based Capital. The NAIC also has drafted a Model Investments in Medium Grade and Lower Grade Obligations Act to establish an aggregate cap of 20 percent on medium and lower grade obligations, with a graded system of caps based upon the quality of the obligations. The purpose of this regulation is to allow insurers some flexibility to invest company assets in medium to lower grade bonds, while at the same time assuring that the special risks associated with such bonds are mitigated in terms of the overall solvency of the company. These limitations will help to prevent a recurrence of the recent problems encountered by Executive Life and other insurers heavily invested in medium to lower grade bonds. 151

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The NAIC is also working on a proposal to conform preferred stock ratings to the same categories used for bonds. The regulators are evaluating the impact of the proposed benchmarks, dictating which stocks would be carried at cost and which would be carried at market value and are expected to develop a proposal for action this year. Additionally, a task force of the NAIC is surveying all insurers to develop more detailed information on their investments in real estate, mortgages, and other assets with real estate related exposure. This information will ultimately be used to further improve the reporting of and establishment of valuation reserves for these investments.

NAIC & Proposed Federal/State Regulation

Conditions of the market have launched a flurry of proposals to improve regulation. Proponents have authored suggestions ranging from complete abandonment of state regulators to a co-op of state and federal agencies. The NAIC has long opposed the expansion of federal involvement in insurance regulation with the exception of a few areas. A highranking NAIC official put it this way: "We have done this, not out of a sense that our "turf" must be preserved, but because of our frequent experience that, more often than not, such involvement (by the federal government) hinders the resolution of the very problems it is intended to solve". An example is the Employee Retirement Income Security Act (ERISA) and its unfortunate consequences for the states which now must resolve the questions about whether certain health and welfare plans, specifically Multiple Employer Welfare Arrangements (MEWAs), are exempt from state insurance laws. Other examples include the federal laws authorizing risk retention groups and purchasing groups. These regulations have done little but promote entanglements between federal and state jurisdiction. In summation, the National Association of Insurance Commissioners states: "We approach the prospect of federal involvement in what historically has been our responsibility with caution, and base our evaluation on a case-by-case analysis. We are certain that overly broad involvement by the federal government poses great risks to the protection of the American insurance consumer". The NAIC does, however, concede that in the federal government can be of great assistance to state regulators in two primary areas: Fraud and Crime Statutes. All regulators, have seen the damage that can be suffered by consumers at the hands of unscrupulous operators -- con artists who ply their trade from board room, office penthouse or agency. In addressing these problems, state insurance regulators usually have only two options -- criminal remedies and civil remedies. Federal assistance, according to the NAIC, could be most helpful on the following issues: Interstate Statutes -- States have power to deter and punish fraud and other corrupt activities in insurance companies in criminal actions. Additionally, the NAIC has recently created the Special Activities Database to help state regulators track individuals who have a history of involvement in insurance insolvencies. Given the existence of these state remedies and NAIC tools, why, then, is a federal criminal statute necessary? The answer to this question lies in the interstate and sometimes international nature of many insurance fraud schemes. In some cases, prosecution of anyone responsible for a company's downfall in a state court would require extradition on a massive scale and could fail, due to jurisdictional problems. In other cases, not a single witness or piece of paper relating to the fraudulent transactions can be found in the state of domicile of the insurance company. A federal network could help remedy this situation. Federal Fraud Statutes -- Federal prohibitions of mail fraud and wire fraud are available criminal remedies for prosecutors seeking to punish those who would raid the coffers of an insurance company. However, these statutes have an important limitations. First, the requirement of the use of the mail can be avoided by perpetrators of fraud with relative ease. In the case of the filing of fraudulent financial reports with the state insurance regulator, some unprincipled thieves have been known to hand deliver financial reports to regulators simply to avoid the reach of mail fraud statutes. Requiring that all insurers mail their reports and applications will raise the specter of federal prosecution in the event those reports have been falsified. Second, there is a five-year statute of limitations found in federal mail and wire fraud. 152

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This imposes a constraint on the usefulness in prosecuting insurance fraud because the detection and investigation of complex multi-state insurance schemes easily can exceed this five-year time period. In essence, NAIC believes there is a need for federal which: Specifically addresses insurance fraud, Prescribes strong criminal penalties Can be used in multi-state schemes Provides investigators and prosecutors with a statute of limitations which provides enough time for the preparation of a solid case.

In recent hearings before Congress, the NAIC did set forth proposals which, if approved, could address many of these deficiencies, improve multi-state coordination and make efficient use of federal and state cooperative regulation. Following is a discussion of the most valuable offerings.

The NAIC Proposal for a Federal Criminal Statute

The National Association of Insurance Commissioners proposal to establish federal crime statutes to aid insurance regulation consists of a set of amendments to Title 18 of the U.S. Code. This section is currently dedicated to federal provisions covering crimes regarding financial institutions. The NAIC's proposed statute is designed to reach criminal activity affecting "the business of insurance", as defined in the McCarran-Ferguson Act. This broad definition is used to encompass activity by the full array of individuals whose fraud might harm insurance consumers, including any acting as or on behalf of an insurer, reinsurer, producer, reinsurance intermediary, broker, insurance consultant or adjustor. The federal statute proposed would specifically establish four federal offenses regarding insurance fraud. First, it would make it a crime to knowingly file with a state insurance regulator fraudulent financial statements. Second, it would ban embezzlement and theft of insurance company money, funds, premiums or credits. Third, the bill would prohibit the falsification of company records with the intent to defraud the company or its policy holders and creditors. Further, the proposal would outlaw the criminal obstruction of proceedings before state insurance regulatory authorities. Finally, the fourth proposal would also make conviction under the statute a predicate offense with respect to a federal civil RICO action. The NAIC proposal calls for stiff penalties, appropriate to the seriousness of the harm that can be caused by the perpetrators of insurance fraud. For the most serious offenses, maximum penalties are as high as $1,000,000 and/or 30 years imprisonment. Perhaps, as important is a prohibition, absent specific approval by the authorized state insurance regulatory official, of insurance related activity by a person who has been convicted of any criminal offenses involving dishonesty or a breach of trust or any of the offenses described in this statute. This is particularly important to the prevention of repeated abuses by previously convicted charlatans who would evade scrutiny by changing jurisdiction after conviction in one state. The proposal also establishes a Ten-year statute of limitations for the offenses proscribed under the act. This is a straightforward recognition that crimes of this sort can take years to detect and investigate, a reality that is reflected in the similar federal statutes dealing with crimes against other financial institutions. A federal statute with significant "punch" that NAIC proposes to access is the RICO Act. In 1970, the Congress enacted The Racketeer Influenced and Corrupt Organization Act (RICO) to curb crime and its spreading influence, particularly in the arena of American business. The RICO Act goes about this task with both criminal and civil provisions. In the 21 years the statute has been in place, federal prosecutors have used the criminal sanctions of the bill with increasing frequency and increasing success. The civil 153

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provisions of RICO, which allow actual damages to be trebled, have been used not only by the federal government, but by state government and private plaintiffs as well. The advantages of these civil remedies over RICO's criminal sanctions are several. First, the criminal justice system is confined in its ability to reach some of the subtler forms of fraud. Limitations on law enforcement resources, the cumbersome nature of criminal proceedings, and the higher standard of proof, all combine to restrict the use of RICO's criminal penalties to only a fraction of the instances of fraud that the Congress targeted by enacting RICO 21 years ago. A second advantage of the civil proceedings provided by the RICO Act is that they extract a very real financial penalty against corporate thieves. The powerful economic deterrent created by the prospect of damages in the amount of three times the actual damages caused by fraud says, loudly and clearly, that this crime will not pay. Third, an injured plaintiff facing the daunting legal costs of a civil RICO action will find that potential burden less intimidating when balanced against the prospects of treble damages. Furthermore, unlike the criminal penalties, RICO's civil damage provisions offer an injured party a very real prospect of being made whole. Too often, regulators and the NAIC claim to have witnessed people entrusted with the health of an insurance company exploit that trust to gut the company and leave its carcass for the insurance commissioner to revive or bury, usually the latter. Because of the limitations posed by existing law -- both state and federal -- to state insurance regulators, the civil provisions of RICO would be a most potent weapon in the arsenal against these types of conspiracies. When financially impaired, an insurance company may be taken over at the direction of the state insurance department under a court order for the purpose of accumulating company assets, paying policy holder claims, and winding up the business affairs of the company. The liquidator or rehabilitator of an impaired or insolvent company, in most cases a state insurance regulator, can bring a federal civil RICO action against persons or companies who, through fraudulent activity, contributed to the financial decline of the company. Today, many state regulators are in the midst of such civil suits. It is no accident that RICO is a favorite remedy for the most serious instances of insurance fraud -- the Act was tailor-made for the kinds of abuses that can be found in the insurance industry. As a cashintensive business that involves the receipt of premiums in exchange for little more than a promise of future payment, insurance acts as a magnet for con artists. As often as not, the fraud connected with the practice of looting an insurance company into insolvency involves a number of people -- corporate executives, agents, brokers, and employees -- engaged in a common scheme involving multiple criminal activities. This is exactly the type of criminal involvement in American business that RICO was intended to address. Furthermore, a civil RICO action is particularly useful to a state insurance regulator trying to minimize losses to insurance consumers and taxpayers alike. Most every state has a property-casualty insurance guaranty fund and a life insurance guaranty fund which are designed to pay the claims of policy holders and other claimants of an insolvent company. State guaranty funds are financed by assessments made against the other insurers doing business in the state, which assessments are often passed on, market conditions allowing, to the healthy companies' policy holders and/or the state's taxpayers. A chief objective of a state regulator in charge of an insolvent insurer is the minimization of guaranty fund costs resulting from the insolvency. When a conspiracy to defraud an insurer contributes to an insolvency and thereby creates the need for such assessments, the policy holders and taxpayers of a state may reap substantial benefits from an insurance regulator's use of civil RICO to recoup at least a portion of the losses to the guaranty fund. In other words, civil RICO is an invaluable means of assuring that the costs of insurance fraud fall upon the culprits instead of the general public. In recent years, there have been efforts in the Congress to limit the use of the civil provisions of the RICO Act. The most recent effort is found in H.R. 1717, currently pending in the House Judiciary Committee. While it is a major improvement over previous versions, the bill would still inhibit the ability of state insurance regulators to pursue the ill gotten booty of insurance fraud. Because of this defect, NAIC continues to oppose this and any other Congressional effort to hamstring any efforts to bring the perpetration of insurance fraud to justice. 154

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The National Association of Insurance Commissioners proposal concerning assistance also focuses on federal regulation of non-U.S. Insurers. The NAIC is considering offering a draft proposal which would expand the function of the NAIC's Non Admitted Insurers Information Office (NAIIO) to include the approval of all non-U.S. insurers doing business in the United States. Currently, the NAIIO, established nearly 30 years ago, maintains the "Quarterly Listing of Alien Insurers," the so called "white list", an advisory listing of alien insurers approved as surplus lines carriers. Under the draft proposal, the NAIIO would also approve non-U.S. reinsurers. The federal bill envisioned by the draft would not create a new federal agency, nor would it require an expenditure of federal funds. Rather, the bill would require that all non-U.S. insurers engaged in insurance in the United States meet the requirements detailed in the legislation. Direct writers would be required to be on the NAIC eligible list to do business in any state. Further, in order for an insurer to take credit for reinsurance ceded to a non-U.S. reinsurer on its Annual Statement, the reinsurer similarly must be eligible. Additionally, the proposal would require the establishment of trust funds for the protection of U.S. policy holders, claimants and cedents. In concept, this proposal represents an excellent blend of the strengths of state regulation -- the nearly 30 years of experience of evaluating alien insurers for financial strength, the NAIC reinsurance database, and its pool of technical expertise, with a key strength of federal law -- uniformity of regulations affecting non-U.S. companies. The guaranty fund system, which protects policy holders and claimants from the most serious harms arising from an insurer's insolvency, is also a potential candidate for federal intervention. Historically, the state-based guaranty fund system has performed quite well. There is substantial, although not complete, uniformity among the various funds, and adoption of guaranty associations acts based on the NAIC model laws on the subject has been nearly universal. Furthermore, to date, the guaranty funds have proven to be adequately designed to provide sufficient funding to meet all the needs of policy holders and claimants of insolvent companies. Yet, state regulators have expressed some concern in recent years that the guaranty system, now 20 years old, should be revised in light of recent increases in numbers of insolvencies and the increasing complexity of those insolvencies. The Guaranty Fund Task Force is holding a series of hearings to determine what, if any, changes need to be made to the system, including the possibility of federal involvement in the system.

Why NAIC Believes Federal Intervention Should be Limited

As we have just learned, the National Association of Insurance Commissioners feels, the federal government does have a constructive role to play in the regulation of insurance. However, in their opinion, it is essential for the protection of consumers that this role be carefully limited. There are several important reasons why this is so. In the 1980s, state insurance regulators were faced with a dramatically changing regulatory environment which featured an explosion of new insurance products, dramatic changes in investment strategies by insurers, and sometimes striking changes in insurers' marketing practices. At the same time, the budgets of state governments across the nation increasingly felt the effects of the collision between a rising need for state government services and a declining capacity to increase state revenue. In fact, much of this budgetary crisis in the states was exacerbated by a sharp increase in federal delegation of program funding to the states. Yet, despite these fiscal pressures on state budgets, state insurance regulators never lost sight of the importance of strong regulations, unlike their federal counterparts, and continued to strengthen solvency efforts throughout the last decade while federal regulators stepped backward. State expenditures for insurance regulation has grown far more rapidly than expenditures of commercial banks and thrifts. 155

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Similarly, states have made a significantly stronger commitment to expanding the human resources needed for sound regulation than their federal counterparts. Not only have states increased their commitment to regulations more rapidly than has the federal government, but they have also devoted more resources, when measured against the size of the insurance industry, than their federal counterparts. While the relationship between industry size and the resultant regulatory burden is difficult to compare among the various financial services industry, one measure of the relationship is the regulatory budget as a percent of insurance industry premiums and bank and thrift deposits. When looked at this way, state insurance departments devote significantly more resources to the regulation of the insurance industry than their federal counterparts devote to the regulation of banks and thrifts. As these figures suggest, those who would argue that the federal government is more likely to provide a stronger commitment to solid regulation than the states simply have ignored the lessons of recent history. It is not simply a commitment of resources by the statistics, however, that provides insurance consumers with solid protection against the pitfalls of insolvency. The very structure of state regulation offers several advantages over unitary regulatory structures. One such advantage is the two layers of regulatory protection for insurance consumers: (1) regulation by the state of domicile of the insurer, and (2) regulation by the states in which the company is doing business. If regulation in the domiciliary state is inadequate, regulators in other states can still take action to protect their policy holders. The NAIC's primary focus is on strengthening the first layer of protection, but some of its efforts also strengthen the second layer. Federal preemption of state regulation could undermine this second layer, which could be disastrous if federal regulation proved to be inadequate, as it did over the last decade for other financial institutions. Even short of complete preemption by the federal government is the possibility of federal involvement which could weaken this two-tiered system. A classic example of such a weakening of the second tier by federal involvement can be found in the Liability Risk Retention Act of 1986 (LRRA). Under this act, liability risk retention groups that are licensed in one state can escape the bulk of normal regulatory scrutiny in any other state in which they operate. This aspect of LRRA has created a number of problems for state insurance regulators and the consumers they are pledged to protect, problems that were the subject of a hearing before a Senate Subcommittee. Yet another structural strength of state regulation can be found in the integration of insurance solvency regulation with other aspects of the regulation of the industry. These functions include company and agent licensing, regulation of policy forms and rates, policing insurers' and agents' marketing practices and claims handling, investigating fraud, conducting legislative and policy research, providing consumer information and handling complaints, monitoring competition, addressing availability problems with special market assistance plans, and collecting premium taxes. These activities are critical to protecting the interests of consumers and ensuring that the promises of insurance contracts are fulfilled. The integration of these responsibilities in one agency in each state offers tremendous advantages in coordinating public policy toward insurance and preventing conflicting regulatory actions. Adequate rates do not ensure that a company will remain solvent, but inadequate rates will ultimately bring it down. Vesting these responsibilities in one entity helps to ensure that rates will not be allowed to fall to a level that would endanger an insurer's solvency. In addition, by monitoring and regulating all insurer operations, state insurance departments are able to take actions more quickly to prevent solvency problems from occurring. A further advantage of state regulation is one that has been portrayed by critics as a weakness: the incremental nature of change under state regulation. This advantage has two primary aspects. First, novel approaches to regulation in a changing economic environment may be tried by a state without committing the entire regulatory system to those new approaches. Thus, by utilizing the Jeffersonian concept of the states as "laboratories of democracy," state regulation is better suited to innovation than 156

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INSURANCE MARKETING ISSUES a unitary national system.

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Second, the incremental nature of change in state regulation protects the national system of insurance supervision from sudden and sometimes radical swings in regulatory philosophy. Perhaps if federal and state regulators of the savings and loan industry had not moved a decade ago in lock-step toward deregulation of the industry, American taxpayers would not be looking at a potential cost of a half-trillion dollar price tag for that policy blunder.

An Assessment of the NAIC as The National Regulator

Having detailed the role and importance that the National Association of Insurance Commissioners plays in the regulation of insurance and its desire to maintain solvency authority at the State level, it is important to present an assessment of their effectiveness. In 1991, at the request of Congress, the U.S. Government Accounting Office (GAO) presented such an assessment -- a critical one at that. It is also appropriate to mention that the NAIC responded to this criticism by firing back at the GAO's methodology and study procedures. This response is discussed in the section that follows. The Government Accounting Office Study In their assessment of the effectiveness of the National Association of Insurance Commissioner's present and future role in handling national insurance issues, the GAO first identified important principles that underlie effective regulation. To effectively create and maintain a national system of insurance regulation, the GAO recommends a regulatory organization would need authority to perform several essential functions, including the authority to: (1) establish rules for the safe and sound operation of insurers, (2) establish minimum standards for effective solvency regulation by state insurance departments, (3) monitor the functions of state insurance departments, and (4) compel the enforcement by state regulators of the rules for safe and sound operation, and the adoption and application by states of minimum standards for effective solvency regulation. While recognizing NAIC's good intentions, the GAO does not believe that NAIC can successfully establish a national system of uniform insurance regulation because it does not currently have the authority necessary to require states to adopt and enforce its standards. Furthermore, GAO does not believe that NAIC can be effectively empowered either by the states or by the federal government to exercise the necessary authority. Empowerment by the states would require that each state legislatively cede part of its authority to NAIC. However, even if each state chose to do this, ceded authority would be subject to revocation at any time by each state's legislature. In effect, NAIC would regulate at the pleasure of those it regulates. Empowerment by the federal government is also undesirable. NAIC is composed of state insurance commissioners. Those commissioners are accountable to their states and should not be made accountable to federal authority as well, since this would create an irreconcilable conflict of interest. Moreover, given NAIC's organizational structure, congressional delegation of the regulatory authority necessary to establish NAIC as an effective public regulator could raise constitutional questions. GAO has identified problems in the state-by-state system of insurance regulation. Even though the responsibility for regulating insurance companies rests with each state individually under the state-bystate system, NAIC has attempted to address some of these problems by assisting or in some cases, overseeing the states as they carry out their activities in attempts to strengthen state-by-state regulation. For example, GAO found that NAIC: (1) has improved the credibility of insurers' reported financial information, (2) is attempting to improve capital standards through the promulgation of risk based capital requirements, (3) is attempting to improve its monitoring systems to better identify troubled companies, (4) has established a peer review process to better ensure that troubled companies are more effectively dealt with, and (5) is providing the states with a variety of automated data bases and tools to facilitate their oversight of companies. These and other efforts are steps in the right direction, though all of them leave 157

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INSURANCE MARKETING ISSUES room for further improvement.

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NAIC's plan to create a national regulatory system consistent across all the states rests in large part on the success of its program to accredit state insurance departments that satisfy a set of minimum standards for solvency regulation. For several reasons, GAO questions whether NAIC's accreditation program can achieve its goal. In conclusion, the GAO feels that NAIC's efforts to strengthen insurance regulation are laudable. However, NAIC does not have the authority necessary to fulfill its assumed role as a national regulator. As a result, NAIC is unlikely to achieve its stated goal of establishing a national insurance regulatory system. It can neither compel state actions necessary for effective regulation nor, in the long run, can it sustain its reforms. Following are areas of concern:

NAIC Funding
There is doubt that NAIC's current system funding would permit a large, federal authority. State insurance commissioners created NAIC, in part, to help address the problems that differing state-by-state authorities and regulatory tools caused as the states regulated multi-state insurers. NAIC's annual revenue is currently about $16 million. While NAIC serves state regulators, assessments on the states on the basis of premium volume of their domestic insurers represent about five percent of NAIC's revenue. Other than education and training, which represent one percent of NAIC's revenues, NAIC's services and publications are available to the states at no cost. NAIC relies on the insurance industry for most of its revenue. Database filing fees -- which represent 46 percent of NAIC's revenue -- are mandatory fees on insurance companies that are required by their states to file with NAIC. The insurance industry also purchases NAIC publications and the services of NAIC's Securities Valuation Office (SVO) and the Non-Admitted Insurers Information Office. Finally, only industry representatives pay to attend NAIC's meetings. Concerning expenses, nearly one third of its $15.5 million expense budget is spent on its executive office and operations to support the NAIC committee system. This also includes overhead costs, such as rent and equipment depreciation, for the entire support office. The other major expenses in 1991 are NAIC's information systems ($3.7 million), Securities Valuation Office ($1.7 million), and financial services ($1.7 million). Further, since 1987, NAIC's support office has grown rapidly. NAIC's budget has increased over two and a half times, from $5.9 million in 1987 to $15.5 million in 1991. The number of employees has about doubled from 72 in 1987 to 142 in 1991. NAIC's employment growth reflects its efforts to provide more service to state regulators. Much of this staffing growth occurred in the information systems department. NAIC operates a $4.5 million computer system and telecommunications network for states to share information and have on-line access to NAIC's financial, legal, and regulatory databases. Computer support staff grew from 17 percent in 1987 to 51 percent in 1991.

Alleged Deficiencies in Goals

NAIC has recently stated the goal of creating a "national" regulatory system. Beyond funding limitations, detailed above, the GAO does not believe that NAIC can successfully attain that goal for many reasons. To effectively create and maintain a national system of insurance regulation, the GAO feels that a regulatory organization would need authority to: (1) establish uniform accounting and timely reporting requirements for insurers, (2) establish uniform rules defining safe and sound operation of insurers, (3) establish minimum capital standards commensurate with the risks inherent in an insurer's operations, (4) establish minimum standards for effective solvency regulation by state insurance departments, (5) monitor the supervisory and regulatory functions of state insurance departments, (6) compel state regulators to enforce the rules for safe and sound insurer operations, including the minimum capital requirements, and to take appropriate actions to resolve or close troubled insurers, and (7) levy assessments to cover the 158

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costs of oversight and supervision and maintain sufficient staff and resources to adequately oversee the industry. Furthermore, like any public regulator, a national insurance regulator would be subject to statutory and constitutional constraints, including appropriate oversight. A public regulator, for example, must often comply with disclosure requirements, restrictions on employee activities, conflict of interest laws, and mandatory decision making procedures such as those contained in federal or state administrative procedures acts. Public regulators are subject to constitutional restrictions -- they may not deprive any person of property without due process of law. GAO does not believe NAIC can effectively carry out all the functions necessary for effective solvency regulation, nor is it subject to the appropriate statutory and constitutional constraints. Although NAIC can and does establish voluntary standards for insurers and state regulators, the states have conferred no governmental power on NAIC, and it does not have the authority to enforce its standards. In the state-bystate system of solvency regulation, NAIC cannot compel states to accept and implement its standards. Because Congress has allocated authority to regulate the business of insurance to the states, each state has exclusive authority to establish and implement solvency regulation within its jurisdiction. However, each state could legislatively cede some of its authority to NAIC. Even if each state volunteered to do this, NAIC's standing as a regulator would always be weak because its authority would be subject to revocation at any time by each state's legislature. In effect, NAIC would regulate at the pleasure of those it regulated. Furthermore, because NAIC is a private organization controlled by state insurance commissioners, it does not appear that NAIC should be delegated federal authority to regulate state insurance departments for at least two policy reasons. First, state insurance commissioners are accountable to their states and should not be accountable to federal authority as well, since this would create an irreconcilable conflict of interest. Second, congressional delegation of the regulatory authority necessary to establish NAIC as an effective public regulator could raise constitutional questions.

Alleged Deficiencies in Accounting Standards

To effectively monitor solvency and identify troubled insurers, regulators need accurate and timely information. In addition, the financial reports that regulators need should be prepared under consistent accounting and reporting rules that result in the fair presentation of an insurer's true financial condition. Although NAIC is working to address these needs, GAO identified a number of areas where improvements are needed. First, a lack of uniformity in the statutory accounting practices (SAP) of the states may hinder effective monitoring of a multi-state insurer's financial condition. Although each state requires most domiciled and licensed insurance companies to use and file the annual financial statement that NAIC developed, individual states may allow accounting practices that differ from those codified in NAIC's practices and procedures manuals. Since a multi-state insurer generally prepares its annual statement in accordance with the SAP of its state of domicile, that annual statement filed in other states may not be consistent with or comparable to the SAP of those states. Other states where the insurer is licensed may require the company to refile or file supplements in accordance with their SAP. In this case, the states would be using different financial data to evaluate the same insurer. In an effort to encourage greater consistency in accounting practices, NAIC plans to revise its accounting manuals to unify existing statutory practices. However, even if NAIC adopts more uniform statutory accounting principles, each state could interpret or modify those accounting principles. Second, certain requirements of SAP may result in an insurer not fairly reflecting its true financial condition. For example, SAP requires insurers to reduce their surplus by 20 percent of certain reinsurance amounts overdue by more than 90 days. In contrast, Generally Accepted Accounting Principles -- used by insurance companies for other-than-regulatory reporting -- require an evaluation and could require as much as a 100 percent write-down. This GAAP requirement would result in the insurer's annual statement reflecting 159

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the amount of reinsurance ultimately expected to be collected, a better measurement than the arbitrary percentage required by SAP. Third, false and misleading financial statements have contributed to insurer insolvencies. Many states had been relying on unverified insurer-reported financial data. NAIC now requires both actuarial certification of loss reserves for property/casualty insurers and, beginning this year, annual audits by independent Certified Public Accountants (CPAs) as part of its annual financial statement which every state uses. In this instance, NAIC has succeeded in using its authority to prescribe reporting requirements to try to improve the credibility of insurer reported data. But, problems persist despite NAIC's improvements. For example: The annual independent audit is a definite improvement, But the basis of the audit opinion still varies from state to state. This is because the CPA audit opinion is based on those statutory accounting practices prescribed or permitted by the state where an insurer is headquartered. Attempts by the NAIC to unify statutory practices could facilitate comparisons of insurers, but differing state laws or prescriptions would still take precedence over NAICs accounting guidance. The actuarial certification of loss reserves is not necessarily credible. NAIC allows states the option of accepting certification by insurance company employees. GAO believes loss reserves should be independently verified and certified.

Fourth, even when insurers correctly report their financial information, regulators are not getting it soon enough to identify troubled insurers. As we have previously reported, annual statements do not give regulators an indication of problems occurring early in a calendar year until between March and May of the following year. That means a lag of between 15 and 18 months from when the problem started and when the annual statement is reviewed. Because a financial entity can fail quickly, we believe quarterly reporting is necessary. NAIC said that, as of February 1991, 21 states required their companies to file quarterly statements, and another 16 states asked insurers to file on a quarterly basis. NAIC cannot require states to adopt quarterly reporting, but it has started to capture quarterly filings that are required by the states. These data are now available on-line to the states and will be used in NAIC's solvency analysis. Fifth, current capital and surplus requirements, which vary widely from state to state, are not meaningfully related to the risk an insurer accepts. For example, minimum statutory surplus requirements for a life insurer range from $200,000 in Colorado to $2 million in Connecticut. Likewise, minimum statutory surplus requirements for a property/casualty insurer range from $300,000 in the District of Columbia to $2.9 million in New Jersey. NAIC is developing risk based capital requirements to be determined by the nature and riskiness of a company's assets and insurance business. It plans to incorporate formulas for calculating capital needs into the annual statement. This would have the effect of requiring all companies to report their risk based capital target as well as their existing capital. NAIC is also working on a model policy for states' consideration to encourage uniform state action against insurers that do not meet the new capital requirements. To be effective, the model would have to be adopted without modification by all states.

Alleged Deficiencies in the NAIC Database

Without early identification of troubled companies, state regulators cannot reverse the affairs of troubled companies or act to minimize the damage resulting from insolvency. As previously reported, regulators have been relying on delayed and unverified insurer reported financial data and infrequent field examinations to detect solvency problems. NAIC has a number of initiatives underway to help remedy deficiencies in timely identification of troubled insurers. Since 1988, NAIC has increased its support staff and computer facilities to improve collection and analysis of financial and other data on insurance companies. Through NAIC's telecommunications 160

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network, states have on-line access to NAIC's database of annual financial statements. The most recent six years of financial data for about 5,200 insurance companies are maintained on-line for regulatory analysis, with tapes available back to 1979. However, NAIC's financial database is only as good as the insurer reported data its actions to improve data quality, according to GAO, have not been sufficient to ensure that outcome. NAIC has also developed legal and regulatory databases to help state regulators share information about troubled multi-state insurers. This way, states can get a better picture of the complete activities of a troubled multi-state insurer and prevent suspicious operations from spreading. Among these databases, NAIC's Regulatory Information Retrieval System gave states on-line access to the names of more than 49,000 insurance companies, agencies and agents, as of 1991, that have been subject to some type of formal regulatory or disciplinary action. Its new Special Activities Database, which has been operating since June 1990, is a clearinghouse for information on companies and individuals that may be involved in questionable or fraudulent activities. NAIC also is developing a national complaint database that will help each state assess policy holder complaints from other states about multi-state insurers and agencies. Complaint information, which can give states indications of solvency and other problems, is now maintained only state-by-state. NAIC's databases are important steps in the right direction, says GAO, but their ultimate success depends on the quality of insurer reported financial data and the willingness of state regulators to volunteer information and use the databases.

Alleged Deficiencies in NAIC's Solvency Analysis

State regulators generally focus their resources on insurers domiciled in their state. NAIC independently operates two solvency analysis programs to help states identify potentially troubled multi-state insurers operating in their state, but domiciled in another state. This is an important service because only a few states routinely provide others with regular updates on financially trouble insurers. Although state regulators are still ultimately responsible for determining an insurer's true financial condition, NAIC's solvency analysis is intended to be an important supplement to the states' overall solvency monitoring. The first of NAIC's solvency analysis programs -- the Insurance Regulatory Information System (IRIS) -is intended to help states focus their examination resources on potentially troubled companies. NAIC also makes preliminary IRIS results available to the public. GAO's concern is that IRIS' effectiveness and usefulness as a regulatory tool is limited by certain deficiencies: (1) it relies on insurer-prepared annual statements that previously were not always independently verified and are subject to significant time lags, (2) its financial ratios have a limited scope and may not identify all troubled insurers, (3) it is not equally effective in assessing different types and sizes of insurers, (4) it does not adequately address some important aspects of insurer operations, (5) it does not consider some readily available sources of solvency information, and (6) it is identifying an increasing number of companies, some of which may not warrant immediate regulatory attention. In 1990, NAIC developed a new computer-based financial analysis system to identify potentially troubled companies requiring state action. The Solvency Surveillance Analysis System appears to address a number of weaknesses we identified with IRIS. However, it is too soon to assess how well it will identify potentially troubled companies or whether it will identify them early enough for effective state action. In addition to NAIC's database and analysis systems to identify troubled insurers, the support office has developed automated tools to help state regulators more efficiently analyze financial statements and examine insurance companies. NAIC also purchased audit software and offered it to state insurance departments at no charge; 35 states had obtained the software. Of particular note, NAIC has developed new tools to help states assess reinsurance collectibility. Uncollectible reinsurance has contributed to several large property/casualty insurer failures. NAIC now requires insurers to disclose overdue amounts 161

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recoverable from reinsurers and has automated these data. State regulators can use NAIC's reinsurance database to quantify overdue reinsurance and identify slow paying reinsurers. NAIC acknowledges that its reinsurance database is only as good as insurer reported financial data, and it is working to identify insurers who report incorrect or incomplete information.

Alleged Deficiencies in Resolving Troubled Companies

Once regulators decide that an insurer is troubled, they must be able and willing to take timely and effective actions to resolve problems that may otherwise result in insurer insolvency. When problems cannot be resolved, regulators must be willing and able to close failed companies in time to reduce costs to state guaranty funds and protect policy holders. In a recent report, GAO analyzed the timing of state regulatory action against financially troubled or insolvent property/casualty insurers. Regulators in 46 states and the District of Columbia reported to us the dates of insolvency for 122 insurers and the dates on which formal regulatory action was initially taken against those insurers. In 71 percent of those cases, the states did not take formal action until after the insurer was already insolvent. We also found that states delayed liquidating insolvent insurers under state rehabilitation. Delays in regulatory action against financially troubled or failed property/casualty insurers increased costs for state guaranty funds and delayed payment of policy holder claims. In 36 failed insurer cases where financial data were available, the company increased its sales of insurance policies, even after state regulators identified financial trouble. This obviously increases the burden on state guaranty funds. In 47 cases where liquidation was delayed, policy holders with claims did not get paid promptly because claim payments were suspended. GAO found many reasons for regulatory delay in dealing with troubled or insolvent insurers. In addition to relying on inaccurate and untimely data reported by insurers, states also generally lacked legal or regulatory standards for defining a troubled insurer, and vague statutory language made establishing insolvency difficult. Actions that are needed to correct these problems include developing a single uniform standard for determining if an insurer is financially troubled, requirements that certain actions be taken when specific hazardous conditions are present, and a single uniform legal definition of insolvency based on loss reserves and capital adequacy. Such action would improve protection of policy holders and state guaranty funds. In 1989, NAIC created a new multi-state peer review committee -- the Potentially Troubled Companies Working Group -- to track how states are handling problem companies. The group looks at the companies that NAIC's independent financial analysis identifies as potentially troubled and selects certain companies for special attention. It requests states to respond in writing to its questions about those companies. State commissioners also are asked to appear before the NAIC commissioner committee that oversees the working group to discuss how they are handling potentially troubled insurers. According to NAIC, regulators are to, at a minimum,: (1) demonstrate an understanding of both the nature and extent of the company's problem, (2) establish that the state has a sufficient plan of action to assist in correcting or stabilizing the company or that the state has an orderly process to withdraw the company from the marketplace, (3) establish that the state has the laws, regulations, and personnel to effectively carry out the necessary regulatory actions, and (4) establish that the state has effectively communicated its concerns to other regulators in states with policy holders who are at risk. NAIC follows up on potentially troubled insurers and, if necessary, may form a special group of state regulators to oversee regulatory activities for a troubled company. According to NAIC, peer review helps to ensure that individual states are promptly addressing problems and keeping other states informed about troubled multi-state insurers. GAO does not know whether this peer review system will prompt individual states to take more timely 162

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action to deal with troubled insurers or the extent to which it will enhance coordination of supervision of troubled multi-state insurers. Whatever the influence of peer pressure, supervisory actions to address problems of a trouble insurer remain the primary responsibility of the domiciliary state regulator, and the coordination of such actions involving multi-state insurers is a matter of negotiation among all involved states. NAIC has no enforcement power to compel a state to take action against a troubled insurer.

NAIC Deficiencies in Controlling Holding Companies and Foreign Reinsurers

To effectively monitor insurer solvency, regulators must be able to routinely oversee insurance holding companies. Inter-affiliate transactions are common in the insurance industry and are not necessarily detrimental. However, such transactions are subject to manipulation and may be used to obscure an insurer's true financial condition. Abusive inter-affiliate transactions caused the Baldwin-United failure -- the largest life insurance failure in history. States do not regulate insurance holding companies and cannot regulate the non-insurance affiliates or subsidiaries of an insurance company. Consolidated statements for insurers and affiliates might help states evaluate the overall financial condition of a holding company, but, according to NAIC, only 13 states require some form of consolidated reporting. NAIC has adopted model laws on holding companies to emphasize the need to regulate these transactions and encourage uniform state regulation. However, not all states have adopted NAIC's current model laws. GAO points out that states have no authority to monitor the financial condition of reinsurers in other countries that do business with U.S. insurers. To effectively monitor insurer solvency, regulators need this authority. Foreign reinsurers provide more than one-third of the reinsurance written in the United States. While many foreign reinsurers are responsible and reliable institutions, some foreign reinsurers have failed to pay claims. Uncollectible reinsurance has contributed to several large insurer failures. NAIC has tried to help state regulators monitor foreign reinsurers operating in the United States by providing to them a database of reinsurance activity reported by U.S. insurers. State regulators can now quantify amounts reported as ceded to any reinsurer worldwide and totals ceded by country. However, NAIC has made little progress, says GAO, in helping states evaluate the financial condition of foreign reinsurers. While NAIC maintains a so-called white list of acceptable foreign insurers, it specifically excludes foreign reinsurers. NAIC cannot require foreign companies to submit financial reports. Thus, its authority to evaluate either foreign insurers or reinsurers is no greater than a private rating organization's. NAIC believes that federal legislation is necessary to empower it to require foreign insurers and reinsurers to submit to monitoring as a condition for doing business in the United States and to require the states to use NAIC's listing.

Alleged Deficiencies in State Solvency Laws

Without uniformity in solvency laws and regulations, the state-by-state regulatory system is only as strong as the weakest link. Because insurers operate in many states, lack of uniformity in state solvency regulation provides opportunities for unsafe and unsound operations while it complicates regulatory detection of those activities. Over the years, NAIC has developed and proposed for states' consideration about 200 model laws and regulations designed to foster state acceptance of the legal and regulatory authorities necessary to effectively regulate insurance. However, NAIC has no authority to require states to adopt or implement its model policies. Before this year, NAIC had only limited success in getting states to adopt its model laws and regulations. Moreover, states that do adopt model laws can -- and do -- modify them to fit their situations. For example, every state has a property/casualty guaranty fund to pay policy holders of failed insurers. Although most guaranty funds are patterned after the NAIC model, significant differences between state laws result in some funds offering less protection than others. This undermines NAIC's efforts to achieve uniformity. Another impediment to uniformity is the uneven adoption by states of NAIC 163

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INSURANCE MARKETING ISSUES amendments to its model laws and regulations.

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Frustrated by the difficulty of getting states to enact model policies and provide sufficient regulatory resources, NAIC adopted a set of financial regulation standards for state insurance departments in June 1989. These standards identified 16 model laws and regulations, as well as various regulatory, personnel, and organizational practices and procedures, that NAIC believes are the minimum for effective solvency regulation. NAIC must rely on state insurance commissioners to introduce the models in their various state legislatures and work for their passage. Individual states, in turn, may modify NAIC models depending on local needs and circumstances. Using NAIC's Model Laws, Regulations and Guideline publication service, GAO tabulated states' adoption of 14 model laws and regulations referenced in NAIC's financial regulation standards. The figures show, adoption of NAIC models varies widely. For example, only two of the four NAIC models adopted before 1980 -- the Standard Valuation Law and the Insurance Holding Company System Regulatory Act -- have been substantially enacted in all states. NAIC's Insurers Rehabilitation and Liquidation Act, or legislation that NAIC identified as substantially similar, has been enacted in 24 states, while 27 other states have legislation or regulations related to the subject, but not the same or substantially similar to NAIC's model. While the original insurance holding company model was enacted in virtually every state, most states have not adopted key provisions that NAIC added in 1984 to control abusive inter-affiliate transactions. In this regard, only seven states adopted expanded authority to issue cease and desist orders and to impose civil penalties, while only six have added a provision allowing a receiver to recover funds from an affiliate. Additionally, NAIC's model regulation to supplement its holding company model act still has not been adopted in nine states. Of the models proposed by NAIC since 1980, only the Model Risk Retention Act has been adopted in more than half of the states. In contrast, the Model Regulation to Define Standards and Commissioner's Authority for Companies Deemed to be in Hazardous Condition has been adopted by only four states since its adoption in 1985. NAIC recommended independent annual audits by Certified Public Accountants in 1980. However, by the end of the 1980s, only 15 states had adopted this requirement. NAIC effectively abandoned the model law process as a means to get states to require this important regulatory tool. Instead, NAIC used its authority to prescribe annual statement reporting to require independent annual audits for insurers. This requirement now applies to all states. Since January 1991, the National Conference of State Legislatures and the National Conference of Insurance Legislators have called on the states to comply with NAIC's standards. Likewise, the National Governors' Association has endorsed NAIC's efforts.

Alleged Deficiencies in NAIC's Accredidation Program

In June 1990, NAIC adopted an accreditation program to encourage state insurance departments to comply with its new financial regulation standards. According to NAIC, its new accreditation program has the effect of establishing a national system of solvency regulation consistent across all states. However, GAO questions whether NAIC's accreditation program can achieve this goal. "First, even if the standards were implemented by all of the states, they would provide little more than an appearance of uniformity. The standards, for the most part, are general, and their implementation can vary widely. Second, the accreditation review process has significant shortcomings that cast doubt upon the credibility of NAIC's program. Third, even if the first two problems were solved, NAIC remains in the position of 164

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INSURANCE MARKETING ISSUES attempting to regulate the state regulators with no authority to compel their compliance."

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Overview of the Accreditation Program: To become accredited, a state must submit to an independent review of its compliance with NAIC's financial regulation standards. An accreditation team is to review laws and regulations, past insurance company examination reports, and organizational and personnel policies; interview key department personnel regarding how legal provisions and regulatory practices are implemented; and assess the department's levels of reporting and supervisory review. The team is to report its recommendation as to whether or not a state meets the standards to the NAIC Committee on Financial Regulation Standards and Accreditation. This committee of state insurance commissioners decides whether or not a state becomes accredited. To avoid a direct conflict of interest, the commissioner from a state applying for accreditation cannot vote on that state's accreditation. Nevertheless, since each state ultimately will undergo an accreditation review, a commissioner voting to deny accreditation to another state may be subject to retaliation. Likewise, according to GAO, commissioners could engage in "backscratching", trading an affirmative vote for their own state accreditation. While GAO has no evidence that this has occurred, they note that the committee process is not sufficiently devoid of potential conflicts of interest to preclude the opportunity. States that satisfy NAIC's financial regulation standards will be publicly recognized by NAIC as "accredited", while departments not in compliance will receive guidance on how to comply. Accreditation is for a five-year period; to be reaccredited, a state must undergo an independent review. NAIC is developing procedures for maintaining accreditation during this five-year period and decertifying states no longer in compliance. NAIC plans to have accredited states penalize insurers domiciled in states that do not become accredited. Among the planned restrictions, which began in January 1994, an accredited state would not license an insurer domiciled in an unaccredited state unless the insurer agrees to submit to the accredited state's solvency laws and regulations and associated oversight. Whereas the home state usually has primary responsibility for solvency monitoring and regulation, this penalty would subject a multi-state insurer domiciled in an unaccredited state to regulation in every accredited state in which it is licensed. Given the varying state solvency laws and regulations, NAIC's penalties would be onerous for insurers domiciled in unaccredited states. If the accredited states carry out the penalties, according to NAIC, this would give insurers the incentive to lobby for the increased authority and resources their home state needs for accreditation. NAIC's standards, says GAO, may not achieve uniformity since they do not set specific criteria or practices for the states to meet. This is why even universal adoption of the standards would provide little more than the appearance of uniformity. For example, NAIC's current capital and surplus standard requires, in part, that a state have a law that establishes minimum capital and surplus requirements. However, the standard does not specify what those minimum requirements should be. NAIC has said that this standard will be replaced when NAIC completes its new risk based capital requirements. Another example is the standard for investment regulation. NAIC's standard is that a state should require insurance companies to have a diversified investment portfolio, but the term "diversified" is not defined. Other important terms -- "sufficient staff" and "competitively based" pay, for example -- in the standards are similarly vague. Furthermore, GAO believes that some of the standards, in addition to being nonspecific, are inadequate to address regulatory problems that we have identified. For example, the model regulation underlying NAIC's standard for corrective action against troubled insurers is qualitative even when dealing with quantifiable conditions. NAIC's standard does not set a uniform measure for determining if an insurer is financially troubled or prescribe regulatory actions to be taken when specific hazardous conditions are present. As previously mentioned, lack of such regulatory guidance causes delay in states' handling of troubled insurers. 165

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GAO feels that NAIC's accreditation review process suffers from two serious shortcomings. First, because the standards are not specific, there are no criteria for the accreditation teams to use in assessing compliance with the financial regulation standards. Second, the lack of documentation and procedural requirements for the team review has, to date, made it impossible to independently decide whether a team's work was sufficient to justify a recommendation for or against accreditation. To evaluate compliance with NAIC's standards, each accreditation team has to develop its own criteria for what constitutes acceptable compliance. To define terms and set more specific criteria for its standards, NAIC plans to have future review teams keep records of the criteria they use in assessing compliance with NAIC's standards. They will document the criteria in their review to the NAIC accreditation committee. NAIC said all criteria will be shared with the states in an effort to achieve greater consistency in the process and so that individual states can better prepare for accreditation. Due to the lack of documentation, GAO does not know the basis for the findings of the accreditation team in Florida and New York. The review reports for the two states -- each about one-half page in length -recommended that the state insurance department be accredited "based upon this evaluation effort and the knowledge and experience of the evaluation team". While the four-page report for the Illinois accreditation better documented what work the review team did, the report still did not document the basis for the team's findings or recommendations. Without such documentation or elaboration, it is impossible to independently verify that the team's analysis was sufficient to support its recommendation. NAIC's accreditation committee required the Illinois review team to submit an additional summary of its findings to support the team's conclusions that the state complied with each standard. Based on lessons learned in Florida and New York, NAIC developed a more detailed work plan for use in subsequent accreditation reviews. The expanded work plan is a good starting point, but it will still be necessary to develop more detailed procedures and documentation requirements to ensure consistency between review teams and support for findings in the future. GAO bases this conclusion on their observations of an accreditation review team planning session in March 1991 and the team's visit to the Illinois Insurance Department in April 1991. GAO questions whether NAIC's work plan for the Illinois review was sufficient to ensure accreditation reviews that are consistent and sufficiently documented. NAIC's only quality control over the team's analysis has been to have an observer from the support office on each review. A final problem with the accreditation review work plan is that coverage of work does not seem to have been sufficient to assess how well a state implements NAIC's standards. GAO questions, for example, how the accreditation team assessed implementation of Florida's regulations, given that several key provisions were adopted through emergency rule-making only weeks before the review. Although the standards called for the review team GAO observed to assess whether Illinois had implemented NAIC's guidance on handling troubled insurers, the team did not. Team members said that they assumed Illinois had followed NAIC's procedures because Illinois helped write the handbook.

GAO Conclusions About NAIC As A National Regulator

Although insurance is a national market, the state-by-state system of insurance solvency regulation is characterized by varying regulatory capacities and a lack of uniformity. NAIC has taken a number of steps toward strengthening the state-by-state regulatory system and addressing a variety of problems. It has been successful in using its authority to prescribe reporting requirements to achieve uniformity in some aspects of state solvency regulation. NAIC has not been as successful with its model laws, which must be adopted by each state. NAIC is trying to establish a national system of effective solvency regulation through its accreditation program. In effect, NAIC has assumed the role of a regulator of state insurance regulators. However, GAO does not believe that state adoption of NAIC's current standards will achieve a consistent and 166

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effective system of solvency regulation. The underlying standards for accreditation are often undemanding and, in some cases, inadequate. Even if NAIC devised sufficiently stringent standards for effective solvency regulation, however, GAO does not believe that NAIC can surmount the fundamental barriers to its long-term effectiveness as a regulator. Most importantly, NAIC lacks authority to enforce its standards. NAIC is dependent on consensus -- indeed unanimity -- among state insurance commissioners and legislatures to enact and implement its policy recommendations in a manner that achieves consistency in state-by-state regulation. Progress toward such consensus and unanimity appears to be occurring presently under the glare of intensified public scrutiny of the insurance industry and its regulators. Given NAIC's historical lack of success in securing state adoption of its model policies, it is highly questionable whether such progress will be sustained over the long run as interest in the industry's condition wanes.

NAIC'S RESPONSE TO GAO CRITICISM

Once testimony before Congress was made public, the National Association of Insurance Commissioners was quick to respond to its critics. Following is their defense and reasons they believe that NAIC is still a credible choice for a National Insurance Regulator: Incorrect Legal Conclusions The GAO claims that it would be unconstitutional for Congress to delegate national regulatory authority to the NAIC. The GAO made no attempt to outline the basis for this legal conclusion. While there are limitations to any delegation of authority Congress may make, a thorough review of the cases does not reveal any impediment to federal delegation drafted to come within these limitations. Indeed, such delegation is quite commonplace and, in fact, there are numerous references to the NAIC throughout federal statutes and regulations. Lack of Analysis or Explanation GAO asserts that one of the three fundamental weaknesses of state regulation is that: States vary widely in the quality of their solvency regulation. There are differences in regulatory workload, such as the number, size, and type of companies domiciled or licensed in a state; the available resources in a state; and each state's "regulatory philosophy". It is a truism that there are differences in regulatory workload, number and size of companies domiciled and licensed in a state, resources and regulatory philosophy. The NAIC does not concede, however, that any of these factors is an indicator of "quality". The difference in workload caused by the differences in company numbers and size result in a rational difference in the amount of resources that should be properly available to handle the workload. A comparison of states for quality of regulation must take into consideration a number of factors not mentioned by the GAO but considered by the NAIC in its accreditation review. These include not only the numbers of staff, their qualifications and training, but also the amount of outside resources that may be available to the department from various sources. Similarly, regulatory approaches may differ from state to state just as regulatory philosophies may differ with each presidential administration and even with one administration. But, clearly, the potential damage that may be caused to the insurance business as a result of an approach taken by one or more states, however, is held in check by the approaches taken by other states. The likelihood of significant negative effect on the insurance business of radical changes of philosophy among insurance regulators is therefore minimal. On the other hand, the same cannot be said of the federal regulatory system, as exemplified in the savings and loan and banking industries. Lack of Understanding of the Regulation of Insurance The GAO describes a third "weakness" of state regulation: State regulators do not oversee holding companies and foreign reinsurers. In part, these blind spots may have prevented regulators from acting to forestall large insurer failures. 167

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In light of the fact that the Model Insurance Holding Company System Act is the law in virtually every state jurisdiction, the GAO is simply wrong, says NAIC. Or, perhaps the GAO is making the suggestion that a weakness of state regulation is that insurance departments do not regulate non insurer corporations such as General Motors and ITT, both of which have insurance subsidiaries. The fact is that transactions between affiliates are regulated and it is these transactions which relate to the insurer's solvency. Further, while non-U.S. reinsurers are not directly regulated, their impact on U.S. reinsurers is. Incredibly, the GAO testimony totally omits any mention of the NAIC Model Credit for Reinsurance Act or its inclusion in the requirements for accreditation. The Act determines when a U.S. insurer may take credit for its reinsurance and assures that adequate security is in place to guarantee the obligation of the non-U.S. insurer. Day-by-day regulation of non-U.S. corporations is impractical whether done by the state or by a federal authority. The NAIC is considering a proposal, however, that would establish minimum requirements for non-U.S. reinsurers which would add an extra layer of protection to the safeguards contained in the Model Credit for Reinsurance Act. The proposal has not yet been ratified and further study must weigh the benefits to be derived from the extra layer of protection against the possible effects on capacity/availability and international trade. Similarly, the GAO's lack of understanding of the complex world of insurance regulation is also revealed in the somewhat naive insistence upon development of a "single uniform standard for determining if an insurer is financially troubled". Insurer solvency is dependent upon a huge number of variables not present in other financial institutions such as banks and savings and loans, and therefore insurer solvency regulation is many times more complex than the regulation of other institutions. Simple principles applying to these other financial institutions are simply not transferable to the insurance industry. Unfair Compairsons The GAO has analyzed and reanalyzed the regulation, or lack thereof, of thrifts and banks. The NAIC is puzzled by the fact that, possessing as it does all the resources needed to compare state regulation of insurance to various regulatory structures of other financial institutions, including federal regulation and dual regulation, it declined to do so. This is unfortunate. The NAIC believes that state regulation of the business of insurance compares remarkably well to federal regulation of financial institutions and to a dual federal-state regulatory structure. It is, of course, true that there are problems at the state level. Prompt communication or action does not always occur in state insurance regulation. Only in an ideal system does it always occur. Our goal is to improve the system to the point that it comes as close as possible to perfection. However, for the GAO to characterize the lack of perfection in the current system as a major inherent weakness is simply absurd. These are but a few examples of a flawed analytical approach that pervades the GAO testimony. However, the NAIC is even more disappointed with the GAO's testimony on a broader, more basic ground: the GAO's testimony is grounded in a strong and rigid bias against state government. This bias is most clearly revealed in the fundamental conclusion of the document that, the "road to effective insurance regulation does not pass through the NAIC." This bias against state government runs directly counter to fundamental principles of American government which vest basic powers of government in the states. The NAIC believes that solvency regulation should meet national minimum standards, but not only need not, but should not, be uniform in all respects. The ability of states to experiment with new forms of solvency regulation is one of the strengths of state regulation. In sum, the GAO testimony is based more on bias than fact; more on unsupported conclusions than on audit findings; more on simple errors than on simple truths. It is that aspect of the GAO testimony, and not the testimony's conclusions, that disappoints the National Association of Insurance Commissioners most.

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NAIC's Conclusion
Overall, the NAIC believes that the long standing tradition and operation of state regulation of the business of insurance have served consumers well. Certainly, they say, state regulation of the insurance industry fares better in a comparison with federal regulation of other financial institutions. State regulators are responding through the NAIC to the changing and challenging environment of the insurance industry. "We believe the NAIC's Financial Regulation Standards and Accreditation Program will succeed in strengthening the state regulatory system", states the NAIC. "Other improvements," (discussed above) "from strengthened solvency analysis support, to enhanced capital analysis and requirements to improved examinations and more, will provide needed enhancement to a regulatory system that has been successful, but could be more so, particularly, as we enter the next century."

COMPANY SAFETY
OVERVIEW
At one time, the topic of insurance company safety was discussed among a tight circle of professional industry groups and regulators. Today, however, potential trouble spots and ideas for constructing new regulations to protect consumers are being unveiled at a fast and furious pace. The suggestions hail from consumer coalitions, industry groups, auditors, state regulators and some members of Congress who continue to press for some form of uniform federal supervision of the entire insurance industry. So great has the call been, that at the outset of the beginning of the of the twenty-first century, an industry that has flourished for hundreds of years is still struggling to redefine itself. At the center of attention are the issues of safety, solvency and agent due care : how to regulate, who will regulate, what the consumer will be promised and whose going to pay if something goes wrong. Clearly, the insurance professional is at risk to know as much about his product and company than ever before. Recent problems are complex and visible and not limited to insurance companies. Most financial markets and many industries have changed dramatically especially through the 1990s. Changes in financial institutions have resulted from events like information and communication technologies -- making the world smaller and competition greater within a chosen financial services industry -- to spectacular financial disasters, e.g., the '87 stock collapse, the junk bond fiasco, the Executive Life / Mutual Benefit Life debacles, national catastrophes (Hurricanes Andrew Hugo, the midwest floods and California earthquakes). Geographic and product boundaries for financial markets . . . traditionally, not a factor for insurance companies . . . have faded, and new products and services have blurred the distinctions between bank or thrift institutions, security brokers and insurance agents. A place once reserved to buy groceries, for example, may now be a convenient spot to deposit or cash a pay check. And who would have thought banks and insurances agent would market and control "managed asset" mutual fund accounts? Further, with news of innovations like the "Information Superhighway" beaming financial and educational services to anyone who owns a telephone, there is no indication that this era of change is over. On the contrary, financial markets and institutions will continue to evolve. The need to adapt to the increasingly competitive environment, new products, financial "heart attacks" and more has presented problems for many types of financial institutions . . . commercial banks, savings and loans, securities firms . . . and insurance companies. As always, when things change or require restructuring, there is a period of adjustment accompanied by trial and error, financial stress and an increased likelihood of less than top performance or the threat of complete collapse. It happens to many kinds of companies . . . including property/casualty and life/health insurers. It is a fact of doing business and part of any free-market system. Multiple and prolonged insolvencies, however, take their toll. The insurance industry becomes tarnished, 169

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and new consumer/political pressures expound. This, in turn, expands the burden on regulators, industry groups and the insurance professionals to correct the potential effects a major insurance failure may have against the public and the economy. In some cases, over-regulation and speculation result in panic or perhaps a "light trigger" that could catapult a seemingly secure company into the solvency spot light. During the 1980s, solvency paranoia was focused on the banking industry. Volumes of information documented faulty and fraudulent investments by banks and savings and loans. Managers were branded as criminals and regulators clamped down like a proverbial ton of bricks. Of course, the insurance industry has had its bout with solvency wars. In fact, just the cast or suspicion of problems or a drop in bond ratings has put companies at bay or, in some cases, out of business. With rare exception, the insurance industry has enjoyed the comfort of consumer and regulator confidence throughout its history. Conservative marketing and investment practices in the industry scored high marks with a remarkably low rate of failure. Performance has periodically fallen below adequate levels, but generally not to a point that would jeopardize solvency. In the few episodes that varied this trend . . . the dangerous securities practices after the turn of the century and the substandard writers in automobile insurance markets of the 1960s . . . insurance regulators, aligning insurance companies and industry groups like the National Association of Insurance Commissioners have appeared to provide appropriate regulatory responses. Recent episodes are no exception. Most of the major insurers that went insolvent are in the process of being rehabilitated by state regulators or private investors. It is doubtful that policy owners will incur material losses.

THE FAILURE RATE

It is true that the decade of the 1980s and the early 1990s subjected the industry to higher levels of financial and market trauma than ever before. This period was marked by new records in sales and innovations. Fierce competition and increasing cost pressures became new problems in addition to outside influences like federal deregulation of financial services, higher interest rates, new financial instruments, expansion of tort liability, class action suits, soaring medical costs, catastrophic claims, the entry of some inexperienced, small insurers and relatively poor investment results. In a rather short time frame, the industry evolved from a conservative, mature business with stable elements and generous profit margins, to a business marked by higher risks and narrowing profit margins. A combination of these factors has also brought media and political attention and a definite erosion in consumer confidence. As this confidence declined, redemptions increased dramatically. At the same time, a major recession created financial havoc via junk bonds and plummeting commercial real estate values. The result: insurer failures. The additional toll of many years of "rate wars" and dramatic natural disasters created even greater pressures on the property/casualty side of the industry. Just how bad did it get out there? The answer depends on the source. The federal government has published volumes on insurance industry abuses and made scathing comparisons of insurer problems and the huge banking debacle of the late 1980s. Actual statistics, however, tell a somewhat different story. For example, in 1989, the peak of the bank and thrift controversy, failures in that industry numbered over 500 institutions involving some $130 BILLION in assisted mergers or closures. In the same year, which coincidently seems to be the peak year for insurance company problems, the number of failed companies numbered about 40 property-casualty insurers and about 40 life companies with a combined total bailout of less than $1 BILLION. While no one should be happy with these results, it is clear that insurance industry failures have and will not likely become another savings and loan fiasco -especially, since recent information seems to indicate a cycle of declining failures. This is indeed good news. But, this should not diminish the severity of failures -- more than the industry has seen since the great depression. These failures have given the industry a "black eye" which will take many years to heal. In a like manner, agents will bear the brunt of new client doubts and increased responsibility, both ethical and legal, to present financially secure companies.

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INDUSTRY TROUBLESPOTS
Life Company Problems
During the 1980s and 1990s, life insurance companies scrambled to satisfy a longstanding customer who transformed from a "saver" into an "investor". As much as life insurers wanted to please, their historically conservative investment practices would not allow them to quickly offer products with returns competitive with high yield products offered by financial institutions and security products. The fact that the high rates offered by banks and thrifts were federally insured put life insurance companies at a further disadvantage. Eventually responding to the pressure, life companies began undertaking new types of risks designed to support more competitive products. Marketing shifted from selling "security" to selling "rate of return". Companies were forced to achieve a greater return on their assets by assuming higher risk in their investment portfolios. Others chose a strategy of increasing cash flow by mismatching assets and liabilities. Still others engaged in new forms of reinsurance arrangements which were intended to ease the strain on their surplus. As mentioned, asset mix is a current problem among life insurers. Although mixing moderate amounts of well diversified higher risk assets in an insurer's portfolio can be an acceptable strategy, concentrations in high risk assets can put policy holders in jeopardy. In some insurer failures, it is specifically the crisis of confidence surrounding these investments, not their liquidation, that created the failure. A recent example was Mutual Benefit Life. A downgrading of bonds in their portfolio triggered a run on the insurer they could not control. For this reason, some state regulators, like New York State, are placing aggregate caps on most types of investments that a life insurer may invest in -- these include stocks, subsidiaries and investment real estate. In the mid 1980s, the spotlight was on "junk bonds". Because original issues were relatively new, it wasn't until 1990 that a more appropriate disclosure system and accelerated reserve system for insurer held "junk bond assets" was adopted by the National Association of Insurance Commissioners. New models and systems are also coming forth that will develop risk reserve coverage for all classes of assets, including real estate mortgages. Another problem area among life insurers has been asset/liability matching. The mismatching of cash flows generated from assets and the cash flows required to cover liabilities can provide a competitive advantage to an insurer but places the insurers policy holders at risk. New regulations are forthcoming that would require all life companies writing interest sensitive products to closely "match" their assets and liabilities. Reinsurance is yet another area of concern. A life insurance company is somewhat unique, in that, due to the conservative nature of statutory accounting, the writing of new business results in a decrease in the company's statutory capital. This, in combination with the fact that all expenses for new business are charged up front created a greater strain on insurer "surplus". In the early to mid 1980s a new type of surplus relief reinsurance called "financial reinsurance" was developed to bolster the surplus of life insurers. The reinsurer placed a block of the ceding company's business on its books but did not assume the primary risks of the business. The ceding company decreased its liabilities, thereby increasing its surplus, without having transferred the real risk of the business. It is said by some that the use of financial reinsurance seriously distorts an insurer's financial statements, and at times, masks real problems. Again, new regulations are being created to deal with this problem. Holding company abuse of insurers is another area of risk for the industry at whole. The failure of some life insurers can be directly tied to a systematic "milking" of these companies by a non insurance parent. Strong holding company laws and aggressive enforcement are essential ingredients to effective regulation of the industry. Again, some model laws were adopted by the National Association of Insurance Commissioners in late 1986. Finally, in an effort to "squeeze" more capital out of the balance sheet, there has been an assault on statutory insurance accounting. For the protection of policy holders, statutory accounting results in a forced conservatism in preparing an insurer's financial statement. Insurers, in a desperate effort to show more surplus, have waged a campaign to recognize all the values in the assets on their books, as well as values in some assets not on their books, and to reduce their liabilities below the conservative levels set by regulation. Many elaborate schemes including sale and leaseback 171

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arrangements and the securitization of future revenues have been tried. Regulators expect this to continue where companies must see their profitability restored to a level at which they can attract real capital. In terms of actual performance, life insurers, through significant efforts to cut product and management costs and liquidate certain assets, are posting "profits". According to A.M. Best, a major downsizing has trimmed expense growth and discipline pricing and effective interest rate management, along with dividend reductions, have "shored-up" insurer earnings -- return on equity for the industry is about 9.5 percent. It is significant to note, however, that while earnings are positive, they follow years of declines in operating profits. In a similar vein, the industry has suffered from major realized capital losses, exceeding $500 million in some years compared with a $2 billion gain a year or two earlier (A.M. Best). A bit of good news is the increase in net business written. Net premiums are up. Much of this growing demand is an offshoot of the increasing popularity and competitiveness of annuities and variable annuities meeting the needs of consumers disappointed with their low-yielding CDs.

Health & Worker Comp Troubles

The health care industry has been a particularly vulnerable target for reform during the past decade. Never before have Congress and an Administration pursued change. At the root of the problem are three unrefutable facts: 1) health care costs are rising far faster than the Consumer Price Index, 2) worker's compensation claims, fraud and tort injustices (medical lawsuits) are higher than at any time in history and 3) long-term care is a burgeoning problem as major portions of the population near retirement age. At the same time, government tinkering and political "showboating" on the health care "crisis" have done nothing but add salt to the wound. The industry is definitely in the grip of a blemished image, as stories of $5 tongue depressors and the plight of the poor uninsured are aired nightly. Needless to say, Congress will leave NO stone unturned in an effort to completely reinvent health care. The thought of government managed competition has sent many companies running. While large companies continue to dominate the field, smaller, more mobile insurers who have less invested in a health system infrastructure have and are making adjustments, including divestitures. For example, ITT Hartford, in 1993 announced agreements to transfer its major group medical business to Mass Mutual. Other carriers are simply exiting markets that are or no longer perceived to be profitable. The survivors are choosing to stand their ground and develop their own managed care capability or focus on specific geographic markets. Concurrently, however, many states are enacting their own reforms to hopefully ward off a full federal intervention. As of 1993, for example, almost 30 states have passed some form of health care reform involving employer mandates and matters such as guaranteed issue and guaranteed renewability. The industry's most significant challenge from the legislative area will be surviving government rate controls. Experts believe that such controls are unavoidable with either state or federal jurisdiction. Facing this prospect, health providers will need to push for significant cost containments, probably through the use of group or "pooled risk" groups and/or managed care relationships. Most observers agree that managed care is expected to expand under the Clinton proposal. Large carriers, like Aetna, Travelers, Prudential and Blue Cross/Blue Shield should be benefactors of this trend. The "Blues" are currently under extreme pressure to keep their low cost image. As a result, some consolidations have taken place. Given their longstanding presence in the marketplace and assuming they do not lose their non-profit status, they should maintain a significant advantage over other commercial carriers. The workers compensation carrier is another insurer facing major claim restructuring. Actual medical costs associated with a workers compensation claim have historically represented about 30 percent of the total claim costs with a factor of 70 percent attributed to salary reimbursement or payroll indemnities. Following today's trend in higher medical costs, these ratios have shifted to 40 percent of all claim payouts going to cover medical costs with 60 percent handling indemnities for lost payroll. Industry experts now believe, the system is on a fast track to a 50/50 proposition. The reason that this has become so costly for workers compensation carriers has to do with the laws regarding payment of 172

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medical cost claims. Medical costs for the injured worker MUST cover medical costs from the first dollar and is typically unlimited in overall costs. The health managed care approach, by contrast, usually involves deductibles and copayments. Since patients are far less likely to seek discretionary medical services if they are footing part of the bill, medical costs under worker compensation are more costly than health insurance claims. In addition, the disabled workers compensation patient has many more options available with less supervision. Chiropractic care, for example, which has been a substantial contributor in driving up medical costs, is legally provided to worker compensation claimants without much restriction in many states. Health maintenance organizations, on the other hand, typically exclude the use of chiropractors. Further, it is not mandatory, in most states to seek the attention of a single medical facility where a record of treatment and results can be tracked. Some states make employers provide a list of a few providers or only require the employer to direct medical supervision for a limited period of time (say the first 30 days). Thus, claimants are free to select and move from provider to provider. A worker with little motivation to return to work could use one provider's opinion against another to delay his recovery for an extended period of time. Another problem for the workers compensation carrier is trying to control the costs involved with disability payments (salary reimbursement), worker fraud, rehabilitation and prevention programs designed to eliminate or reduce workplace accidents or illnesses at the source. Costs associated with these programs and general liability defense against worthless claims are creating extreme financial pressures of unprecedented size. Liability claims, in particular, are a major part of costs since damages from general liability typically include medical costs which are usually awarded for extended periods of recovery. Many companies have decided to move away from the workers liability and health markets and focus on less regulated and potentially more profitable venues: Long term care and Medicare supplement lines. These specialty areas are expected to experience little disruption from proposed heath care reform. The long term care market is a relatively new entry for insurers. And, for the most part, carriers have been very conservative in coverage. However, now that there are hundreds of companies offering long term care insurance regulatory intervention has started, e.g., federal tax qualified LTC legislation. Accusations against long term carriers include policy violations such as: unrealistic benefits, illusory benefits, misleading sales presentations, high premiums which buyers could not possibly continue, absence of non forfeiture values, rising premiums but level benefits, inadequate inflation protection and inadequate disclosures about solvency standards of the insurer. The National Association of Insurance Commissioners has adopted a Model Act and Regulation for Long Term Care Insurance with many consumer protections including: prohibition of preexisting condition exclusion periods longer than six months, policies must not be canceled due to age or diminishing health status, 30-day free look, policies may not exclude coverage for Alzheimer's disease, policies may not limit coverage to skilled nursing care only, prior hospitalization requirements are prohibited, policies must be guaranteed renewable, inflation options must be provided, new claims protections, policies must meet a 60 percent loss ratio and detailed outlines of coverage must be provided to all prospective applicants at the time of solicitation. On top of these types of requirements, the care provided must contend with a real possibility that long term care could end as an actuarial nightmare. Factors that make it somewhat experimental include: medicines and technology that could greatly extend life could result in long term care being something close to "permanent care" -- the absence of an experience factor, the absence of any way to determine how the courts will interpret specific language incorporated in policies, uncertainties with respect to federal income taxation and the long run risks of changes in the supply of nursing homes.

The Trouble in Property/Casualty

In addition to enduring some of the greatest natural disasters of modern times, property/casualty insurers are still paying the price for some heavy price competition that has continued since 1985. At the same time, liberal tort liability concepts have expanded and claim costs related to environmental issues (asbestos, toxic,etc) have soared beyond all previous levels. In order to remain "head above water", property and casualty companies, who had previously limited themselves to more conservative lines of liability insurance, entered markets with higher risks and greater underwriting uncertainty. In some cases, these changes were made with inadequate expertise, utilizing marketing techniques that 173

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inappropriately relinquished underwriting authority. Some insurers severely underestimated their reserves and underpriced their policies with disastrous consequences. Far and away, the casualty losses of mega events like Hurricanes Andrew, Hugo and Floyd, the Midwest floods and the California earthquakes, one right after another, will prove to be the losses hardest to recoup. Hurricane Andrew alone amounted to losses almost 20 times greater than the premiums paid by all Florida homeowners in that year and approximately equal to all homeowner premiums written countrywide for the same period. Unfortunately, rate regulations prohibit setting off losses in one state with gains from another. So, raising rates in all states to cover extraordinary costs resulting from problems in one state is not possible. Allowable rate increases are also inadequate. It is estimated, for example, that Florida insurers would have to increase their premiums by 25 percent, each year for the next 15 years to recover recent hurricane losses! Obviously, the State of Florida will not allow such an increase. Since many property/casualty companies are reinsured, the reinsurance industry has felt the brunt of the impact. As a result, reinsurers have substantially withdrawn from the marketplace. Industry experts worry that this could create a capacity shortage. For the meantime, however, things appear stabilized for property/casualty insurers simply because they have been able to reap major capital gains from recent bond sales and the stock market has been very supportive in raising capital as investors needed higher paying issues. As mentioned, these two events have softened the blow of reinsurance withdrawals. The bad news is that the industry and reinsurers alike are now reinvested at much lower yields than before so there will be less net income available to relieve future underwriting losses. Further, if major catastrophes continue in a period where interest rates are rising, it is doubtful, that the insurers/reinsurers will be able to turn to bond sales to offset losses since rising interest rates cause bond portfolios to lose value. In addition, it is not sure how much help the securities industry could be during a period of rising rates since investors may lean toward more conservative "insured" issues like municipals. The bottom line of these events could mean that the property/casualty business will have less access to reinsurers and could experience more insolvencies in the years ahead when major claim events occur. A survey of the top 100 casualty companies by A.M. Best documents recent financial changes. "Assets for these 100 insurers, which totaled $533.8 billion, collectively represent nearly 85 percent of the property/casualty industry's assets. In line with the industry's growth, admitted assets of the top 100 show consistent declines in recent years, most significantly in the early 1990s. The diminished growth occurred because of reduced growth of invested assets and cash flow depletions reflecting continued growth in negative underwriting cash flows, which culminated in substantial Hurricane Andrew & Flloyd claims payments and a decline in cash flow from investment income -- the first decline in 50 years for the property/casualty industry. Declining investment yields and diminishing cash flows reinvested in the industry's portfolio combined in these years to cause a decline in net investment income. Today, the market continues soft due to continued pricing (premium) declines and lagging claims from the same natural disasters. If there is one bright spot on the horizon, it is the fact that new carriers are not showing up as quickly as they used to and old players are becoming more restrictive in their underwriting requirements. While these facts have not produced a clear hardening trend or price firming, experts are happy to declare that it is not getting any softer.

WHAT DO THE PROBLEMS MEAN

The sum total of the P&C industry problems is lack of premium growth and dwindling profits. In fact in 1997 and 1998, the industry is less profitable than ever before in modern times. In the 1980s the pressures described above "vented" in the form of a rise in a number of insurance companies failures, at least by certain regulatory standards, and those requiring formal action. Most of the underperforming activity was confined to companies writing between $6 million and $12 million in premiums per year and assets of between $20 and $40 million . . . small companies in the world of insurance. Today, however, many industry professionals say that the typical American insurance company, is in no way facing the kinds of risks faced by major company breakdowns like Executive Life, Mutual Benefit Life and others. In their opinion, the bulk of the industry has pulled through a tough economic environment and remains 174

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financially responsible. Most insurers are generally well capitalized, relative to other financial institutions, and are restructuring assets to meet new solvency standards, merging with stronger insurance and non-insurance companies and still conservative. Whether these measures are enough to weather the economic storms and other natural disasters of the 1990s remains to be seen. As between property casualty companies and life/health companies, it appears that the casualty carriers continue to maintain greater liquidity -- about 77 percent of their assets are liquid vs. 56 percent for life companies (A.M. Best Survey). The life industry's affliction to real estate, mortgages and non investment grade bonds account for its low liquidity ratio. In contrast, property/casualty carriers have invested primarily in stocks, a trend they have maintained for the past five years. One must wonder, however, if the potential for loss in the casualty industry greatly offsets this liquidity edge. On the other hand, it has been principally life companies that have experienced the most serious failures. Despite these statistics, the industry is, nonetheless optimistic. The independent agent, however, continues to walk a tightrope between clients who demand a "close to perfect" recommendation, an industry that is reeling from some major restructuring, aggressive competition and regulators who seem to have their own agenda. Through it all, no one has decided on a uniform system to determine safety and solvency and what role the agent will play. Any practicing agent should obviously stay close to this developing arena.

COMPANY SAFETY IN THE YEARS AHEAD

During the last half of the 1980s and into the 1990s, industry failures and regulatory focus catapulted the issue of solvency to the front line. While in the spotlight, other problems in the industry were brought to surface like deceptive sales practices, misleading illustrations, national health care, asset risks, the adequacy of the state guaranty system, private rating service deficiencies and certain industry tactics used to "shore up" balance sheets. This negative exposure accelerated political investigations which have and will continue to result in new regulatory pressures. For the meantime, most insurers have been fairly successful in stabilizing their financials -- particularly capital surplus -- through aggressive cost containments and the "bulk sale" of selected assets. Some experts believe that company managers are overcompensating, building surplus beyond reasonable levels in response to new or proposed risked based capital rules. While this will help companies meet new regulatory quotas, future earnings will decline, as potentially profitable acquisitions are by passed and the development of new product lines is placed on the back burner. This, in combination with proposals like the model investment law, render industry managers some complex limitations. Some believe, in the long run, insurers will be legislated out of their ability to make any investment risks. Since investment profits play a major role in surplus, this could leave the industry at a major disadvantage to cover future liquidity problems. A major turn of events or more catastrophic hurricanes or floods could again push many insurers over the brink. Further, the insurance industry position as a major source of capital for real estate and bond markets will be diminished or lost.

FUTURE OPERATIONAL CHANGES

The biggest challenge facing insurance companies is how to balance profits and solvency . The industry is entering a period of higher regulatory action and reaction. But what standards will they have to meet and who will regulate them? Further, will complying with new surplus and investment standards jeopardize an insurer's ability to satisfy shareholders and meet its own financial goals? These questions will probably NOT be answered for many years. In the meantime, insurance companies will likely be taking a "double books" approach of testing for regulatory reporting on one side, while the other side is testing for investment strategies and new products. Blending the two together will not be easy. While insurers have improved their monitoring of cash flows and asset/liability matching, the danger of interest rate flucuations is now a substantial risk. If rates edge upward, carriers risk disintermediation, or a major outflow of funds, if they are unable to keep pace with consumer demands for higher rates. A concern shared by industry groups is that this condition, or additional casualty catastrophes (hurricanes, floods, earthquakes) might strain carriers beyond their resources. And, even though their liquidity level may be higher, under new risk based capital rules where future investment returns might be less, there will not 175

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be large "profit pools" to draw on for contingencies and as emergency claim funds. As a result, insurers may be forced to raise mortality and/or premium rates at a time when the forces of competition, regulatory pressures and consumer demand can least tolerate it. Aside from slim profit margins, other factors which could influence future solvency include changing demographics which have reduced the demand for life insurance; increased competition for savings dollars / insurance products from the banking and mutual fund industry and the ever present threat of potential loss of insurance tax advantaged status. On the casualty side, the industry is still suffering from past baggage in the form of liability suits and environmental claims (asbestos, toxic, etc). And, of course, no one knows what mother nature is likely to dish out.

POSSIBLE REGULATORY CHANGES

In recent years, the industry has experienced a small taste of the new regulatory "bite". Despite huge insurer losses from hurricane and Midwest flood claims, regulators in these states prohibited major rate hikes and required companies to continue providing coverage. In Florida, consumer outcries prompted the state legislature to initiate a moratorium on "non-renewals" and limit annual rate increases to five percent when an increase of 20 percent is needed to recoup from hurricane losses. The liquidity problems of life insurers are also a definite target for regulators. So great is the pressure and so many are the proposals that life companies are totally consumed with restructuring for regulatory solvency to the detriment, some say, of passing on investment opportunities that could mean substantial earnings in years ahead. The management of profitability under these conditions runs a clear second to solvency issues. This could place life companies at a competitive disadvantage to banks and other financial services industries, where solvency issues have improved and profitability is again the first priority. The end result is still anybody's guess. What is certain is that new regulatory laws and proposals will proliferate. Here are a few that are already on the books or in motion:

Risked Based Capital

Guidelines for RBC were effective as of 1994 for life and health companies and 1995 for property/casualty insurers. Risk Based Capital is the "brainchild" of the National Association of Insurance Commissioners. Since its inception, the National Association of Insurance Commissioners has strived to create a "national regulatory system" by the passage of "model acts", or policies designed to standardize accounting and solvency methods from state to state. Risk Based Capital is one of many "model acts" recently adopted by the National Association of Insurance Commissioners. While the jury is still out on the effectiveness of Risk Based Capital, no one can argue that any attempt to establish a universal form of solvency regulation is attractive, and quite possibly mandatory in light of recent pressure by Congress and consumers. The National Association of Insurance Commissioners can be considered a logical conduit for national regulation, since its members are the insurance commissioners of each state and at present, the authority of states to regulate the insurance industry is allocated to the states under the 1945 McCarran-Ferguson Act. The Risk Based Capital Model Act defines acceptable levels of risk that insurance companies may incur with regards to their assets, insurance products, investments and other business operations. Insurers will be required, at the request of each state insurance department, to annually report and fill out Risk Based Capital forms created by the National Association of Insurance Commissioners. Formulas, under Risk Based Capital, will test capitalization thresholds that insurers must maintain to avoid regulatory action; recalculate how reserves are used; reduce capitalization required for ownership of affiliated alien insurers and non insurance assets; and allow single state insurers to qualify for exemption from reinsurance capitalization if their reinsurance doesn't exceed five percent of total business written. The Risked Based Capital system will set minimum surplus capital amounts that companies must meet to support underwriting and other business activities. Because the standards will be different for each company, the guidelines run counter to existing state-by-state regulations that require one minimum capitalization requirement for all insurers regardless of their individual styles of business or levels of risk. 176

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Insurers reporting Risk Based Capital levels of say less than 70 percent to 100 percent may be subject to strict regulatory control. Scores from 100 percent to 150 percent might be issued regulatory orders requiring specific action to cure deficiencies. Higher scores might receive regulatory warnings and corrective action stipulations. Attaining 250 percent or more, would relieve an insurer from any further Risk Based Capital requirements in a given year. It is clear that Risked Based Capital encourages certain classes of investment over others. For example, an asset-default test under Risked Based Capital, called C-1, establishes varying reserve accounts be established for various classes of investments based on their default risk. These amounts could be as much as 30 percent for stocks and low quality bonds and 15 percent for real estate owned as a result of foreclosed mortgages. Industry critics say that the C-1 surplus requirements alone could be far greater than all other categories of Risked Based Capital like mortality risk assumptions, interest rate risks and other unexpected business risks. Since Risked Based Capital reports are based on previous year financial conditions, many insurers routinely restructure their portfolios to avoid as many C-1 assignments as possible. This has included the wide scale disposition of real estate and real estate mortgages, the repackaging of real estate products into securities and large reductions in "junk bond" holdings. Despite these efforts, C-1-rated classes of assets continue to represent a sizeable share of insurer portfolios. In many cases, companies have very few options to unload foreclosed real estate as long as the market continues soft. A Saloman Brothers Inc study of almost 500 insurance companies clarifies the problem. Using some recent reports, the median level of surplus capital was found to be at 189 percent of their respective risked based capital levels. Even though, a majority of companies exceeded the 150 percent threshold--thus, not requiring regulatory correction--the results indicate that hundreds of companies did not measure up. The concern by industry groups is that when risked based capital is enacted, the results could generate significant "bad press" which could weaken demand for individual company and industry products. There is also speculation that companies will change investment portfolios to achieve higher Risked Based Capital ratios. This may critically hamper real estate investing for a some time to come. On the surface, Risk Based Capital seems to solve many regulatory concerns. Solvency rulings are standardized from state-to-state and specific action is mandated across the board. This would appear to be acceptable by insurance companies who could now predict regulatory response in any state. However, as we have seen, Risked Based Capital could also adversely affect financially sound companies simply because they own more real estate -- performing or not. Risked based capital also scores low among insurers for another very important reason--Risk Based Capital Reports can be disclosed and misunderstood by the public, despite National Association of Insurance Commissioners confidentiality promises. It is easy to realize that disclosure concerning a low scoring company could damage or cause a "run" on the insurer. The National Association of Insurance Commissioners feels it has adequately provided for confidentiality within the Risk Based Capital Act. Specifically, the Model prohibits anyone in the insurance industry from using Risk Based Capital data and analysis in any public statement. There is even a provision recommending that state legislatures exempt Risk Based Capital information received from the National Association of Insurance Commissioners from state "freedom of information" laws. Insurers doubt that any such exemption from disclosure will suffice, since few states have adopted any exemption legislation, and there is history that pressure from public, political and judicial arenas ultimately lead to access by anyone for any reason. In fact, there may be reason for insurance company concern about disclosure of Risk Based Capital data. Recently, there has been attempts to retrieve information similar to Risk Based Capital data by an insurance journalist/analyst using "freedom of information" statutes. Many states denied these requests for reports, called IRIS ratios (Insurance Regulatory Information System reports) since this data is considered confidential by state financial examiners. Yet, in some states, the same requests for information had mixed success via direct court action. In response, the National Association of Insurance Commissioners adopted a policy to withhold IRIS report information from states that could not assure confidentiality. Under court order, however, they later agreed to disclose the actual IRIS ratio themselves but not the analysis of their examiners that usually accompany IRIS reports. The court argued that even 177

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though the National Association of Insurance Commissioners is considered to be a private organization of government officials, rather than a government agency, IRIS ratios eventually became the exclusive property of state insurance departments and thus subject to public access under freedom of information. In another state, the courts rendered a different decision and granted an exemption under freedom statutes thus asserting the state regulators right to withhold IRIS reports. They concluded that the privacy rights of the insurance company outweighed the merits of public disclosure. Indeed, insurance companies have reason to remain uncomfortable about disclosure of confidential information like IRIS and Risk Based Capital reports. In fact, they might be uneasy to learn that efforts to win access to even more sensitive information, like minutes of insurance company board meetings, has been met with some success. Once information is demanded and then delivered to state regulators it becomes potentially fair game under freedom of information statutes. In a similar vein, there is concern that federal political pressure to subpoena confidential records of an insurer would allow even greater access since federal "freedom of information" statutes are typically more liberal that individual states. Safeguards proposed by the National Association of Insurance Commissioners and state regulators may help forestall public access, but it may be optimistic to think that a foolproof method to avoid disclosure is possible. Troubled insurers, may well brace themselves for the likelihood that data on their Risk Based Capital could make national news or influence their ratings. Some, in the industry, also feel that the Risk Based Capital rules are simply too restrictive, subjecting many of the best known insurers to immediate regulatory action and/or "bad press". This, in turn might lead to a "run on the bank" that could tip these insurers into worse condition. The concern of these parties is that the risk based capital system doesn't falsely identify adequate capitalized insurance companies and undercapitalized ones as being adequately capitalized. Too much is concerned with the type of investment, rather than its quality. Just how companies react to these guidelines remain to be seen. As mentioned, many life and health insurers have already changed their investment strategies to more favorably align with Risked Based Capital guidelines by selling their large scale real estate investments and junk bonds.

Solvency & Financial Enforcement Trust (Safe -T)

In the search for a solvency "cure", it is possible that simple is better. Nothing could be simpler than a concept proposal called "Solvency & Financial Enforcement Trust" or SAFE-T for short. SAFE-T is considered a simple, straightforward solution because it eliminates the complex formulas proposed by many other plans, such as the National Association of Insurance Commissioners "Risk Based Capital" plan. Developed years ago by State Farm for use by property/casualty companies, the SAFE-T method would require each insurer to fund a custodial account at an institution that is not related or affiliated with the insurer. The funding of this account would be accomplished using real, liquid assets. The amount of assets in the account would be sufficient to cover loss reserves and loss adjustment expenses. To facilitate claim payments from an insolvent insurer, the guaranty fund for a particular state has, in essence, a lien against the SAFE-T trust account. The value of assets in the custodial account would be verified annually by a Certified Public Accountant along with a certification of loss reserves. More recent amendments to the proposal allow the insurer to retain all ownership rights to the assets in the custodial account, as well as the rights to sell and trade them, so long as any securities meet qualifying standards under the act. Only cash, cash equivalents, publicly traded securities classified by the National Association of Insurance Commissioners as medium or high quality would be accepted. Also, an insurer could submit an approved letter of credit to meet assets requirements. The amount of this letter of credit, however, could not exceed 15 percent of the amount required to be on deposit in the SAFE-T account. Further, an insurer would be provided some leeway if the value of the assets in the account dropped during the year. So long as assets maintained 80 percent of the required value, the insurer would not be required to add more assets in the middle of the year. If, however, the value drops below 80 percent of the required amount, the insurer must immediately respond with additional asset deposits or risk a "cease 178

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and desist" order restricting the company from writing any new business. Custodians of the SAFE-T accounts would be responsible for reporting to the respective insurance commissioners the activity and value of the insurer's account. In the event an insolvency was eminent, the SAFE-T account would be available to make prompt claims or to reimburse the state guaranty fund. The advantages of the Solvency & Financial Enforcement Trust are many. First, many of the standards, such as the use of Certified Public Accountants and certification of loss reserves, are already in place. This will enable easier set up and enforcement. Second, SAFE-T is based on the use of assets considered by many, including the National Association of Insurance Commissioners, to be the most valuable to an insurer's ability to meet its obligations to its policy holders. Third, the requirements of SAFE-T seem to align with the needs of state regulators looking for an improved "early warning" system that could be enforced without the need to apply complicated formulas and legal hoops. And, fourth, the number of insolvencies may be minimized, since liquid assets of the company will be "marshalled" by the custodian. In past cases, by the time an insurer faced insolvency, most of the liquid assets had already been sold, leaving less valuable and illiquid ones to the liquidator, state guaranty fund and policy owners.

The Compact Approach

Another approach to solvency regulation is to improve the existing state guaranty system. One proposal by the National Conference of Insurance Legislators seeks to provide a uniform set of standards for all state guaranty fund regulators. This would be accomplished by creating an interstate "compact" or agreement among all states to standardize the protection provided by guaranty funds, as well as procedures to rehabilitate and/or liquidate an insolvent insurer. The idea of a "compact" between states is nothing new. Article 10 of the Constitution provides for a mechanism for states to make agreements among themselves in order that fair treatment of the citizens be served. This has resulted in over 100 interstate compacts over the years on issues like taxes, vehicle laws and crime. There is no reason this wouldn't work to overhaul the current state guaranty systems which are riddled with loopholes, exclusions and diverse protection limits. It is common knowledge in the industry and among regulators that improvements to the system are needed, especially in the aftermath of public hearings presented to members of Congress in 1991 and 1992. Significant weaknesses in the guaranty fund system were discussed, and the fear among industry leaders and regulators alike is that a lack of action to respond with corrective action may result in efforts to replace the state guaranty system with a federal mandate. State fund problems aired in the public hearings include guaranty limits, insurer and policyowner residency and specific product exclusions. Guaranty fund limits vary widely between states. In Kansas, life and health benefits are covered up to $100,000. The limits are $500,000 in New York. Utah includes a $500 deductible others do not. Michigan guarantees 1/20 of one percent of all property/casualty premiums while New York stands behind a whopping $1 million. Some funds will only cover residents of their state, others will back anyone insured by a company that is domiciled in the state. Additional variations include service and product coverage. Some funds guarantee all annuities written by domiciled companies while others exclude variable type policies. Some cover HMOs and Blue Cross/Shield plans, while others do not. The National Association of Insurance Commissioners developed "model acts" which it hoped most states would follow -- The Post-Assessment Property and Liability Insurance Guaranty Association Model Act (1969) and the Life and Health Insurance Guaranty Association Model Act (1970). The property/casualty model sets maximum limits at $300,000 for any claim with unlimited coverage for workers compensation. The life/health model includes maximum benefits of $100,000 in cash values of life, annuity and health contracts and $300,000 in death benefits. To date, not all states have followed these guidelines. On the property/casualty side, about 14 states meet or exceed the NAIC limits. The remaining follow some, but not all standards. In life/health, only 15 states limit guaranty funds in line with the Model Act.

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The interstate "compact" proposed by the National Conference of Insurance Legislators could potentially smooth out the differences among states and bring about a set procedure for handling insurance company insolvencies. The proposal suggests this could be accomplished by creating a commission, called the Insurance Claimant Protection Commission, to coordinate the activities of all state funds participating in the compact and act as the receiver of insurers placed in rehabilitation or liquidation. The commission would be comprised of the commissioner of each state. Each state would have one "member vote", as well as a designated number of "premium votes", based on the state's total premium volume. Any decision by the commission would require a majority of BOTH member and premium votes. Commission meetings would be public, unless a majority of members agreed that subjects discussed would reveal trade secrets or confidential information. Funding of the commission would be through assessments of insurance companies doing business in the compact states. Reports would be made annually to the governor and legislature of each state as well as the National Conference of Insurance Legislators. Regulations and statutes approved by the commission would be binding on all state funds in the compact. As an escape measure, each state's legislature could vote to reject a commission statute. If a majority of states follow suit, the specific regulation would have no force and effect on any compact participant. Under the threat of federal intervention, it is likely that the interstate compact should attract major attention. Already, insurance departments of several states are amenable to working on a compact plan and the National Conference of Insurance Legislators is in process of contacting state legislators, policymakers and industry trade groups. The fact that the interstate compact was conceived by state legislators with technical assistance from one of the nation's top insurance law firms give it a greater chance of success than many other solvency proposals.

Federal/State Co -Regulation
On the heels of several large insolvencies a flood of regulatory initiatives have emerged. Critics of solvency proposals say there is no panacea for the problem. Even federal intervention will not bring an end to insolvencies, since they are inevitable in a free market. Then, too, the federal government does not have a stellar record in the area of efficiency and regulatory success. Others, however, believe that federal involvement in the regulation of insurance is necessary to industry stability and the centralization of authority. While there is cause to doubt this last proclamation, it is possible that some form of federal and state system of regulation will be attempted. The Federal Insurance Solvency Act of 1992 is one such example. Under this act, a solvency commission would regulate all insurers. Insurance companies and reinsurers would receive the equivalent of a "solvency certificate" which would permit them to do business anywhere in the United States. The bill also created a protection or guaranty fund to cover any insolvency losses. As good as all this sounds, this regulation has come with a hefty price tag and since it leaves rate regulation with each state, it establishes a system of "dual control". The regulatory hurdles and snafus that come with the program are many. Some believe that a slightly different "two-tiered" system can work. Federally licensed companies could do business alongside state licensed insurers much like they do in the banking industry where some institutions are federally chartered while others operate solely under the jurisdiction of the state. Insurers, both large and small, could have the choice to be federal or state licensed and limits on guaranty funds could be standardized. Additionally, an insurer could and should be totally regulated by either the federal or state system, not partially regulated by both. The advantages of such a system key on uniformity for the insurer wishing to do business on a nationwide scale. Policy owners would also know that guaranty fund limits are the same from state to state. One would wonder, however, if such a system would favor federally licensed companies where policy owners might feel a federally backed guaranty fund is safer than a state fund. It is suggested, then, that for a successful federal-state system to exist, competition must be eliminated: This could be difficult, if not impossible to accomplish. That is why many industry regulators and players believe that a new, untried federal system is not practical. They argue that in place of scrapping state systems of regulation, a major restructuring of existing state guaranty funds and universal solvency rules would have greater value. Thus, proposals like Risk Based Capital, SAFE-T and 180

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INSURANCE MARKETING ISSUES the Interstate Compact must be seriously considered to "head off" federal intervention.

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Model Investment Laws

The National Association of Insurance Commissioners has also made headlines for its proposal of Model Investment Laws. The purpose of these regulations would be to prevent insurance companies from concentrating too much cash in too few types of assets. Critics feel the National Association of Insurance Commissioners' guidelines rely too heavily on classifying by type of investment and risk and setting percentage maximums. This, they say, will leave regulators with little opportunity to use their own judgement.

National Catastrophe Fund

Although it may be years in the making, a National Catastrophe Fund is also being considered. During hearings before the Senate Commerce, Science and Transportation Committee, details indicate that this fund would reinsure existing companies to ease the impact of major disasters. A company with losses that exceeded 20 percent of its surplus would qualify for assistance. Because only regional and small companies are likely to collect from such a federal fund, the current thinking is that the amount of losses would not be large enough to seriously strain the fund.

State Catastrophe Funds

Regulators have and will be influential in convincing state legislatures to establish catastrophe funds. These funds may start out to be permanent solutions only to fizzle out within months or years after the disaster has struck--like the earthquake fund in California. Current efforts include Hawaii and Florida, where major hurricanes have hit in the 1990s. In Hawaii, the state hurricane fund is the exclusive provider of hurricane insurance. The programs is financed through a variety of real estate fees, premium taxes and assessments. The systems functions as a reinsurer to companies writing within the catastrophe zone. Florida's hurricane trust fund reimburses insurers for 75 percent of their losses once claims surpass two times the amount of the company's annual premium. Financing of the program will be through surcharges on policies, a percentage of premiums written, emergency assessments and state guaranteed bonds.

RATING CHANGES
For now, while interest rates and mother nature is lying low, insolvencies are down. Agents should, however, be prepared for the very minimum expectation -- the new regulatory environment coupled with diminished profits and the need for rating agencies to clamp down will affect ratings. The major rating services expect downgrades to outpace upgrades for many years to come. As case in point, A.M. Best recently issued life companies 172 downgrades and only 56 upgrades. While this is not the same as widescale insolvencies, it is a deteriorating condition that could affect client confidence. Marketing products and services in the face of reduced ratings will test agent due diligence and company selection skills beyond any previous limits. In a period following major company failures it is logical that the rating agencies will emerge with new, tighter criteria. They must also adapt to changing regulatory laws and formulas. Needless to say, major changes are going to occur. A preview of the intensity and breadth of change possible took place in July 1993 when A.M. Best shocked the insurance world by downgrading over half of the life companies who previously held A+ or A++ ratings to A. Before this, in late 1992, Best added six new letter ratings (A++, B++, C++, D, E and F). This increased the ratings of this firm from 9 to 15. It also brought to light the huge differentiation the company anticipates in company ratings. Further, it could be a indication that the company will no longer be timid in swiftly downgrading a company . . . perhaps to as low as D and F (liquidation). In a recent article, Best explains its rating modifications . . . "The purpose of these changes was to enhance the usefulness and clarity of our rating system . . . More important than the structural 181

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changes to Best's rating classification has been the continuing evolution of our analytical review. Specifically, qualitative considerations have become increasingly important in Best's rating system". Some feel that the Best downgrades are tied to size of company. One company's analysis showed that 77 percent of the 71 companies adjusted downward had assets less than $600 million. Best contends that its rating framework is the same for all companies, regardless of size. They do admit, however, that there are advantages to size in certain lines of business. According to the company . . . "Administrative capabilities, technological advantages, lower unit costs and management depth can provide competitive strengths that contribute to market penetration and presence difficult to achieve in highly competitive businesses on a relatively small scale. Though such advantages may be reflected in rating assignments, smaller companies that remain highly focused and maintain sustainable and defensible strengths also fare favorably in Best's rating assignments". Other rating services will also recognize the need to adapt their solvency formulas. In the past, some of these companies, namely Standard & Poors and Weiss, have based their analyses primarily on quantitative issues such as the insurer's claims-paying ability based on statistics generated from statutory filings with individual state insurance departments or the National Association of Insurance Commissioners. With new risks of regulatory violations, competition from new entrants, banks, thrifts, etc, and the delicate line insurers must walk between solvency and profit, it is likely these agencies will add fresh information to modify their approach. Few raters, with the exception of Moody's, have focused on the breadth of such issues. This is likely to change in the years ahead with the inevitable result being lower ratings.

THE RATING SERVICES

The activities of insurance company rating agencies have become increasingly prominent with the industry's recent financial difficulties and the well-publicized failures of several large life insurers. The ratings issued by these agencies represent their opinions of the insurers' financial conditions and their ability to meet their obligations to policy holders. Rating downgrades are watched closely and can significantly affect an insurer's ability to attract and retain business. Even the rumor of a downgrade may precipitate a "run on the bank", as in the case of Mutual Benefit, and seriously exacerbate an insurer's financial problems. There is little doubt that rating organizations play a significant role in the insurance marketplace. Some have expressed concerns about the potential adverse effect of ratings on particular insurers and consumer confidence in the insurance industry in general. Once the province of only one organization, A.M. Best, a number of new raters emerged during the 1980s. Questions have been raised about the motivations and methods of the raters in light of the recent sensitivity regarding insurers' financial conditions and what some perceive to be a rash of arbitrary downgrades. On the one hand, insurer ratings historically have been criticized for being inflated or overly positive. On the other side, there are concerns that raters, in an effort to regain credibility, have lowered their ratings arbitrarily in reaction to recent declines in the junk bond and real estate markets and the resulting insurer failures and diminished consumer confidence. Of particular concern to some regulators and the industry are the practices of Weiss Research and Standard & Poor's (S&P) publications of qualified solvency ratings. Both the Weiss "safety" ratings and the S&P "qualified solvency" ratings are based on a strictly quantitative analysis of financial data. While there has been a concern about inflated ratings historically, Weiss has been criticized for marketing bad news to consumers, i.e. ratings that are skewed to the negative. S&P's qualified solvency ratings also have been criticized for utilizing a scale that appears to be lower than their claims paying ability ratings. Some have accused S&P of using the qualified solvency ratings to "extort" insurers to pay a $22,000 $28,000 fee to obtain a higher claims paying ability rating. S&P strongly denies these allegations and believes that consumers and agents properly understand the meaning of the qualified solvency ratings. Both S&P and Weiss contend that their quantitative ratings provide valuable, unbiased information to 182

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The influence of the rating agencies and the practices of Weiss and S&P have prompted some regulators and insurers to suggest that the states and others should limit access to their database, which is utilized by these raters. There also have been calls for regulators and the NAIC to evaluate and certify rating agencies to ensure that their methods and practices meet certain established standards. However, other regulators have questioned whether it is appropriate and practical for regulators to withhold data or regulate rating agencies. These regulators suggest that a more appropriate regulatory role is to improve consumers' understanding of the rating process and allow them to decide how to use the information raters provide. This discussion of the rating agencies presents certain factual information relating to the structure and activities of the five most prominent rating agencies -- A.M. Best, Standard & Poor's, Moody's, Duff and Phelp's and Weiss Research. A summary of their rating classifications is shown on the next page. The philosophy, scope, fees, resources, process, methodology and classification scheme of each of these agencies is described below. While issues relating to certain practices of the raters is discussed, this is not an attempt to evaluate the validity of the raters' methods or practices. Also, there is no information provided on other insurer rating agencies which has not received as much attention as the five agencies listed above, such as Demotech, Fitch Investors Service and Thompson Bankwatch, Conning & Company, Thompson & Schupp and/or other organizations that provide financial analysis of insurers but not ratings per se, such as Ward Financial Group.

INSURANCE COMPANY RATING CLASSIFICATIONS

RATING AM BEST S&P MOODYS WEISS DUFF& PHELPS

Superior Excellent Very Good Good Fair Marginal Below Standard

A++ A AB++ B B BC++ C+ C CD E* F**

AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC CC C,D

Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa Ca C

A= A AB+ B BC+ C CD+ D DE+ E EF

AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCC-

* Under state supervision ** In liquidation

A.M. BEST COMPANY

The A.M. Best Company has been rating insurance companies since 1906 and its long association with the industry is important to understanding its philosophy and approach. Its stated mission is "to perform a constructive and objective role in the insurance industry towards the prevention of insurer 183

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insolvencies ". Best views its ratings as an inducement for insurers to operate in a prudent manner and maintain strong financial health. It actively consults with and advises companies on the basis for their rating and what actions a company must take to maintain its rating or improve it. The objective of Best's rating system is to evaluate the factors affecting the overall performance of an insurance company and to provide its opinion as to the company's relative financial strength and ability to meets its contractual obligations. Best conducts an extensive quantitative and qualitative evaluation of rated insurers based on various sources of information and knowledge of the company accumulated over a long period of time. This knowledge is acquired through frequent contacts with company officials as well as statutory financial statements, special questionnaires and a variety of other sources. Typically, there will be meetings once a year with company management at Best's headquarters in Oldwick, New Jersey. There may be more meetings, if necessary, but Best attempts to meet at least once with a company over a two-year period, in addition to telephone contacts and correspondence. If adverse developments occur that may affect a company's financial condition, Best will discuss the situation with management. If the company can present an effective plan to resolve the problem, Best may not immediately downgrade the company. The company's situation would continue to be monitored to ensure that the corrective action was implemented. To obtain an alphabetical Best's rating, an insurer must have been in existence for at least five consecutive years of representative operating experience, have net premiums in excess of $1.5 million for a life/health insurer, $1.5 million in surplus for a property/casualty insurer, submit the requested financial information and pay a $500 fee. In a recent edition of Best Insurance Reports, 811 life/health insurers and 1,513 property/casualty insurers received an alphabetical rating. An additional 530 life/health insurers and 970 property/casualty insurers received rating "not assigned" (NA) classifications which explains why they did not meet Best's eligibility requirements. Of these non-rated companies, 291 life/health insurers and 597 property/casualty insurers received a Financial Performance Index (FPI) assignment, introduced in 1990. Insurers are required to have at least three consecutive years of representative operating experience to obtain an FPI rating. The $500 fee does not apply to companies receiving a "not assigned" rating classification or an FPI assignment. Insurers can elect to not have their rating published. If that happens, a company receives an NA-9 "Company Request" designation. In this instance, Best normally requires a minimum of two years to elapse before the company is again eligible for the assignment of a rating. A recent Best's alphabetical rating consisted of nine categories, ranging from A+ (Superior) to C- (Fair). On January 13, 1992, A.M. Best announced an expansion of its alphabetical categories to fifteen ratings. They range from A++ (Superior) to F (In Liquidation). The stated purpose of this expansion was to add finer distinctions among rated companies. About the same time frame, Best also eliminated its "Contingent Rating" modifier and the rating categories of NA-7 (Below Minimum Standards) and NA-10 (Under State Supervision). Also, a new category NA-11 (Rating Suspended) was added. Best's classification system is described in greater detail later in this section. A.M. Best employs 360 full-time employees, of which 210 directly support its rating activity in addition to 125 temporary employees hired each spring to assist in processing insurer filings and data compilation. Of the 210 full-time staff, more than 100 are analysts and supervisory personnel directly involved in analyzing and rating companies. Best's analysts typically possess significant experience with respect to financial analysis of insurance companies, acquired at Best as well as in the industry. The productivity of Best's analysts also is enhanced by sophisticated computer-based analytical tools and a large amount of information accumulated on each company. In addition, A.M. Best has ongoing consulting and educational arrangements with a professional reinsurer, an accounting firm and an actuarial firm to keep its analysis informed of current developments and industry issues. A more detailed description of Best's rating process, methodology, rating classifications and distribution follows. 184

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Rating Process
Best's annual rating process begins with the receipt of insurers' annual statements and other questionnaires between March 1 and April 15. The statements are checked and discretionary items and write-in items are adjusted and standardized to put insurers on a comparable basis. Data is loaded to the mainframe computer after statement errors are reconciled with the insurer. The data is then compiled and prepared to reflect groups, pools or other organizational structures to perform appropriate unit or group rating analysis. Once the data is compiled and prepared, a series of worksheets are generated which begin the analysis process. Utilizing the worksheets, an analyst reviews various financial ratios and assigns points based on a company's results relative to industry, peer group and Best's financial norms as compiled through an algorithm. The rating worksheets are reviewed to identify an insurer's adequacy and reinsurance protection. Ultimately, a score is produced which serves as a starting point leading into extensive qualitative analysis to fully understand and assess the company's true financial condition. The qualitative analysis involves review of the rating worksheets, supporting documentation and various other information sources. Supporting documentation includes supplemental and background questionnaire, company reports, examination reports, SEC filings, reinsurer audits, and actuarial reports. Other information sources include management meeting notes, business plans, previous year and quarterly rating remarks, the current first quarter results and statement interrogatories. After evaluating the quantitative and qualitative information, the primary analyst assigned to the company submits a rating recommendation to a manager for review and discussion. The manager either accepts the analyst's recommendation as submitted or modifies it before sending it on to an executive rating committee for final approval. The company is notified of its rating and has the option of discussing it with Best's analysts and officers before its publication. The insurer may present additional information or agree to take actions (e.g. adding capital) that may result in a revised rating. Insurers can elect to not have their rating published. In that event, they will receive an NA-9 "Company Request" designation, which also is assigned if a company fails to pay the $500 rating fee. In a recent year, 37 life/health insurers, or 2.8 percent, and 8 property/casualty insurers, or 0.3 percent, had been assigned NA-9 classifications. Best officials estimate that about half of these instances involve rating disputes. After this process is completed, the ratings are published, on a weekly basis beginning in April, in Best's Rating Monitor, a special supplement to Best's Insurance Management Report, and made available through BestLink, the on-line computer service, and BestLine, 900 phone service. Ratings are also reported in other Best publications, including Best's Insurance Reports, as they are released. Companies continue to be monitored after their annual rating is assigned. Ratings are reviewed with receipt of the second- and third-quarter statements and changes are released through Best's Rating Monitor, BestLine and BestLink. Meetings are held with company officials throughout the year, and there may be other frequent contacts with the company, if necessary. Analysts also monitor a variety of information, such as press clippings and correspondence from agents and competitors, to keep tabs on companies and note any new developments with respect to their activities or the markets in which they operate. In addition, Best conducts impact studies on the companies it monitors following a major catastrophe or regulatory/legislative development, e.g. California Proposition 103, Hurricane Hugo.

Rating Methodology
The objective of Best's rating system, as described in its literature, is "to evaluate the factors affecting the overall performance of an insurance company in order to provide our opinion as to the company's relative financial strength and ability to meet contractual obligations." Best's ratings are based on a quantitative evaluation of a company's performance with respect to profitability, leverage and liquidity and 185

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a qualitative evaluation of its spread of risk, reinsurance program, investments, reserves and management. The quantitative evaluation analyzes an insurer's reported financial condition and operating performance for at least the previous five years against industry peer group and Best's financial norms, utilizing more than 100 financial tests and supporting data. If a company has a relationship with an affiliate through an investment, reinsurance or pooling agreement, data is consolidated to reflect this affiliation. Best views profit as a measure of the management's competence and ability to provide insurance at competitive prices and maintain a financially strong company. Best's profitability analysis reviews the degree, trends and components of earnings over the most recent five-year period. Net investment income, federal income taxes, expenses, mortality and persistency (life companies only), reinsurance, reserving practices and methods, statement versus market value of assets, regulatory constraints and underwriting experience are evaluated with regard to their relative effect on a company's earnings and capital and surplus. Also, the stability, trend, type and diversification of premium volume are evaluated as to their impact or potential impact on an insurer's reported statutory operating results. Best is watchful of highly leveraged companies that are exposed to a high risk of instability and adverse changes in underwriting or economic conditions. Best reviews a number of leverage measures including the ratio of premium to capital and surplus, both gross and net of reinsurance. Affiliated investments are considered in the analysis of capital and surplus which also is adjusted to reflect the adequacy and equity of policy reserves, the market value of assets and potential default risk, market value fluctuation, nonperforming assets and reinsurance quality. For property/casualty companies, Best looks at the ratio of reinsurance premiums ceded and loss reserves to surplus to measure the companies' exposure and dependence on reinsurance. The leverage analysis evaluates the relationship of net liabilities to adjusted surplus, insurance and investment risk based capitalization and other tests which measure a company's surplus or its asset and insurance risks. Best believes that insurers' liabilities should be supported by sound, diversified and liquid investments to meet unexpected needs for cash without the untimely sale of investments or fixed assets. Best measures an insurer's "quick liquidity" position -- the amount of cash and quickly convertible investments as a percentage of liabilities; "current liquidity" -- the amount of cash and unaffiliated invested assets as a percentage of liabilities; and its cash flow position. The assessment of an insurer's liquidity incorporates an evaluation of the quality, market value, and diversification of assets, cash flow and asset/liability matching programs. Best also considers exposures maintained in single large investments. Stress tests assess the surplus impact of a 20 percent decline in common stock prices and the reduction in market value of bonds, preferred stocks and mortgage loans caused by a two percentage point increase in interest rates. Best's qualitative evaluation looks at any items which cannot be totally reflected in the "numbers" that may have affected a company's performance or may potentially affect its long-term viability. The qualitative evaluation includes, but is not limited to the: 1) composition of a company's book of business, i.e. spread of risk; 2) adequacy of the reinsurance program; 3) quality, estimated market value and diversification of investments; 4) adequacy of reserves; 5) adequacy of surplus; 6) experience and competency of management; 7) asset/liability matching programs; and 8) the distribution and nature of liabilities structures. Also, Best recently instituted a "policy holder confidence factor" which measures a life insurer's relative vulnerability to all surrenderable liabilities in relation to its liquid assets. To evaluate a company's spread of risk, Best analyzes its book of business on both a geographic basis and by line of business. Best also reviews a mix of a company's business relative to the distribution of its assets and their respective maturity and expected performance. Best looks for concentration in volatile lines of business or hazardous areas which can negatively affect an insurer's financial stability. Best reviews each insurer's reinsurance program to determine whether coverage is adequate for the 186

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potential risks involved. If an insurer carries a large amount of reinsurance, Best evaluates the quality, diversification and purpose of the reinsurance. An insurer's rating may be adversely affected if it has a large amount of reinsurance or reinsurance recoverable, particularly if the financial condition of the reinsurer is unknown. Significant amounts of reinsurance undertaken primarily for financial reasons also may negatively affect an insurer's rating. Best examines an insurer's marketable assets (common stocks, bonds, mortgage loans) to determine the potential impact on its surplus if an insurer had to sell assets unexpectedly. The liquidity, diversification and quality of assets are evaluated to assess the uncertainty of the value to be obtained on their sale. The adequacy of an insurer's reserves is essential to Best's analysis of its profitability, leverage and liquidity. For life companies, reserve analysis involves examining the types of business written and the valuation bases and interest assumptions used. For property/casualty companies, Best evaluates the losses and loss adjustment expenses on an ultimate payout basis. Best also considers the magnitude of a company's loss reserve discount relative to its surplus. In addition, the degree of uncertainty in loss reserve, recognizing that they are only actuarial estimates of future events, is evaluated. If the degree of uncertainty exceeds any equity in the reserves and is large in relation to net income and policy holder's surplus, Best's assessment of a company's reported profitability and leverage performance may be adjusted accordingly for rating purposes. Best assesses the adequacy of an insurer's surplus relative to the degree of risk associated with its book of business. Best's rating evaluation accounts for the fact that varying degrees of underwriting risk and volatility exist with certain lines of business, with lines of higher volatility requiring greater capital adequacy. Best prides itself on close working relationships and frequent contacts with the managements of the companies it reports on and rates. Best's rating evaluation considers the character, objectives, experience and competence of an insurer's management. Various other important factors may be considered in the qualitative analysis, particularly those which may significantly affect a company's ability to meet its contractual obligations. Best's research and analysis in other areas may identify market or economic trends that could affect an insurer's financial condition. A company's relative standing within a rating category can be weakened, maintained or strengthened, based on the qualitative analysis. In a few instances, an insurer may be precluded from a particular rating classification or downgraded because of severe qualitative concerns.

Rating Classifications
Best has several different rating classification systems. The majority of companies rated receive an alphabetical rating which range from A+ (Superior) to C- (Fair). Best recently announced an expansion of its alphabetical categories from nine to 15. The stated purpose of this expansion was to provide for finer distinction of financial strength among companies. Double-plus rating categories of A++, B++ and C++ were added to the existing A+ rating (Superior), B+ rating (Very Good) and C+ (Fair) rating categories. In addition, rating categories of D (Below Minimum Standards), E (Under State Supervision) and F (In Liquidation) were added to complete a range that now extends from A++ through F. Insurers that do not receive an alphabetical rating receive an NA classification for various reasons. The former rating categories NA-7 (Below Minimum Standards) and NA-10 (Under State Supervision) were eliminated in 1992. Companies previously rated in these categories were included in the expanded alphabetical ratings. Also, a new category NA-11 (Rating Suspended) was added. A portion of the not assigned companies also received an FPI rating. Best issues reports even for non-rated companies. Best's rating classifications are described below in abbreviated form. A++ and A+ (Superior) : Assigned to those companies which in Best's opinion have achieved superior overall performance when compared to Best's standards. According to Best, A++ and A+ (Superior) rated 187

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insurers have a very strong ability to meet their policy holders and other contractual obligations over a long period of time. A and A - (Excellent) : Assigned to those companies which, in Best's opinion, have achieved excellent overall performance when compared to Best's standards. According to Best, A and A- (Excellent) rated insurers have a strong ability to meet their policy holder and other contractual obligations over a long period of time. B++ and B+ (Very Good) : Assigned to those companies which in Best's opinion have achieved very good overall performance when compared to Best's standards. According to Best, B++ and B+ (Very Good) rated insurers have a strong ability to meet their policy holder and other contractual obligations, but their financial strength may be susceptible to unfavorable changes in underwriting or economic conditions. B and B- (Good) : Assigned to those companies which in Best's opinion have achieved good overall performance when compared to Best's standards. According to Best, B and B- (Good) rated insurers generally have an adequate ability to meet their policy holder and other contractual obligations, but their financial strength is susceptible to unfavorable changes in underwriting or economic conditions. C++ and C+ (Fair) : Assigned to those companies which, in Best's opinion, have achieved fair overall performance when compared to Best's standards. According to Best, C++ and C+ (Fair) rated insurers generally have a reasonable ability to meet their policy holder and other contractual obligations, but their financial strength is vulnerable to unfavorable changes in underwriting or economic conditions. C and C- (Marginal) : Assigned to those companies which, in Best's opinion, have achieved marginal overall performance when compared to Best's standards. According to Best, C and C- (Fair) rated insurers have a current ability to meet their policy holder and other contractual obligations, but their financial strength is very vulnerable to unfavorable changes in underwriting or economic conditions. D (Below Minimum Standards) : Assigned to companies which meet Best's minimum size and experience requirements, but do not meet Best's minimum standards for C- rating. Note: This rating category was formerly the NA-7 (Below Minimum Standards) Rating Not Assigned classification. E (Under State Supervision) : Assigned to companies which are placed under any form of supervision, control or restraint by a state insurance regulatory authority such as conservatorship or rehabilitation, but does not include liquidation. May be assigned to a company under a cease and desist order issued by a regulator from a state other than its state of domicile. Note: This rating category was formerly the NA10 (Under State Supervision) Rating Not Assigned classification. F (In Liquidation) : Assigned to companies which have been placed under an order of liquidation or have voluntarily agreed to liquidate. Note: This was a new rating category in 1992 to distinguish between companies under state regulatory supervision and those in the process of liquidation.

Performance Modifiers
Best assigns modifiers to their alphabetical ratings to identify a company whose assigned rating has been modified because of performance, affiliation or contractual obligations. As part of its rating structure changes, Best is eliminating its "Contingent Rating Modifier" (c) because of the availability of finer distinctions within the new rating structures. The full list of modifiers are listed below: "q" Qualified Ratings (property/casualty companies only): Indicates the company's assigned rating has been qualified to identify those insurers whose financial strength could be adversely affected by 1) existing or pending state legislation which mandates rate restrictions or surcharges that cannot be passed on to policy holders; or 2) having payments due from mandated state residual market programs or reinsurance facilities equal to, or in excess of, their policy holders' surplus. The company's current rating does not reflect the potential impact of these programs as they represent a future circumstance which 188

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"w" Watch List : Indicates the company was placed on Best's Rating "Watch List" during the year to advise its subscribers that the company is under close surveillance because it has experience a downward trend in its current financial performance or may be exposed to a possible legal, financial or market situation which could adversely affect its performance. "x" Revised Rating : Indicates the rating shown was revised during the year.

Affiliation Modifiers
"e" Parent Rating : Indicates that the rating assigned is that of the parent of a domestic subsidiary in which ownership exceeds 50 percent. The rating is based on the consolidated performance of the parent and its subsidiaries. To qualify for a parent rating, the subsidiary must be eligible for rating based on its own performance after attaining five consecutive years of representative experience; have common management with its parent; underwrite similar lines of business; and have interim leverage and liquidity performance comparable to that of its parent. "g" Group Rating (property/casualty companies only): Indicates the rating is assigned to an affiliated group of property/casualty companies. To qualify for a group rating, the companies in a group must be affiliated via common management and/or ownership; pool a substantial portion of their net business; and have only minor differences in their underwriting and operating performance. All members are assigned the same rating and financial size category, based on the consolidated performance of the group. "p" Pooled Rating : Indicates the rating assigned to companies under common management or ownership that pool 100 percent of their net business. All premiums, expenses and losses are prorated in accordance with specified percentages that reasonably relate to the distribution of the policy holders' surplus of each group member. All members participating in the pooling arrangement are assigned the same rating and financial size category, based on the consolidated performance of the group. "r" Reinsured Rating : Indicates the rating and financial size category assigned to the company are those of an affiliated carrier that reinsures 100 percent of the company's net premiums written. "s" Consolidated Rating (property/casualty companies only): Indicates the rating is assigned to a parent company and is based on the consolidated performance of the company and its domestic property/casualty subsidiaries in which ownership exceeds 50 percent. The rating applies only to the parent company because subsidiaries are normally rated on the basis of their own financial condition and performance. A.M. Best does not assign an alphabetical rating to a number of insurers because they do not meet certain requirements such as size or operating experience. A list of these not assigned classifications is provided below with brief explanations. NA-1 Special Data Filing : Assigned primarily to small mutual and stock companies that are exempt from the requirement to file the standard NAIC annual statement. These company reports are based on selected financial information requested by Best, and the majority are submitted via Best's Data Collector under a cooperative program with the National Association of Mutual Insurance Companies (NAMIC) and other supporting organizations. NA-2 Less than Minimum Size : Assigned to companies that file the standard NAIC annual statement, but do not meet Best's minimum size requirement of writings of $1.5 million for life/health insurers or $1.5 million of surplus for property/casualty insurers. NA-3 Insufficient Operating Experience : Assigned to a company which meets, or is anticipated to 189

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meet, Best's minimum size requirement, but has not accumulated at least five consecutive years of representative operating experience. NA-4 Rating Procedure Inapplicable : Assigned to a company when the nature of its business and/or operations is such that the normal rating procedure for insurers does not properly apply. Examples are companies writing lines of business uncommon to the life/health or property/casualty field; companies not soliciting business in the United States; companies retaining only a small portion of their gross premium writings; companies which have discontinued writing new and renewal business and have a defined plan to run-off existing contractual obligations; or companies whose sole operation is accepting business written directly by a parent, subsidiary or affiliated insurance company. NA-5 Significant Change : Assigned to a previously rated company which experienced a significant change in ownership, management or book of business whereby its operating experience may be interrupted or subject to change; or any other relevant event which has or may affect the general trend of a company's operations. NA-6 Reinsured by Unrated Reinsurer : Assigned to a company which has a substantial portion of its book of business reinsured by unrated reinsurers and/or has reinsurance recoverables from unrated reinsurers which represent a substantial portion of its policy holders' surplus. Exceptions are unrated foreign reinsurers that comply with Best's reporting requirements. NA-7 Below Minimum Standards : Discontinued in 1992 and replaced by D rating. NA-8 Incomplete Financial Information : Assigned to a company that is eligible for a rating, but fails to submit complete financial information for the current five-year period under review. This requirement includes all domestic subsidiaries in which the company's ownership exceeds 50 percent. NA-9 Company Request : Assigned to a company that is eligible for a rating, but requests that the rating not be published. The majority of these companies, such as captives, operate in markets that do not require a rating, but cooperate with Best's request for financial information so that a report can be prepared and published on their company. The classification is also assigned to a company that requests its rating not be published because it disagrees with Best's rating assignment or payment of the $500 rating fee. In this situation, Best's policy normally requires a minimum of two years to elapse before the company is again eligible for the assignment of a rating. NA-10 Under State Supervision : Discontinued in 1992 and replaced by rating of either E or F. NA-11 Rating Suspended : Assigned to a previously rated company which has experienced a sudden and significant event affecting the company's financial position and operating performance, of which the impact cannot be evaluated due to a lack of timely or appropriate information. A recent sample distribution of insurers by Best ratings found that of the total companies rated, 41.7 percent of life/health insurers and 52.6 percent of property/casualty insurers were assigned a "Superior" or "Excellent" rating. Of the companies receiving alphabetical or NA-7 (Below Minimum Standards) ratings, 68.8 percent of life/health and 82.9 percent of property/casualty insurers were assigned a "Superior" or "Excellent" rating.

Financial Performance Index (FPI)

In 1990, A.M. Best instituted the FPI rating for companies not meeting the size and operating experience requirements for an alphabetical rating. The FPI is assigned to companies that have three years of representative operating experience, submit NAIC statements, complete a supplemental rating questionnaire and qualify or NA-2 or NA-3 categories. The assignment of the FPI involves the same notification and discussion process with company management as with alphabetically rated companies. 190

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The FPI procedure includes both a quantitative and qualitative review of a company's operating and financial performance. The quantitative evaluation is based on an analysis of a company's financial performance, utilizing essentially the same key tests required for the alphabetical rating. The qualitative review for the FPI rating is not as extensive as that for an alphabetical rating, but it does include adjustments for adequacy of reinsurance protection, geographic spread of risk and loss exposure by product line. A company is assigned an index of from 1 to 9 based on the quantitative and qualitative review of its overall performance. An FPI of 1 is assigned to a company that does not have three consecutive years of representative operating experience or, in a few cases, was assigned an FPI which was lower than it found acceptable and requested that it not be published.

Dissemination of Rating Information

Best disseminates company reports and ratings through various publications and information services. Best's Insurance Report are published annually and available to consumers through most public libraries and state insurance departments which receive complimentary copies. Updated year end ratings and interim rating changes are also made available through various subscription publications, weekly, monthly and quarterly; daily through BestLink, the on-line computer network service; and through BestLine, a direct dial 900 rating service. These publications and services are complimented by other Best reports and analyses that deal with industry issues and developments.

STANDARD & POOR'S

Standard and Poor's (S&P) has emerged as the second leading insurer rating agency in terms of the number of domestic insurers rated, with virtually the same number of insurers assigned letter grade ratings as A.M. Best. It has been rating bonds since 1923 and insurance companies' claims paying ability since 1983. S&P's insurer rating activity draws from its experience and procedures in rating debt issues and utilizes a similar classification framework, but is conducted by professional analysts whose background, experience and/or training is focused on the insurance industry. S&P's philosophy and approach to rating the financial strength of insurers is more like that of Moody's and Duff & Phelps than like A.M. Best. S&P sees its role as one of providing risk assessment of insurers to insurance buyers rather than serving as an advisor to insurers to assist them in improving their financial condition and rating. S&P's Insurance Rating Services is one of six departments within its Ratings Group which has a staff in excess of 700 located in offices in seven countries. S&P's Insurance Rating Services provides ratings on fixed income securities, including long-term debt, commercial paper and preferred stock issued by insurance companies, as well as claims paying ability ratings and qualified solvency ratings of the financial strength of insurers. S&P's claims paying ability rating is an assessment of an operating insurance company's financial capacity to meet its policy holder obligations in accordance with their terms. Claims paying ability ratings are based on a comprehensive quantitative and qualitative financial analysis using various sources of information, including interviews with company management. S&P introduced qualified solvency ratings in 1991, after two years of development, to extend its coverage of opinions on insurers in response to market demands for information on insurers for which it did not provide a claims paying ability rating. The qualified solvency ratings are based on a statistical analysis of statutory financial data filed with the NAIC and purchased by S&P. S&P's qualified solvency methodology provides a solely statistically based indication of financial strength among insurers and differentiates broadly between classes of risk to policy holders. S&P's insurer ratings are not recommendations to buy, retain or surrender a policy from any particular insurer. 191

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Some regulators and insurers have questioned the fairness of qualified solvency ratings. Conversely, other insurers have referred to their qualified solvency rating, along with other agencies ratings, in sales material or have expressed disappointment in not receiving a qualified solvency rating. Some brokers and agents have expressed the view that qualified solvency ratings are not well understood in the market. S&P notes others have expressed the view that qualified solvency ratings add useful information to the market. A more detailed discussion of qualified solvency ratings is provided later in this section. All claims paying ability ratings are voluntary and insurers pay a rating fee that typically ranges from $15,000 to $32,000 depending on size, number of affiliated insurers, and other factors. In connection with their initial application for a claims paying ability rating, insurers have the option of not completing the process and/or not having a claims paying ability rating published. Once a claims paying ability rating is published, the insurer can request that it be withdrawn, although this option has been very rarely exercised. A statement of S&P's current opinion of the insurer's financial strength will be released at the time of the rating withdrawal. If an insurer requests that its claims paying ability rating be withdrawn because it anticipates that the rating will be lowered, S&P will complete its review process and if a rating downgrade is viewed as warranted, will announce it before withdrawing the rating. S&P has assigned claims paying ability ratings to approximately 200 life/health insurers, 400 property/casualty insurers, 25 monoline financial guaranty insurers and 80 non-U.S. insurers. In addition, S&P has assigned "qualified solvency" ratings to approximately 750 life/health insurers and 1,230 property/casualty insurers. S&P also has a subsidiary, Insurance Solvency International (ISI), which has assigned ratings to approximately 900 alien property/casualty insurers and reinsurers. S&P also provides reports on Lloyd's syndicates and life insurers in the United Kingdom. S&P's Insurance Rating Services has a staff of 80 in New York and London of which 25 are analysts who assign claims paying ability ratings and monitor insurers' claims paying ability. S&P indicates that its analysts generally have advanced business degrees as well as professional experience in financial analysis of the insurance industry. Each rating analyst is assigned to rate and monitor 20 companies on average. In addition to rating analysts, S&P employs 10 statistical and computer support personnel and other support staff to assist the analysts. S&P distributes its ratings through several publications and over the telephone. S&P also publishes other insurance industry reports and analyses supporting its ratings and provides other information on market conditions. A more detailed description of S&P's insurer rating process, methodology and classification scheme follows.

Rating Process
S&P's claims paying ability rating process begins with an application and a commitment from an insurer to provide the necessary financial information for a full evaluation. A lead analyst is assigned to work with the company and obtain financial information including five years of statutory financial statements, GAAP financial statements (if available) information provided on special questionnaires dealing with debt securities, mortgage loans and real estate investments, and other company documents. Various spreadsheets, profiles and financial ratios are prepared to assist S&P analysts in forming an initial opinion about the financial condition of an insurer relative to Best's standards. S&P analysts also meet with company management to discuss issues relating to the company's business goals and strategies, profitability, underwriting standards, reserving policy, leverage and use of debt, earnings outlook, accounting policies, targeted markets, acquisition and growth philosophy, planning processes, asset distribution and quality, and asset/liability management. In an initial rating, S&P prefers to meet with an insurer for a full day at its headquarters to have full access to the appropriate personnel. Subsequent meetings may be held at the company's location or at S&P. 192

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Subsequent to the management interview, the lead analyst prepares a report and preliminary rating based on a quantitative and qualitative evaluation of all the information compiled. The report is presented to a rating committee comprised of five or more senior insurance industry specialists and also including, when necessary, other S&P specialists in areas such as real estate, private placements and other investments. The rating committee scrutinizes the preliminary rating, questions the analyst's assumptions, verifies the material facts and challenges the analyst's conclusions. After this review, the rating committee makes a final determination on the rating that will be assigned to the insurer. The insurer is informed of the committee's rating assignment and the basis for the rating. However, the nature of the rating committee's deliberations and the identity of its members are not disclosed to the insurer. If the company can provide additional information and/or demonstrate that the basis for the initial rating was incorrect, the committee may revise its rating decision. Otherwise, the rating stands. An insurer does have the option of requesting that an initial claims paying ability rating not be published. S&P believes that this option is necessary to ensure that it receives the cooperation of insurers to provide the information that it needs to do a proper evaluation, not only with respect to the initial rating assignment, but in connection with S&P's ongoing rating surveillance as well. S&P indicates, however, that this is an option that has rarely been exercised, and that when exercised, has to date virtually always resulted in ratings in the AA, A or BBB categories not being published. Also, insurers that decline their claims paying ability rating will receive a qualified solvency rating. Once assigned and approved, insurers' ratings are released through monthly and quarterly publications as well as made available to consumers over the telephone. After a claims paying ability rating is assigned, S&P analysts continue to monitor an insurer's performance for new developments. The surveillance process involves reviewing the insurer's financial statements and reports each year, annual meetings with company management, and monitoring company, industry and market developments. Any rating may be reviewed at any time when new information suggests that the financial strength of the insurer may have changed. S&P will always notify a company when a rating change is contemplated, and will meet with the company as part of the process leading up to the potential change. S&P also may issue a general advisory, referred to as a "CreditWatch", if new developments may affect an insurer's claims paying ability rating. Insurers are always made aware of a rating change or a CreditWatch advisory prior to its release.

Rating Methodology
S&P conducts a comprehensive quantitative and qualitative evaluation in assessing an insurer=s financial strength and ability to meet its future obligations to policy holders for the claims paying ability rating. S&P applies a common set of qualitative principles to every company regardless of its line of business, but then tailors its analytical approach to each of the four primary insurance industry segments: life/health insurers; property/casualty insurers; consolidated property/casualty groups; and professional reinsurers. Its rating methodology profile covers eight basic areas 1) industry risk; 2) management and corporate strategy; 3) business review; 4) operational analysis; 5) investments; 6) capitalization; 7) liquidity; 8) financial flexibility. S&P also looks at interest rate management and asset/liability matching for life insurers and loss reserve adequacy for property/casualty insurers. Insurers are "benchmarked" against industry norms in the quantitative portion of the evaluation, but there is no specific formula or algorithm used to score companies based on their statistical results. S&P's industry risk analysis looks at four competitive factors; 1) potential threat of new entrants; 2) threat of substitute products or services; 3) rivalry among existing firms; 4) bargaining power of buyers/suppliers. Industry sectors are defined largely by the type of insurance written. When a company does business in more than one sector, a weighted average risk score is assigned based on premium revenue.

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With respect to management and corporate strategy, S&P evaluates whether the strategy management has chosen is both consistent with the organization's capabilities and whether it makes sense in its marketplace. S&P also evaluates a company's operational skills, which essentially involves an assessment of a company's ability to execute its chosen strategy. S&P evaluates management's expertise in operating each of the company's lines of business as well as the adequacy of audit and control systems; its financial risk tolerance, which relates to the amount of debt in its capital structure and the level of operating leverage which a company is willing to accept; its organizational structure, and how it fits the company's strategy. S&P's business review analysis identifies the company's fundamental characteristics and its source of competitive advantage or disadvantage. This includes a description of the portfolio of business units and/or product lines, distribution systems, and the degree of business diversification. The business review includes analysis of those aspects of the business that affect the absolute level, growth rate and quality of the revenue base and focuses on the long-term revenue generating capabilities of the insurer. Through an analysis of operating results, S&P determines a company's ability to capitalize on its strategy and company strengths. Operating results are analyzed independently of the firm's operating leverage. S&P's analysis of an insurer's earnings performance focuses on its underlying economic profitability rather than its stated statutory net gain. If available, S&P will review a firm's GAAP financials in making its assessment, although it will rely on statutory figures is GAAP financials are unavailable. S&P focuses on the after-tax return on assets as the most comprehensive ratio not affected by leverage. For a life/health insurer, S&P's analysis includes a review of its persistency, expense structure, mortality/morbidity experience, effective tax ratio, pricing policies and actual performance versus pricing. For a property/casualty company, S&P examines underwriting performance including premium growth rates, loss ratios, expense ratios, combined ratio and loss reserve adequacy. The trend and stability of a company's earnings are also evaluated. S&P's analysis of an insurer's investments considers the insurer's allocation of assets among investments such as bonds, mortgages, preferred stock, real estate, common stock and other invested assets. The assets are evaluated for credit quality and diversification. An insurer's asset allocation is also examined to determine how appropriate it is to support policy holder liabilities. Asset quality is reviewed throughout the investment portfolio, and charges are applied against the insurer's capital for problem and risky assets to establish what S&P believes to be the appropriate level of investment reserves. Delinquencies on mortgage portfolios, restructured mortgage loans, loans in the process of foreclosure and foreclosed real estate are also assessed. S&P applies a default rate model, based on historical experience and current S&P projections, to determine the appropriate level of investment reserve needed for mortgages, bonds and other fixed income assets. Credit is given for existing investment reserves in the statutory balance sheet. Equity assets, including common stock, real estate, and schedule BA assets, are reviewed for appropriateness of valuation. S&P may adjust capital to reflect what it believes to be over valued assets or to incorporate hidden asset values. S&P also evaluates how well an insurer manages its interest rate risk and asset/liability matching strategies relative to its product lines. S&P reviews an insurer's asset/liability management by identifying the specific asset and liability durations and cash flows of interest rate sensitive portfolios. Investment risk and the degree of mismatch between the maturity and duration of the investment portfolio with an insurer's liability structure is principal to S&P's evaluation of management's tolerance for risk. S&P's analysis of insurers' capitalization incorporates financial leverage and fixed charge coverage concepts as well as the degree of operating leverage. The ratios used by S&P for all insurers are total debt to capital; long-term debt to capital; short-term debt to capital; fixed charge coverage; preferred stock to capital; and fixed charge coverage of preferred dividends. The analysis of operating leverage is analyzed in relation to the business lines of an insurer. For life/health insurers, operating leverage is defined as total liabilities to statutory capital, treating the 194

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mandatory securities valuation reserve (MSVR) as capital and excluding separate accounts from liabilities. For property/casualty insurers, the applicable ratios are net written premiums to surplus; loss reserves to surplus; loss reserves to earned premiums; ceded written premium to gross written premium; and investments in subsidiaries/affiliates to surplus. Other risks inherent in an insurer's operations such as asset/liability mismatch are also examined in relation to the level of capital. In addition, the use and quality of reinsurance is analyzed. Finally, the quality of capital is analyzed in terms of the degree of exposure to reinsurers and equity assets such as common stocks, including investment in affiliates, real estate equities, and equity investments in partnerships relative to the capital base of the firm. Property/casualty insurers' loss reserves are also evaluated for adequacy. S&P's loss reserve analysis looks at six lines individually and combined utilizing data filed on Schedule P: personal auto liability; commercial auto liability; other liability; medical malpractice; workers' compensation; and commercial multiperil. S&P utilizes several different standard techniques to arrive at a degree of confidence in the loss reserve for each line and to identify areas where management will be asked to explain deviations from expected results. In evaluating liquidity for life insurers, S&P focuses on an insurer's ability to handle reasonable increases in cash outflows due to lapses, surrenders, policy holder loans or other cash withdrawals. S&P analyzes the nature of a company's policy holder liabilities and their associated surrender charges and/or market valuation charges in determining the susceptibility to increased cash outflows before policy maturity. In addition, it looks at the maturity structure of large dollar investment-oriented contracts such as guaranteed investment contracts (GICs) in evaluating a company's liquidity needs. The amount of liquid assets available to meet increased cash outflows and policy maturity are compared. S&P defines liquid assets to include cash and short-term securities; government and government-backed securities; investment grade public bonds; private placements in NAIC categories 1 or 2 maturing in one year or less; and other liquid assets as determined by S&P through discussions with management. The liquidity ratios examined by S&P for life/health insurers include operating cash flow to benefits paid; operating cash flow to liabilities; and cash and short-term investments to invested assets. For property/casualty insurers, S&P looks at underwriting cash flow to sources/uses; total cash flow to sources/uses; and cash and short-term investments to invested assets. Finally, S&P evaluates an insurer's financial flexibility in terms of its capital requirements and capital sources. Capital requirements refer to factors that may give rise to an exceptionally large need for either long-term capital or short-term liquidity. Capital sources involve an assessment of the extent to which a company has access to short and long-term capital beyond normal operating earnings and cash flow.

Rating Classifications And Distribution Claims-Paying Ability Ratings

As indicated above, S&P provides either of two types of ratings of an insurer's financial strength: a claims paying ability rating or a qualified solvency rating. The claims paying ability rating is an opinion of an insurer's financial capacity to meet the obligations of its insurance policies in accordance with their terms. Claims paying ability ratings are further divided into two classifications: secure and vulnerable. Rating categories from "AAA" to "BBB" are classified as "secure" claims paying ability ratings and are used to indicate insurers whose financial capacity to meet policy holder obligations is viewed on balance as sound. Rating categories from "BB" to "D" are classified as "vulnerable" claims paying ability ratings and are used to indicate insurers whose financial capacity to meet policy holder obligations is viewed as vulnerable to adverse developments. In fact, the financial capacity of insurers rated "CC" to "C" may already be impaired, while insurers rated "D" are in liquidation. Ratings from "AA" to "CCC" may be modified by a plus or minus sign to show the relative standing of the insurer within those rating categories.

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INSURANCE MARKETING ISSUES The specific claims paying ability ratings are further described below:

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AAA : Insurers rated AAA offer superior financial security on both an absolute and relative basis. They possess the highest safety and have an overwhelming capacity to meet policy holder obligations. AA : Insurers rated AA offer excellent financial security, and their capacity to meet policy holder obligations differs only in a small degree from insurers rated AAA. A : Insurers rated A offer good financial security, but their capacity to meet policy holder obligations is somewhat more susceptible to adverse changes in economic or underwriting conditions than more highly rated insurers. BBB : Insurers rated BBB offer adequate financial security, but their capacity to meet policy holder obligations is considered more vulnerable to adverse economic or underwriting conditions than that of more highly rated insurers. BB : Insurers rated BB offer financial security that may be adequate but caution is indicated since their capacity to meet policy holder obligations is considered vulnerable to adverse economic or underwriting conditions and may not be adequate for "long-tail" or long-term policies. B : Insurers rated B are currently able to meet policy holder obligations, but their vulnerability to adverse economic or underwriting conditions is considered high. CCC : Insurers rated CCC are vulnerable to adverse economic or underwriting conditions to the extent that their continued capacity to meet policy holder obligations is highly questionable unless a favorable environment prevails. CC and C : Insurers rated CC and C may not be meeting all policy holder obligations and may be operating under the jurisdiction of insurance regulators and are vulnerable to liquidation. D : Insurers rated D have been placed under an order of liquidation.

Qualified Solvency Ratings

S&P's qualified solvency ratings are based strictly on the application of statistical analysis to statutory financial data filed by insurers with the NAIC. The objective of the statistical analysis is to distinguish insurers that are financially weak or more likely to get into financial trouble from insurers that are financially strong or less likely to encounter financial difficulty. Multi-variate discriminant analysis is used to develop a model which assigns a numerical score (Z-score) to each insurer based on its financial results. The financial ratios or variables which comprise the model are measured over a four-year period to incorporate trend. The model is tested using alternate data sets to affirm its stability and ability to predict failed insurers. The analysis is conducted separately for the four different industry segments: consolidated property/casualty insurers; individual property/casualty insurers; professional reinsurers; and life/health insurers. The procedures used were reviewed by independent actuarial and accounting consultants. The models used are updated as new data become available and the characteristics of failed and solvent insurers change over time. A sample summary of S&P's qualified solvency ratings is shown on page 20 with the relative importance or weight of each factor analyzed in terms of the degree of exposure to reinsurers and equity assets such as common stocks, including investment affiliates, real estate equities, and equity investments in partnerships relative to the capital base of the firm. Insurers' Z-scores are divided into three broad groups. Insurers with the highest scores are assigned 196

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a BBBq rating indicating "adequate" financial security. Their scores most closely resemble those of financially strong insurers. The next segment of scores are assigned a BBq rating, indicating that financial security "may be adequate". Insurers receiving the lowest scores are rated Bq, indicating a "vulnerable" financial condition. Their scores most closely resemble those of insurers that have actually experienced financial difficulty. Insurers that do not voluntarily apply for a claims paying ability rating are assigned a qualified solvency rating based on a quantitative analysis of their statutory financial data. Qualified solvency ratings are computed for individual insurers on a stand alone basis, without consideration for strength or weakness that might be added by a parent or affiliated companies. Qualified solvency rating designations range from BBBq to Bq. The "q" suffix indicates the qualified nature of the rating because it is based strictly on a statistical analysis. The definitions of the qualified solvency ratings are given below. BBBq : Results of quantitative tests on the insurer's statutory financial results are consistent with those of insurers providing adequate or better financial security. BBq : Results of quantitative tests on the insurer's statutory financial results are consistent with those of insurers providing financial security that may be adequate. Bq : Results of quantitative tests on the insurer's statutory financial results are consistent with those of insurers providing vulnerable financial security. S&P has been criticized by some insurers and regulators because the highest qualified solvency rating possible is BBBq which appears to be lower than the highest claims paying ability rating possible, AAA. However, S&P's rationale for the use of B-range symbols for qualified solvency ratings is that they are consistent with the definitions of S&P's claims paying ability ratings. In S&P's Insurer Solvency Review , it points out that a BBB claims paying ability is considered secure, but not superior. Similarly, a BBBq rating is presumed to represent a secure insurer, although it is uncertain how secure based on its statistical analysis alone. S&P acknowledges, "It is possible that a more comprehensive evaluation would reveal that a BBBq-rated insurer could be rated BB or lower on the claims paying ability rating scale. It is most likely, however, that an insurer rated BBBq would be rated among the top four categories (AAA to BBB) for claims paying ability." S&P describes insurers rated BB for claims paying ability as providing "financial security that may be adequate but caution is indicated since their capacity to meet policy holder obligations is considered vulnerable to adverse economic or underwriting conditions..." S&P links that definition to its BBq qualified rating, indicating that insurers rated BBq appear weaker than insurers rated BBBq but, nonetheless, offer financial security that may be adequate. The most likely range of claims paying ability rating is A to B. S&P's definition of a B claims paying ability rating says: "Vulnerability to adverse economic or underwriting conditions is considered high." A Bq rating is intended to convey a similar notion. Insurers rated Bq show material weaknesses according to the financial data, similar to insurers that have encountered financial difficulty in the past. However, just as some insurers rated BBBq in reality may be weaker than the data suggest, it is probable that some insurers rated Bq may in fact be stronger than the data suggest. For example, an apparently weak subsidiary can be bolstered by the firm support of a strong parent. Nevertheless, insurers with qualified solvency ratings of Bq would, on their own merits, be least likely to receive claims paying ability ratings in the "secure" range of BBB or higher. S&P contends that consumers properly understand the distinction between the claims paying ability and qualified solvency ratings. However, some insurers and regulators believe that consumers tend to equate the two. No research has been conducted to determine whether consumers properly understand the difference between the two types of ratings. S&P bases its conclusions on telephone contacts with consumers. 197

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Because of concerns about consumer misperceptions, some insurers and industry trade associations indicate that they feel coerced to "purchase" a claims paying ability rating the fee for which typically ranges from $22,000-$28,000 and which may be different than their qualified solvency rating. Some insurers have claimed that it is unfair to subject them involuntarily to a statistically based rating and to be confined to a qualified B-range rating because they have not paid for a more in- depth claims paying ability rating. Some smaller insurers express additional concerns that S&P's qualified solvency rating model tends to favor larger insurers. However, S&P believes that the qualified solvency methodology provides an unbiased indication of insurers' financial strength and can differentiate broadly between classes of risk to policy holders. It further maintains that the classification framework used for the qualified solvency rating is appropriately conservative to protect consumers. In a recent sample distribution of claims paying ability and qualified solvency ratings, of the total companies rated, 16 percent of life/health and 19 percent of property/casualty companies received an AAA (Superior) or AA (Excellent) rating. Of the companies receiving claims paying ability ratings, 78.1 percent of life/health and 75.6 percent of property/casualty insurers received an AAA or AA rating.

Dissemination of Rating Information

S&P disseminates its ratings and other financial information about insurers through several publications. S&P's Insurance Book is a quarterly looseleaf service providing comprehensive coverage of more than 500 insurance companies: property/casualty, life/health, reinsurance, bond insurance and mortgage insurance. S&P's Insurer Solvency Rating provides qualified solvency ratings for 1,600 insurers in addition to all of S&P's claims paying ability ratings. S&P's Insurance Digests are quarterly publications containing capsule reports on S&P-rated companies. S&P's Insurers Ratings List is a monthly publication listing all of S&P's insurer claims paying ability ratings by industry. Select Reports are fourpage reports, excerpted from S&P's Insurance Book, containing a full, in-depth review of each company. Consumers also can obtain information on up to five insurers at a time, free of charge, by calling S&P's Rating Information Department.

MOODY'S INVESTOR SERVICE

Moody's Investors Service was founded in 1900 by John Moody, who invented bond ratings in 1909. Today, Moody's rates securities of some 4,000 industrial companies, public utilities, banks and other financial institutions. In addition to bonds, Moody's rates the credit worthiness of a wide variety of financial obligations, such as commercial paper, bank deposits, money market funds and GICs. In the insurance sector, Moody's has been rating the debt securities of insurance companies since the mid1970s. Moody's began assigning insurance company financial strength ratings in 1986. Although Moody's rates fewer insurers than A.M. Best or S&P, it has acquired a solid reputation for thoroughness and expertise in its insurer rating activities. Moody's financial strength ratings reflect its opinion as to an insurer's ability to discharge senior policy holder obligations and claims. It seeks to measure "credit risk", i.e., the risk that an insurer will fail to honor its senior policy holder claims in full and on a timely basis. Moody's financial strength ratings are based on quantitative and qualitative analysis of the industry, regulatory trends and the business fundamentals of the insurer. Insurers can apply to Moody's for a financial strength rating. There is a basic annual appraisal fee of $25,000 for life insurance financial strength ratings and $22,000 for property/casualty financial strength ratings. In addition, where Moody's believes there is sufficient policy holder and investor interest, Moody's is prepared to assign financial strength ratings to life companies that have not requested a rating. Although Moody's will generally solicit the company's cooperation under such circumstances, Moody's is prepared to go forward without company participation on the basis of publicly available information. Moody's will only do so if adequate information is available in the public domain to reach a credible rating 198

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conclusion. Moody's does not charge a fee, at least initially, to insurers that have not applied for a rating. Moody's primary focus on the life side has been insurers that are large annuity writers, but it is expanding into other segments of the life industry and also has rated property/casualty insurers. Moody's currently has assigned financial strength ratings to approximately 80 domestic life insurers, 180 property/casualty insurers and reinsurers and 20 alien insurers. It also has assigned about 175 debt ratings for insurers. Moody's estimates that its rated life companies represent roughly 75 percent of industry assets and more than 90 percent of GIC assets. Moody's estimates that its rated property/casualty insurers represent 60 percent of net premium written for the domestic property/casualty industry and 50 percent of net written premiums for the domestic reinsurance industry. Moody's financial strength ratings and debt ratings for insurers are produced by its Insurance Group, which is part of its Financial Institutions Group. The Insurance Group is composed of an associated director, eight senior analysts including two actuaries, and four support personnel. Moody's analysts generally have significant insurance industry experience. Moody's committee rating process also utilizes expertise of other Moody's staff and management in analyzing and rating insurers. A more detailed description of Moody's rating process, methodology and classification scheme follows.

Rating Process
In assigning financial strength ratings to insurers, Moody's employs a committee process that draws upon the perspective and expertise of a number of analysts, associate directors and directors. The lead analyst is responsible for analyzing the insurer and preparing a rating recommendation to Moody's Corporate Rating Committee. This committee is ultimately responsible for the final rating decision. Once a committee decision is reached, the insurer is informed of the decision, and the rating is usually released to the public shortly thereafter. Once a rating has been assigned, it is considered to be "continuously under review ", and it can be changed if Moody's becomes aware of developments within the company, the industry, or any other general developments that Moody's believes could change the fundamental risk embodied in the rating. Moody's analysis typically, but not always, involves meeting with the company management. Insurers are given the right to appeal first-time financial strength ratings and to meet with Moody's staff to disclose new information that may be relevant to the rating decision. However, since 1992, Moody's has reserved the right to disclose an insurer's rating, whether the insurer agrees with its rating or not. When entering new areas, Moody's has initially given insurers the option of not having their rating published until a "framework of comparability is achieved within the given sector". Recently, Moody's determined that its rating coverage of U.S. life insurers has met this standard and, therefore, it no longer offers the refusal option to life insurers. It does still offer the refusal option to property/casualty insurers.

Rating Methodology
Moody's financial strength ratings are based on industry analysis, regulatory trends, and an evaluation of an insurer's business fundamentals. Its industry analysis examines the structure of competition within the insurer's operating environment and its competitive position within that structure. The analysis of regulatory trends attempts to develop an understanding of potential changes in a particular country's regulatory system and tax structure. The analysis of a company's business fundamentals focuses primarily on financial factors, "franchise value", management and organizational structure/ownership. In conducting its industry analysis, Moody's looks at a number of factors, including: the degree of concentration within the industry; the extent of inter-industry competition; the degree to which competition is likely to remain orderly; and the level of national protectionism, explicit or implicit. Moody's analysis of regulatory trends includes consideration of potential changes in regulations or taxation that could inhibit an insurer's competitive position or could lead to a significant restructuring of segments of the industry. Moody's also considers the failure-resolution practices of state regulators in its overall financial strength 199

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INSURANCE MARKETING ISSUES rating.

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Moody's analysis of the financial fundamentals of a company encompasses capital adequacy, investment risk, profitability and liquidity. To assess capital adequacy, Moody's adjusts an insurer's statutory data to estimate its economic capital as a going concern. Adjustments include consideration of the conservatism in statutory reserves and asset valuation, acquisition costs recoverable from future earnings, hypothecation of future earnings through financial reinsurance, and investments in subsidiary companies. Moody's also employs a risk-based benchmark capital ratio to assess capital adequacy which recognizes an insurer's mix of lines of business and assets, each of which has varying risk characteristics, including asset default, pricing adequacy, and interest rate risk. Moody's assesses a number of factors to reach conclusions about an insurer's expected long-run profitability and the risk that actual results may differ from expected profits. The factors assessed include 1) market focus of the insurer; 2) competitive dynamics in each market segment; 3) relative distribution costs; 4) underwriting record and outlook; 5) investment strategy. Moody's liquidity analysis attempts to understand the liability structure of the company, the options that may exist in the liabilities, and the degree to which the company's liabilities are confidence-sensitive. For life companies, when there is a high proportion of confidence-sensitive policy holders, Moody's analyzes the company's assets. It considers an insurer's asset structure and its "cushion" of a large portfolio of liquid, marketable assets as well as alternative sources of liquidity for a company. Moody's qualitative evaluation of an insurer also includes an assessment of its "franchise value", management and its organizational structure. In assessing an insurer's franchise value, Moody's looks at its competitive position in its marketplace. This involves assessing the quality of the company's products and distribution systems, and whether its product or service is essential. Moody's also will evaluate whether the company has sustainable competitive advantages in its key lines of business. Moody's evaluation of management considers its financial track record in such areas as investment risk taking, profitability, and product innovation. Management's strategy, as measured by rapid growth or new business development, is also assessed. Moody's also examines an insurer's relationship to a parent, to subsidiaries or affiliate companies to assess their impact on the financial strength of the insurer. If an insurer is part of a holding company structure, its financial strength rating will typically be constrained by the senior long-term debt rating of the holding company.

Rating Classification & Distribution

Moody's uses the same symbols for its insurer financial strength ratings and bond quality ratings. The rating gradations are broken down into nine symbols, each symbol representing a group of ratings in which the quality characteristics are considered to be broadly the same. Numeric qualifiers (1-3) further distinguish insurance within the rating symbol. The rating symbols are divided into two distinct segments: strong companies (Aaa-Baa) and weak companies (Ba-C). Moody's rating symbols and descriptions are listed below. Aaa : Insurance companies rated Aaa offer exceptional financial security. While the financial strength of these companies is likely to change, such changes as can be visualized are mostly unlikely to impair their fundamentally strong position. Aa : Insurance companies rated Aa offer excellent financial security. Together with the Aaa group, they constitute what are generally known as high-grade companies. They are rated lower than Aaa companies because long-term risks appear somewhat larger.

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A : Insurance companies rated A offer good financial security. However, elements may be present which suggest a susceptibility to impairment sometime in the future. Baa : Insurance companies rated Baa offer adequate financial security. However, certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Ba : Insurance companies rated Ba offer questionable financial security. Often the ability of these companies to meet policy holder obligations may be very moderate and thereby not well safeguarded in the future. B : Insurance companies rated B offer poor financial security. Assurance of punctual payment of policy holder obligations over any long period of time is small. Caa : Insurance companies rated Caa offer very poor financial security. They may be in default on their policy holder obligations or there may be present elements of danger with respect to punctual payment of policy holder obligations and claims. Ca : Insurance companies rated Ca offer extremely poor financial security. Such companies are often in default on their policy holder obligations or have other marked shortcomings. C : Insurance companies rated C are the lowest rated class of insurance company and can be regarded as having extremely poor prospects of ever offering financial security. In a recent sample distribution of Moody's ratings, 58.3 percent of life companies and 77.4 percent of property/casualty companies were rated as Exceptional (Aaa) or Excellent (Aa).

Dissemination of Rating Information

Moody's disseminates its ratings through various publications and over the telephone. The public can obtain Moody's ratings, free of charge, by calling its public ratings desk. Moody's Life Insurance Credit Research Service includes detailed reports on insurers, special comments on the industry, and access to analysts. Moody's Life Insurance Handbook contains summary credit opinions of all rated life insurers.

DUFF & PHELPS

Duff and Phelps, located in Chicago, is another well-known rater of securities that branched into rating insurers' financial strengths. D&P has been providing investment research since 1932, public credit services since 1980, and claims paying ability ratings of insurers since 1986. D&P had been rating insurers debt issues since the early 1980s and expanded to claims paying ability ratings of insurers to respond to a growing demand for analyses of major pension contract carriers. D&P's philosophy and approach are similar to that of S&P and Moody's in terms of its risk assessment of insurers from the standpoint of insurance buyers. D&P emphasizes a very thorough qualitative analysis along with quantitative analysis in conducting its rating evaluation. A D&P claims paying ability rating reflects D&P's opinion as to the likelihood of payment of policy holder and contract holder obligations in accordance with the terms of such obligations. Insurers apply to D&P to obtain a claims paying rating and are required to pay a $17,000 annual fee, in addition to agreeing to supply the necessary financial and other information. However, D&P has rated three carriers that did not apply for a rating. Insurers also can opt not to have their rating published although no company is currently in that status. Currently, D&P provides claims paying ability ratings for 91 life/health insurers, 7 property/casualty 201

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insurers and 6 bond insurers. Seven analysts, in addition to other staff financial analysts and experts, are primarily involved in developing claims paying ability ratings for insurers. A more detailed summary of D&P's rating process, methodology and classification scheme follows.

Rating Process
Insurers are subject to a thorough quantitative and qualitative evaluation in D&P's rating process. The rating process starts with an application from the insurer. This is followed by a D&P request for financial information including: Current year budget covering expected statutory performance, and, if available, current five-year projections with assumptions. Materials that will help to illustrate the asset/liability matching process, including investment policy and methods for estimating asset and liability durations. Current New York Regulation 126 filing. Listings of problem loans/assets for each major asset class. Organizational charts covering corporate structure and principal executive reporting lines. Descriptive materials concerning key products. Strategy statement by product line. Distribution of bond assets by quality ranking, industry category and other categories perceived to be important. History of the company focusing on major milestones. Any available relative industry comparison statistics on investments, expenses, market share, etc. Long form (including all schedules) annual statements for most recent six years. Separate annual statements for subsidiary organizations for most recent year. Separate account statements for most recent two years. Separate account statements for subsidiaries for most recent year. Quarterly statutory statements for current and preceding year. Also, subsidiaries' quarterlies. Most recent insurance department triennial examination report. Annual shareholder reports, 10Ks (current and preceding year 100s) for most recent six years and current proxy and recent prospectus. Most recent two years audited SAP and GAAP financial statement for entity being rated. Annual policy holder reports for most recent two years.

After the information has been received, D&P representatives visit the insurance company for an initial on-site interview. During that meeting, D&P representatives talk with key management personnel including the chief executive officer, chief financial officer, chief investment officer, chief marketing officer and product managers. In special situations, company officials are also invited to D&P headquarters in Chicago to meet with members of the D&P rating committee. Upon receiving the insurer's financial data, D&P analysts conduct a number of tests that include comparative analysis and financial ratios in areas such as profitability, operating efficiency, investment risk, leverage and liquidity. The analysts also conduct an extensive qualitative evaluation of the company's management, competitive position, economic fundamentals, ownership structure and asset/liability management practices. There also is considerable cross comparison of quantitative and qualitative factors to reach an analytical judgement as to the financial condition of the insurer. Upon completing their evaluation, D&P analysts present a report and initial rating recommendation to the D&P rating committee. The rating committee, consisting of 11 senior credit rating company officers, reviews the analysts' report and recommendation and determines a rating. The rating and an analysis is presented to the insurance company. The company has the option of not having the rating published, 202

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but currently no companies are in that status. Insurer ratings are then disseminated over the telephone, through electronic mail, press releases and D&P publications. Insurers are also allowed to distribute their D&P rating and report. After its initial rating is completed, insurers are subject to ongoing review . This includes obtaining quarterly updates of financial information as well as annual reviews. In addition, D&P insists on being informed of any significant developments affecting the company to be able to assess their impact and support the rating.

Rating Methodology
Analysis of an insurance company's claims paying ability is "closely allied" to credit analysis at D&P. The process emphasizes analysis of the company's future ability to pay its policy and contract obligations when they are expected to come due. Confidence in an insurer's long-term solvency and its ability to maintain adequate liquidity are critical considerations in D&P's review. D&P's assessment of an insurer's claims paying ability is based on both quantitative and qualitative analysis. Moreover, interaction between D&P analysts, senior credit rating committee members and senior management of the company being rated is central to the rating process. Critical areas of analysis are an assessment of the rated company's capital adequacy and the ability to maintain adequate capital in future years; review of investment returns; review of the liability structure (principally statutory reserves) with heavy emphasis on the inherent stability of such liabilities; an assessment of asset and liability management practices including scenario testing in connection with controlling interest rate risk over a range of possible interest rate scenarios; a detailed review of liquidity management and "worst case" scenario testing; analysis of profitability, tax issues, product line returns, reinsurance relationships and marketing strategy; and an actuarial review of product design, pricing and performance together with interest rate crediting practice. In addition, historical, current year-to-date and budgeted financial results are reviewed together with long-range strategic forecasts. The purpose of this review and analysis is to develop a set of financial performance expectations for the company being rated reflecting the prospective nature of the rating. The subsequent monitoring of the assigned rating and a company's financial performance is a continuing process with actual financial performance regularly compared to expectations. Ratios included in D&P's quantitative tests are: Return on Average Admitted Assets Return on Adjusted Surplus Net Investment Income Yield Combined Ratios Expense Ratios Surplus Formation Higher Risk Assets to Adjusted Surplus Investment in Affiliates to Adjusted Surplus Premiums to Adjusted Surplus Adjusted Liabilities to Adjusted Surplus

In determining adjusted surplus, D&P sums a company's reported surplus, mandatory securities valuation reserve, deficiency reserves, and other balance sheet items which it considers to represent "capital" employed. D&P's rationale on these adjustments is to identify and measure total capital employed and thus measure both profitability and operating leverage on a basis consistent with a company's economic reality. Surplus formation measures growth in adjusted surplus relative to the growth in adjusted liabilities. A 203

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ratio of 1.00 indicates that adjusted surplus and adjusted liabilities are increasing at equivalent rates. A ratio of less than 1.00 implies increased use of operating leverage as the growth in liabilities exceeds the growth in adjusted surplus. D&P rating evaluation also places considerable emphasis on qualitative factors including: Economic fundamentals of the company's principal insurance lines; Company's competitive position; Management capability; Relationship of the rated entity to either parent, affiliate, or subsidiary; and Asset and liability management practices.

Ultimately, D&P's rating conclusions rest on integration of the quantitative and qualitative factors in a company's picture. In D&P's view, the critical consideration in rating is the analytical judgement as to whether historical trends will persist or reverse themselves. For example, a company with sharply declining profitability measures would normally have a lower claims paying ability rating than a company with either lower and stable or lower and increasing profitability measures. Conversely, a company with higher absolute but stable leverage could receive a higher claims paying ability rating than a company with lower but increasing leverage. D&P also is very attentive to an insurer's sensitivity or exposure to both underwriting and business cycles. For example, it notes that the profitability of a life insurer's group accident and health business is typically very sensitive to competition induced rated inadequacy, inflation-driven increases in claim costs, and business cycle-related reductions in client company employment levels. Similarly, an insurer's assets and liabilities are highly sensitive to interest rate changes, which is the principal factor accounting for balance sheet volatility. Consequently, D&P focuses on asset and liability mismatches and management techniques to control interest rate risk. It also is concerned with measuring the adequacy of a company's adjusted surplus relative to the effects of this volatility. Finally, D&P will weigh certain factors differently in making a rating judgement depending on the circumstances. For instance, for a company with either demonstrated significant parent support or well above average stability as gauged by trend and volatility, the absolute level of leverage would normally take on less importance in reaching a rating decision than for a company for which these circumstances were not present.

Rating Classification and Classification Distribution

The rating scale that D&P uses for its claims paying ability ratings is the same as the one it uses for bonds and preferred stock although different definitions of safety are used. D&P's claims paying ability rating concerns only the likelihood of timely payment of policy holder and contract holder obligations and is not intended to refer to the ability of either the rated company, or as the case may be, a parent, affiliate, subsidiary, etc., to pay non-policy/contract holder obligations. A scale from AAA to CCC is used with "+" to "-" signs to further delineate quality within the broad alphabetical categories. D&P's ratings and definitions are provided below. AAA : Highest claims paying ability. Risk factors are negligible. AA : Very high claims paying ability. Protection factors are strong. Risk is modest, but may vary slightly over time due to economic and/or underwriting conditions. A : High claims paying ability. Protection factors are average, and there is an expectation of variability in risk over time due to economic and/or underwriting conditions. 204

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BBB : Below average claims paying ability. Protection factors are average. However, there is considerable variability in risk over time due to economic or underwriting conditions. BB : Uncertain claims paying ability and less than investment grade quality. However, the company is deemed likely to meet these obligations when due. Protection factors will vary widely with changes in economic and/or underwriting conditions. B : Possessing risk that policy holder and contract holder obligations will not be paid when due. Protection factors will vary widely with changes in economic and underwriting conditions or company fortunes. CCC : There is substantial risk that policy holder and contract holder obligations will not be paid when due. Company has been or is likely to be placed under state insurance department supervision. In a recent sample distribution of D&P ratings, 77 life/health insurers rated, 68 or 88.4 percent received above an A+ rating. However, only two of the seven property/casualty insurers had a rating above A+.

Dissemination of Rating Information

D&P disseminates financial and rating information on insurers through several means, including telephone inquiries, electronic transmission, press releases, company reports and two publications. The Insurance Company Claims Paying Ability Rating Guide, issued quarterly, contains detailed reports, financial information and ratings for all D&P rated insurers. There is also a monthly Rating Guide which provides claims paying ability ratings for insurers as well as ratings for long-term and short-term debt instruments and preferred stock. In addition, the public can telephone D&P free of charge to obtain insurer ratings and an explanation of what the ratings mean.

WEISS RESEARCH
Weiss Research, located in West Palm Beach, Florida, is somewhat different from the other insurance company raters discussed in this paper in terms of its approach. Its founder, Martin D. Weiss, has been publishing newsletters about money markets, interest rates, bank safety and economic forecasting since 1971. In 1989, Weiss began publishing "safety ratings" of life, health and annuity insurers. Weiss' methodology and rating scale has generated some controversy within the industry. Weiss' safety rating indicates its opinion regarding an insurer's ability to meet its commitments to its policy holders not only under current economic conditions, but also during a declining economy or in an environment of increased liquidity. A computer model comprised of some 200 financial ratios is used to determine an insurer's rating. The data for the model is obtained from statutory statements and other supplemental financial information provided by insurers. Weiss stresses that it bases its analysis exclusively on objective, quantifiable information. It eschews interjecting subjective and unquantifiable judgement into the rating process. Consequently, unlike other raters, Weiss does not interview insurer's management nor utilize other subjective information. Weiss believes that good management will produce good results and that bad results cannot be explained away by management. Weiss' ratings are essentially involuntary. Insurers do not apply to Weiss for a rating, nor do they pay a fee for being rated. Weiss supports its insurer rating activities through the sale of its rating information to the public. Weiss believes that this approach allows it to be independent in its rating evaluation. Currently, Weiss rates more than 1,700 life, health and annuity insurers. Weiss Research employs a total staff of 70, including analysts, programmers and technicians, clerks and 205

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customer service counselors who support all its services. Of these staff, seven analysts, including a consulting actuary, are directly involved in developing and running its computer model. A more detailed description of Weiss' rating process, methodology and classification scheme follows.

Rating Process
Weiss follows a five-step process to arrive at a rating. The process begins with data collection. Weiss obtains quantitative information on insurers from several sources including 1) statutory data in computerized form from the NAIC; 2) statutory annual and quarterly data not provided by the NAIC; 3) supplemental data from surveys sent to the companies; and 4) additional data supplied by the companies. The next step in the process is data validation. This involves running crosschecks on data to identify errors, which are corrected by reference to the hard copy statement or by contact with the company. Data is then mailed to the companies for validation. The next steps are ratio analysis and modeling. The modeling procedure involves automated generation of ratings through a hierarchical series of calculations involving weighting, capping and filtering of the ratios. Weiss describes its rating system as a pyramid. At the top of the pyramid is the overall rating. This rating is composed of several indexes. Each index, in turn, is derived for a series of "components". The components are based upon several "subcomponents". The subcomponents are derived from the statutory data and data from the companies. The last step is "reality checking". This involves manual verification of the results and modifications of the overall model so that all companies are affected fairly. The results of Weiss' analysis and its ratings are sent to the companies with a request that the data be examined and verified. Some companies do not respond to these requests and others may object to the rating. Insurers are invited to visit Weiss Research to discuss the rating methodology and conclusions. Insurers are requested to provide new, objective and verifiable information, which will be put into the process and evaluated along with other data. Once finalized, Weiss ratings are communicated over the telephone and through several publications and software to consumers, agents and others. Review of the insurer also continues. Weiss Research receives quarterly reports from the insurance companies. New information is added to the analytical process and is reported in quarterly updates.

Rating Methodology
Weiss' rating model utilizes five key indices: 1) risk adjusted capital; 2) profitability; 3) liquidity; 4) spread of risk; and 5) sources of capital. Weiss utilizes two risk-adjusted capital ratios to determine a company's exposure to investment liquidity and insurance risk in relation to the capital the company has to cover those risks. The first risk-adjusted capital ratio evaluates the company's ability to withstand a moderate economic decline. The second ratio evaluates the company's ability to withstand a severe economic decline. To calculate these risk-adjusted capital ratios, Weiss sums all of the company's resources that could be used to cover losses. These resources include capital, surplus, MSVR, and a portion of the provision for future policy holders' dividends, where appropriate. Additional credit may also be given for the use of conservative reserving assumptions and other "hidden capital" when applicable. Next, Weiss determines the company's target capital. This answers the question: Based on the company's level of risk in both its insurance business and its investment portfolio, how much capital would it need to cover potential losses during a moderate economic decline? For Weiss, an average recession is one in which the real gross national product (GNP) declines by about the same amount as it did in the postwar recessions of 206

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The first risk-adjusted capital ratio is equal to capital resources divided by target capital. If a company has a risk-adjusted capital ratio of 1.0 or more, it means the company has all of the capital Weiss believes that it requires to withstand potential losses which could be inflicted by a moderate economic decline. If the company has less than 1.0, it does not currently have all of the basic capital resources Weiss thinks that it needs. Weiss notes that during times of financial distress, companies often have access to additional capital through contributions from a parent or holding company, current profits or reductions in policy holder dividends. Therefore, an allowance is made in the rating system for firms with somewhat less than 1.0 risk-adjusted capital. The second risk-adjusted capital ratio is equal to capital resources divided by target capital calculated under conditions of severe economic decline. According to Weiss, a severe recession is a prolonged economic slowdown in which the single worst year of the postwar period is extended for a period of three years. This ratio is then converted into an index measured on a scale of zero to 10, with 10 being the best and seven or better considered strong. A company whose capital, surplus, MSVR and other capital reserves equal its target capital will have a risk-adjusted capital ratio of 1.0 and a risk-adjusted capital index of 7.0. Weiss' profitability index also is a major factor in measuring the financial strength of an insurer and is derived from an analysis of the following five components: 1) the adequacy of investment income; 2) average and weighted average of net gain on operations over the past five years; 3) volatility of operating gains; 4) contribution of gains to capital growth; and 5) control over expenses, in relation to anticipated norms. The adequacy of investment income to meet the interest requirements of policy reserves is measured in the same way as IRIS ratio 4. It compares the interest credited to life and annuity, health and deposit funds (such as GICs) with the company's investment income to determine whether the company's investment income adequately covers its needs. If income levels are inadequate, the rating will be adversely impacted. Significant margins above the break-even point have a positive impact on the profitability index. The average and weighted gain on operations look at the overall profit levels of the company over a fiveyear period. They are measured in terms of return on assets and return on equity. Weiss looks for stable, consistent profits and does not give additional credit for return on equity figures above the 7.5 percent level. A subcomponent is the difference between the straight average and weighted average of net gains. This reveals the profit trend. If the weighted average is greater than the straight average, profits are generally improving. An up trend favorably affects the profitability index, helping to offset the negative impact of net loss in the current period. Conversely, a downtrend with marginal current profits may have a negative impact on the profitability index. With respect to volatility of profits, credit is given for a low standard deviation. Conversely, large swings in operating results are viewed negatively. Additionally, volatile operating gains are viewed as a possible indicator of surplus relief insurance. Additional deductions are made for weighted aggregate operating losses over the last five-year period. The sources of a company's capital are viewed as an important barometer of a company's financial health. Weiss believes that a company should fund its growth internally from its profits. Contributions from stockholders and/or parent corporations and capital gains are also considered positive factors. However, gains from surrenders, large amounts or reinsurance with non-affiliates and changes in reserve valuation basis are viewed negatively. These and other sources of capital are weighted to produce an index that measures the quality of capital sources. 207

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Weiss sees control over expenses as a key indicator of management's skill in controlling operations. In the Weiss analysis, based on studies by the Canadian Institute of Actuaries, average expenses are derived by function and by line of business. A mean cost figure is derived based on a series of unit costs. For each company, the number of units is multiplied by the average unit cost, which, in turn, is compared with that of all the other companies. If total expenses are more than 100 percent of the standard, it indicates a less than average efficiency of operations, negatively affecting the profitability index. If they are less than 100 percent, it indicates a greater than average efficiency positively affecting the index. Weiss' liquidity index compares: 1) the company's liquid assets; 2) illiquid assets; 3) cash flows to its potential liquidity needs. The following are the subcomponents of each of these components: Liquid assets include cash and marketable securities, such as bonds with maturities of less than one year, publicly traded bonds of investment grade and common or preferred stock. Illiquid assets include items such as real estate, mortgages and investments in affiliates. Cash flow items include premiums and investment income less benefits and other expenses. Subcomponents affecting potential liquidity needs include: Liability for interest sensitive products (e.g. GICs, deferred annuities and other deposit funds), depending on cash-out provisions; The company's surrender experience; Market value adjustments; and Surrender fees as disincentives for disintermediation.

The spread of risk factors utilized by Weiss include: size of investment portfolio; distribution of net premium and deposit funds by line of business; number of policies and contracts in force; and retention limits on ordinary and group life and use of reinsurance. Sources of earnings/capital include: operations (retained risk); reinsurance; investment earnings; realized capital gains; unrealized capital gains; capital infusions; paper adjustments (changes in MSVR, reserve valuation basis, etc.); and appropriateness of dividend levels (policy and stock). Weiss' investment safety index utilizes risk and liquidity calculations separate from those used in the risk-adjusted capital ratios. Weiss' model considers investment yields, bond default rates, mortgage nonperformance rates and portfolio diversification. The process evaluates the relative risks in each investment category and considers these in relation to a company's resources for dealing with them. Exceptional values are noted and analyzed to determine its relevance to a company's financial strength. As indicated above, Weiss does not allow subjective judgements to alter a factual interpretation of the data. However, there are factors which other raters might treat as qualitative which are quantified in Weiss' system. For example, the New York Regulation 126 filing is analyzed in terms of the severity of the underlying assumptions used and the results of the scenario testing in terms of their impact on profits and capitalization. These are then carried over to the interest-rate risk factors in the risk-adjusted capital equation and other equations. Another example is where the nature of the policy-loan provisions in each company's contracts is quantified in the risk factor associated with policy loans in the risk-adjusted capital calculation. Also, the impact of mergers, acquisitions and other special historical circumstances on mechanical ratios are factored out with filters tailored to the particular situation and then used for all companies falling into a similar category. Weiss also measures the quality of management through quantitative analysis of historical data on past performance. Areas evaluated include: cost control skills; bond portfolio management skills; mortgage portfolio management skills; asset-liability management skills; and profitability management skills as measured by current and recent trends.

Rating Classifications and Distribution

In Weiss' view, the rating of an insurer's financial health should reflect the probability of that company 208

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meeting claims in the future as well as its probability of insolvency. Its objective is to place companies in a risk-class that accurately describes the likelihood of insolvency. Weiss' basic rating scale ranges from A to F with "+" and "-" modifiers. A "+" sign indicates that, with new data, there is a modest possibility that this company could be upgraded. The A+ rating is an exception since no higher grade exists. A "-" sign indicates that, with new data, there is a modest possibility that the company could be downgraded. In addition, companies with less than $25 million in capital and surplus are designated with an S in front of their alphabetical rating. The S is simply a reminder that consumers may want to limit the size of their policy with this company so that the policy's maximum benefits do not exceed one percent of the company's capital and surplus. Also, companies receive an unrated classification U if: 1) total assets are less than $1 million; 2) premium income for the current year is less than $100,000; 3) the company functions almost exclusively as a holding company rather than as an underwriter. Weiss' basic ratings are listed below with their definitions. A Excellent : This company offers excellent financial security. It has maintained a conservative stance in its investment strategies, business operations and underwriting commitments. While the financial position of any company is subject to change, Weiss believes that this company has the resources necessary to deal with severe economic conditions. B Good : This company offers good financial security and has the resources to deal with a variety of adverse economic conditions. However, in the event of a severe recession or major financial crisis, Weiss feels that this assessment should be reviewed to verify that the firm is maintaining adequate financial strength. Carriers with a rating of B+ or higher are included on Weiss' recommended list of companies. C Fair : This company offers fair financial security and is currently stable. But, during an economic downturn or other financial pressures, Weiss feels that it may encounter difficulties in maintaining its financial stability. D Weak : This company currently demonstrates what Weiss considers to be significant weaknesses that could negatively impact policy holders. In an unfavorable economic environment, these weaknesses could be magnified. E Very Weak : This company demonstrates what Weiss considers to be significant weaknesses and has also failed some of the basic tests used to identify fiscal stability. Therefore, even in a favorable economic environment, it is Weiss' opinion that policy holders could incur significant risks. F Failed : Company is under the supervision of state insurance commissioners. The distribution of Weiss' ratings tends to be more bell-shaped with more insurers receiving average or below average ratings than assigned by other raters. A recent sample distribution of Weiss' ratings showed that of the 1,470 insurers receiving a letter grade, only 3.8 percent received an A grade and only 15.2 percent received a B grade. Of the rated insurers, 48.2 percent received a C grade and 32.8 percent received less than a C rating.

Dissemination of Rating Information

Consumers and agents are able to obtain a verbal rating over the telephone from Weiss for a $15 charge. A personal safety brief, which is a one-page summary of Weiss' rating for an individual company, is $25, or three for $55. For $45, a consumer receives an 18-page in-depth analysis of a company, or three for $95. Consumers also can order an Insurance Safety Directory issued quarterly for all life and health insurance companies. The Directory includes key financial data and ratios for each company and a list of recommended companies with a rating of B+ or higher.

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SUMMARY ON RATING SERVICES

There is a good deal of similarity among the rating agencies in terms of their basic objectives and approaches in evaluating the financial strengths of insurers. Their essential objective is to assess and offer an opinion as to the ability of an insurer to meet its obligations to policy holders. With the exception of S&P's qualified solvency ratings and the Weiss' safety ratings, the raters utilize both qualitative and quantitative analysis, apply certain basic principles, and follow similar rating processes. At the same time, there are differences among the raters, and they sometimes issue different rating opinions of the same insurers. Rating the financial strength of an insurer is inherently a complex process, and there is considerable opportunity for variation. In terms of quantitative analysis, raters differ with respect to the specific financial ratios used; adjustments to data or ratios to reflect reserve adequacy, reinsurance quality, investment quality, ownership structures and other factors; the weights or significance attached to different financial ratios; and ultimately the way in which quantitative information is utilized in an insurer's overall evaluation. Qualitative analysis provides even greater opportunity for different evaluations among the raters. Assessing the implication of qualitative factors for a company's financial strength, particularly over a long time horizon, inherently involves a considerable amount of subjective judgement. That subjectivity inevitably can result in at least marginally, and sometimes significantly, different rating conclusions. Rating opinions are also affected by somewhat different rating philosophies. The securities rating firms -- Standard and Poor's, Moody's and Duff & Phelps -- essentially assess the risk that an insurer will not be able to meet its obligations to policy holders. Weiss also assesses an insurer's risk to policy holders but bases its assessment on more pessimistic economic scenarios than other raters. Alternatively, A.M. Best places greater emphasis on prevention than detection of insolvencies. For that reason, Best may exhibit greater patience than other raters in allowing a company to resolve its problems before downgrading it. Insurance company ratings which are based strictly on statistical analysis -- S&P's qualified solvency ratings and Weiss Research's safety ratings -- fit into a special category. The primary advantages of quantitative ratings are that they cost less to perform and do not require the insurers being rated to cooperate. The agencies that issue quantitative ratings contend that they expand the availability of unbiased information to consumers. Critics complain that quantitative ratings do not consider various qualitative factors that could explain adverse statistical results. Weiss responds that its approach avoids influence by company management to reach a more favorable rating determination than what the company's actual results suggest. However, in theory, qualitative considerations could also result in a less favorable rating. Indeed, it is difficult to argue with the fact that quantitative ratings are inherently more limited than ratings that consider qualitative information as well as quantitative information. From a public interest standpoint, the issue boils down to whether the benefits gained from having additional rating opinions available, albeit statistically based, outweigh any costs that inure from their limitations. This analysis did not evaluate which rating philosophy or methodology was better or worse. Each rater offers support for its particular approach. We also did not attempt to assess the accuracy of ratings by looking retrospectively at how failed insurers had been graded by different raters prior to the insurers failure. Ideally, such an assessment would consider accuracy in identifying financially strong insurers, as well as financially weak insurers. This is easier said than done because the fact that a low rated insurer has not failed does not necessarily mean that the low rating is not justified or that the insurer will not ultimately fail. The emergence of additional raters during the 1980s responded to a perceived demand for more information and alternative opinions about insurers' financial strength. There seems to be fairly unanimous agreement that the availability of multiple rating opinions benefits consumers, even if there is disagreement about how these opinions should be formulated. There are also different opinions about 210

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the ability of the users of rating opinions to evaluate the validity of those opinions and to sort good methods from bad ones. Some believe that regulators should intervene to prevent the supply of misinformation while others would prefer to rely on the market, i.e., users of rating information, to sort good information from bad information.

STATE GUARANTY FUNDS

PURPOSE OF GUARANTY ASSOCIATIONS
The purpose of the state guaranty associations is to fully guaranty the reasonable expectations of the vast majority of individual policy and group insurance certificate holders. It is important to note that these associations DO NOT exist to underwrite any and all promises, no matter how large or reckless. In essence, state guaranty associations have limitations. Guaranty associations are created by state law "to protect policy owners, insureds, beneficiaries, annuitants, payees and assignees against losses, both in terms of paying claims and continuing coverage, which might otherwise occur due to an impairment or insolvency of an insurer." When an insurer becomes insolvent, it frequently exits the market with liabilities in excess of its assets. The ultimate questions to be answered is: who is going to bear the burden of this shortfall? To date, state legislators have used guaranty funds to shift most of the burden of the shortfall from the policy holders of the insolvent company back to insurers. Absent guaranty fund protection, the policy holders of the insolvent insurer would be forced to absorb the complete loss produced by the insolvent insurer. Guaranty funds provide policy holders and beneficiaries with an entity ready to absorb most of the losses left by the insolvent insurer. Guaranty funds are able to provide protection to policy holders by assessing surviving insurers for amounts necessary to pay the claims of the insolvent insurer. Essentially, these funds shift the burden of the shortfall from policy holders to surviving insurers. Managers of the surviving insurers must then allocate the assessment. Groups that could be called upon to absorb the assessment include: equity holders, policy holders, employees, and taxpayers. Most states use premium tax credits to shift the shortfall to taxpayers. The assessment paid by insurers can be viewed as an interest free loan to the state by way of the guaranty fund. The loan is partially repaid in the form of tax credits and deductions. Federal taxpayers also receive part of the burden as assessed insurers deduct their assessments from taxable income.

THE NEED FOR A SAFETY NET

In any competitive environment, even one as intensively regulated as insurance, insolvencies will occur. The proper role of insurance regulation is to avoid financial failure if possible, detect it as soon as possible when it cannot be prevented, and act promptly to contain its size and impact once the insolvency is known. The vast majority of insurers failed because they priced their product too cheaply. They neglected to underwrite adequately by identifying the nature and extent of the insured risk. An in almost all these cases, the signals were disproportionate increases in premiums written; entry into new and exotic lines of business; risky investments; precipitous drops in surplus; reinsurance to temporarily bolster surplus; overly generous dividends to parent companies; and low claim reserves. A recent comprehensive Best's Insolvency Study confirms this conclusion. Of all property-casualty 211

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insolvencies since 1969, 28% were caused by inadequate pricing, which resulted in inadequate loss reserves; 21% by rapid growth; 10% by alleged fraud; 10% by overstated assets; 9% by significant change in business; 7% by reinsurance failure; 6% by catastrophic losses; and 9% by "miscellaneous". Some believe that inadequate pricing and deficient loss reserves, rapid growth, overstated assets, and significant change in business should have been detected through regular examinations, market conduct exams, holding company reports, annual statements and CPA audited annual reports of non-insurers, as well as by just listening to street talk. It is true that a few insurers were known by general industry discussion to be in trouble long before regulators took action. Reinsurance failure as a cause of insolvency can be prevented by exercise of the existing regulatory authority by the ceding insurer's domestic commissioners as to the granting or denial of credit for unauthorized reinsurance and by the regulation of the solvency of licensed reinsurers by their domestic commissioners. Moreover, "reinsurance failure" as it impacted on some ceding insurers can more appropriately be characterized as "poor management" by the ceding insurer because, as Best's stated, they "purchased the least expensive reinsurance protection without sufficient regard to the financial strength of the reinsurer." Many insolvencies attributed to "reinsurance failure" are almost always the result of other causes, with reinsurance only becoming a factor after the ceding insurer has been declared insolvent, when the reinsurer disclaims its coverage, alleging fraud. Whatever their cause, none of these insolvencies occurred overnight. Did they occur in states with modest resources and few or inexperienced personnel? The biggest states with larger department funding were those with the most insurer failures. Best's also confirms this failure of the regulatory giants. Of the 372 property-casualty insurance insolvencies between 1969 and 1990, 187, or 50%, occurred in six states. These states, that domiciled only 34% of the insurers during the period, were Texas (47 insolvencies); California (35 insolvencies); Pennsylvania (35 insolvencies); New York (30 insolvencies); Illinois (22 insolvencies); and Florida (18 insolvencies). Of these six states, four, California, New York, Texas and Florida, accounted for 48% of the $429 million budgeted for all 50 state insurance departments (plus those of the District of Columbia and Puerto Rico), and the other two highest insolvency states, Illinois and Pennsylvania, with another 5.6%, were in the top 9 states with the highest regulatory budgets. It is unlikely that more money to these six states would have avoided any insolvencies. Why do states so rich in funding and expertise permit so many large insolvencies to occur? Why don't they catch them sooner? One school of thought blames the political nature of insurance regulation and the very existence of guaranty funds. As insurance has become a more public factor in our economy, insurance regulators have found themselves in an increasingly political arena. They have permitted or been forced to allow their focus to shift from the primary role of the regulator -- solvency -- to what has become the more visible issue of pricing. Rate and policy form approval, particularly for commercial insurance where the buyer neither needs nor wants this layer of "protection", drains essential regulatory resources that could better be directed to the solvency of insurers. Examinations of insurers that focus on trivia as much as essentials and that take up to three or more years to complete, being outdated by the time they are released, no longer perform the investigatory and preventive role that used to spot trouble before it became fatal. Like everyone, insurance commissioners do not like to admit failure, and many commissioners and their staff view the insolvency of a domiciled insurer as a personal and institutional failure. That, despite the 212

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INSURANCE MARKETING ISSUES fact that however intense and expert the regulation, some insolvencies will occur.

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Thus, regulators welcome promises of cash infusion, assertions of improved payout patterns, claims of better quality of new business and investments, and the assertion that "things can't get any worse" -anything to avoid or delay the admission that, despite their best efforts, a failure occurred. Unfortunately, in too many cases these promises are unrealistic and are never fulfilled, and, during the period of regulatory indulgence, the insurer's financial condition rapidly deteriorates, new policy holders pay for coverage they will never receive, and, as a result, other insurers and taxpayers end up paying more to clean up the default. Although the insolvency most likely was predetermined years earlier when bad business was written below cost or unrealized investments were made, the situation worsens as new business is written at even less adequate prices in desperation to maintain liquidity.

HOW GUARANTY FUNDS GOT STARTED

The timing of regulatory action, in catching the insolvency early and cutting losses, is essential. This was one of the rationales for the creation of guaranty funds. It was believed that, in addition to the direct benefit of the funds providing compensation to policy holders and claimants, the fact that such compensation was available would encourage regulators to act promptly to take over insolvent insurers while the deficit was relatively small, and to liquidate them if they could not be rehabilitated. It was expected that the relatively small automobile insurer insolvencies of the late 1960s, which resulted in property-casualty insurer guaranty fund legislation, would not improve an undue burden on either other insurers who initially provided the guaranty fund payments, or on taxpayers and policy holders who ultimately paid for the insolvent insurer's obligations. The first state guaranty mechanism for life and health insurance and annuities was formed in 1941 in New York. The second such mechanism was created in Wisconsin in 1969. In 1970, the National Association of Insurance Commissioners (NAIC) adopted the Life and Health Insurance Guaranty Model Act. The NAIC has made several major revisions to the Model Act since its adoption, the most recent in 1987. At this point, all 50 states and Puerto Rico have created some form of guaranty mechanism.

HAVE THE FUNDS ACCOMPLISHED THEIR GOAL?

Some believe that while the guaranty funds have, for now, met the goal of compensating policy holders, they have not had the intended result of strengthening regulatory backbone. They have had exactly the opposite effect. Confident that continued forbearance towards a financially troubled insurer will not embarrass them because most claims are likely to be paid by the guaranty funds, some feel that regulators have tended to procrastinate in the unfounded hope that somehow the insolvency will heal. It is alleged in congressional testimony that two major regulatory states delayed taking action against large financially hazardous or insolvent insurers until pending guaranty fund legislation was enacted. It is unlikely that a single insurer backed up by a guaranty fund has been prematurely liquidated. Conversely, belated receivership, with escalating deficits during each day of continued operation, has become the rule. Although it has become obvious in banking and savings and loan insolvencies, guaranty funds are not without cost. Whether a small auto insurance insolvency or a large commercial one is involved, the payments by guaranty funds are borne by the contributions of surviving insurers and, one way or another, 213

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It is likely that the movement to restrict guaranty fund coverage to large commercial policy holders will be endorsed in a growing number of states, but for non-commercial insureds, guaranty funds are likely here to stay, regardless of unintended and anti-solvency results.

STRUCTURE AND WORKINGS OF CURRENT FUND SYSTEMS

The guaranty associations are non profit legal entities whose members comprise all insurance companies licensed to write insurance or annuities in the state. Each association is governed by a board of directors approved by the state's insurance commissioner.

Exclusions
In general, guaranty acts exclude from coverage policies issued by entities that are not regulated under the standards applicable to legal reserve carriers. Insurance exchanges, assessment companies, fraternals, HMOs and, in many cases, the Blues (Blue Cross and Blue Shield -- especially where they have not been converted to legal reserve carriers), are commonly excluded. The guaranty laws also commonly exclude from coverage policies or portions of policies under which the risk is borne by the policy holder or which are not guaranteed by the insurer. Variable accounts in some life policies or annuity contracts are examples as are certain surplus lines in the casualty arena. Significant variation does exist in the treatment of unallocated funding obligations (UFOs), including GICs, which are commonly purchased as pension plan assets on professional, sophisticated advice by pension plan trustees (more on this in a later section).

Limits of Protection
Most guaranty associations limit their protection to policy holders who are residents of their own state. (It does not matter where the policy owner's beneficiaries live.) The trend toward adopting such a residents only provision follows a major amendment to NAIC's model guaranty act adopted in 1985. Arizona, Virginia, West Virginia, Nevada, North Carolina and Oregon very recently amended their lifehealth guaranty laws to cover only their own residents. However, if the insolvent insurer's domiciliary state follows the NAIC model, coverage would be extended by the domiciliary state to residents of another state if that state also has a similar guaranty act and the impaired company was not licensed there and the policy holder is not eligible for coverage there. An example of such a situation would be a New York resident who owns a policy of the Executive Life Insurance Company, which is domiciled (chartered) in California. Since New York has a life-health guaranty association but the company was not licensed to do business there, New York residents will be covered by the California Life Insurance Guaranty Association. However, residents of a jurisdiction such as the District of Columbia which does not have a life-health insurance guaranty association would have no guaranty association protection, even though Executive Life was licensed there. Other states, like Alabama, still follow an older model act and guaranty benefits of impaired or insolvent insurers domiciled in their own state, no matter where the policy holders live, and they also cover their own residents who are policy holders of licensed companies domiciled in other states, unless coverage is provided by the state of domicile.

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Dollar Limits
Typical payouts to policy holders who are victims of failed or financially strapped insurance companies might read as follows: Life and Health Guaranty Funds Maximum Death Benefit Maximum Cash Value Covered Maximum Annuities Maximum Health and Disability Maximum Aggregate Per Person $300,000 $100,000 $100,000 $100,000 $300,000

Property/Casualty Guaranty Funds Maximum Claim $300,000 - $500,000

Individuals who have several policies may have additional limits. For example, a person who owned a term life insurance for $500,000, a whole life policy with cash values of $150,000 and a single premium annuity with an accumulated value of $200,000, will collect ONLY $300,000 -- the maximum aggregate limit per person regardless of how many policies. The fact that these policies may be spread among three different insurers does not make any difference. There would still be a $300,000 maximum in most states. The same is true for property/casualty claims. Regardless of the number of policies or how they are distributed among different insurance companies, the maximum claim that can be paid by a state guaranty fund is fixed at between $300,000 and $500,000 per individual. In addition to the individual annuity contract coverage provided, state life and health insurance guaranty associations generally cover individuals under group annuity certificates. Where an individual has been issued evidence of insurance by or on behalf of the insurer, i.e, a "certificate", that individual is covered as though he had purchased an individual insurance policy. Coverage generally will be provided by the guaranty association of the state of residence.

Unallocated Funding Obligations

Unallocated funding obligations (UFOs) are group contracts that are not issued to and owned by an individual, and do not provide guarantees to any individual. They include unallocated annuities, funding agreements, guaranteed investment contracts (GICs), deposit administration contracts (DACs), and other arcane titles. As mentioned, employers often purchase such investment vehicles to fund retirement plans. The types of UFOs not covered under the NAIC Model Act are referred to as "financials", a contract which is not issued to or in connection with a specific employee, union or association of natural persons benefit plan or a government lottery, and any unallocated annuity contract issued to an employee benefit plan protected under the Federal Pension Benefit Guaranty Corporation. However, when allocated annuities are purchased for pension plan participants in connection with a plan termination, normal guaranty association coverage then attaches. Some states exclude all UFOs from coverage. The reason for this, and the reason for the limited, although high, coverage in the NAIC model act, is the moral hazard of unlimited coverage on giant contracts, under which investors could rely on outside guarantees instead of the financial strength of the issuer. This is the very problem that brought down so many Savings and Loans, swallowed the FSLIC, and that has also badly bitten the banks and FDIC.

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Triggers
Generally, the guaranty associations provide coverage when the company has been declared financially impaired or has been ruled to be insolvent by a court of law. However, there are some situations preceding such a judicial action when many associations may take measures to cover the impaired insurer's policy holder obligations, particularly for health benefits, death benefits, and immediate annuity payments. However, since the primary purpose of the guaranty associations is to protect policy holders, and not to bail out impaired or insolvent insurers, most associations are reluctant to provide coverage before an order of liquidation, unless it is clearly demonstrated that to do so in a particular case will be less costly over time.

Coverage Options
Guaranty associations may provide coverage directly, or through outside administration or other insurance companies. In many cases, the guaranty association will continue coverage for the full policy period. It may do this directly or it may transfer the policy to another insurer or administrator. In multi-state insolvencies, most guaranty associations work through NOLGHA to secure an assumption reinsurance agreement with another insurer or a claims servicing agreement with a third party administrator on a multi-state basis. If the impaired or insolvent insurer is licensed in more than one state, as most are, NOLHGA's affected member associations try to work closely through our Disposition Committee with domestic receivers to protect policy holders and ensure early and equitable access of guaranty associations to the insolvent company's assets. On behalf of its participating member guaranty associations, NOLHGA's Disposition Committee expedites reinsurance assumptions, claims processing and audits.

HOW DO LIFE/HEALTH GUARANTY ASSOCIATIONS DIFFER FROM PROPERTY/CASUALTY GUARANTY ASSOCIATIONS?

The NAIC Post-Assessment Property and Liability Insurance Guaranty Association Model Act limits the obligation of the association to covered claims unpaid prior to insolvency and to claims arising within 30 days after the insolvency, or until the policy is canceled or replaced by the insured, or it expires, whichever occurs earlier. There is no reason for the association to continue existing coverage since policy owners will be able to replace their property and liability policies. The function of the property/casualty association is to allow policy holders to make an orderly transition to other companies. Unlike the property/casualty guaranty associations, life/health associations do not terminate coverage. The NAIC Model Act requires the associations to "guarantee, assume or reinsure, or cause to be guaranteed, assumed, or reinsured, any or all of the policies or contracts of the impaired insurer." Life and annuity contracts are long-term obligations for which coverage must be continued. An insured may have impaired health or be at an advanced age so as to be unable to obtain new and similar life or health insurance coverage in the open marketplace. Coverage may be continued directly by the guaranty association or, more often, by a new company to which the business is transferred. Guaranty associations generally avoid assuming the business of an insolvent company. They are not insurance companies and are not well equipped to track large numbers of long-term obligations. When possible, the policies and contracts of an insolvent company, with the help of an infusion of funds from the guaranty associations, will be reinsured with another company.

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OPERATING A GUARANTY ASSOCIATION

The powers of the association are exercised through a board of directors selected by member insurers, subject to the approval of the commissioner. The directors are officers of insurance companies who serve on the board without renumeration. Expenses incurred in fulfilling the duties of a director may be reimbursed by the association. The association fulfills its functions under a plan of operation developed by the association and submitted to the commissioner for approval within a period of time, typically 30 days, after the guaranty association is created. The NAIC Model Act requires the plan of operation to: establish procedures for handling the assets of the association establish the amount and method of reimbursing members of the board of directors for their expenses establish regular places and times for meetings of the board of directors establish procedures for records to be kept of all financial transactions of the association, its agents, and the board establish the procedures whereby selections for the board of directors will be made and submitted to the commissioner establish any necessary additional procedures for assessments besides those set forth in the statute contain additional provisions necessary or proper for the execution of the powers and duties of the association

The NAIC Model Act also permits a board of directors, with the approval of the commissioner, to delegate its powers or duties, except its assessment power and its right of subrogation, to a corporation, association, or other organization that performs functions similar to those of those associations in two or more states. The association is also empowered to employ or retain such persons as are necessary to handle the financial transactions and other necessary and proper functions of the associations.

WHO PAYS FOR GUARANTY ASSOCIATION PROTECTION & WHEN?

The funds necessary to fulfill an insolvent insurer's obligations are obtained by assessments levied against other insurance companies doing business in the state . The amount each company must pay depends upon how much business that company writes in the state of the same type written by the insolvent company. Assessments are capped on an annual basis to ameliorate the adverse impact upon the insurers financial stability. The limits range from 1% to 4%, with most states imposing an annual assessment limit of 2%. State law also provides that an assessment may be waived for an individual insurer if the commissioner of that state determines that payment of the assessment would endanger the insurer's ability to meet its own obligations. Assessment waived for an individual insurer are paid by the remaining insurers doing business in the state. Assessments are levied when an insurer has been declared financially impaired or when the insurer has been declared insolvent by a court of law . To enable a guaranty association to fulfill policy holder obligations quickly, state statutes permit the associations to borrow money. This enables an association to pay claims while work continues to determine the appropriate amount to be assessed. Forty-two of the fifty-one jurisdictions with guaranty associations allow insurers to offset, against their premium or other tax liability to the state, all or part of the amount paid as assessments to the state guaranty association. These numbers illustrate the recognition by most state legislators of the soundness of allowing companies to offset assessments against premium taxes. A breakdown in the system resulting in the insolvency of the company is one of the costs that the state should bear as part of its responsibility for solvency regulation. The tax offset, therefore, acts as an incentive to effective solvency 217

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INSURANCE MARKETING ISSUES oversight by the state regulators.

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To maintain a balanced budget, state governments face the choice of raising other state taxes, increasing borrowing or reducing services. For this reason, governmental interest in reducing the costs associated with insolvency is understandable. Yet, states seem unwilling to recognize the relationship between the funding of insurance regulatory oversight and the possibility that lower funding levels may mean a higher number of insolvencies. A higher number of insolvencies may cause a decline in available revenue through the tax consequences of guaranty fund assessments. The Government Accounting Office (GAO) implies such a linkage exists between regulatory resources and the number of insolvencies. In depth audits of insurance departments nationwide determined that over 40 percent had difficulty in obtaining adequate funding that prevented them from hiring needed or qualified examiners. A specific example included one state where a staff of 29 was in charge of analyzing almost 6,500 annual statements. The GAO and others have proposed regulatory improvements. Most of the improvements require additional regulatory funding. However, if regulatory improvements result in the earlier detection of troubled insurers, a situation exists with the possibility of a gain for all parties. Because an improvement in regulatory oversight is likely to result in a reduction in the need for assessments, it is possible that the associated tax and insurance cost savings could more than offset the increased regulatory cost.

THE CONSEQUENCES OF GUARANTY FUND PAY OFFS

Two questions arise as a consequence of guaranty fund distributions: 1) What are the implications of shifting the burden of the shortfall from the policy holders of the insolvent firm to assessed insurers? 2) What are the implications of allowing assessed insurers to shift parts of the burden to taxpayers? First, what is the impact of shifting the burden away from the policy holders of the insolvent insurers? The existence of guaranty funds reduces the incentive for consumers to review the financial strength of prospective insurers. Individual policy holders covered by guaranty funds do not typically bear losses beyond delays. Therefore, consumers may focus attention on price or interest rate without much regard to financial strength when selecting an insurer. This reduction in policy holder monitoring may cause insurers to seek higher rates of return by adopting riskier investment strategies. With regard to insurance, the guarantees result in pressure for insurance managers to increase the risk level of their investments in order to lower the price of their products. The increased risk results in a general increase in the probability of insolvency. Another incentive produced by the existence of guaranty funds involves regulator behavior. Because the cost of a shortfall in an insolvent insurer is initially borne by assessed insurers, with the state tax credits being spread over five years, and sometimes more, the effect of an insolvency is spread over time. In addition, the effect is spread over a larger constituency: taxpayers rather than just policy holders. Therefore, guaranty funds appear to reduce the incentive of consumers to shop based on the financial strength of the insurer. They may also reduce the incentive for regulators to quickly remove a failing insurer from the market. The second issue was the implication of allowing assessed insurers to shift some of the burden of the assessment to taxpayers. Before addressing this issue, it may be helpful to remember what events cause a policy holder to rely on a guaranty fund for compensation. Ultimately, if the state regulator does not remove a failing insurer prior to it depleting its capital, then a shortfall is created. At present, the responsibility for removing failing insurers is the jurisdiction of the state governments. This does not imply that an insolvency is a failure on the part of state regulation. Failing insurers are evidence of a competitive market where some providers are driven out of business. However, some industry will argue that because the state failed in its legislative and regulatory oversight, it should be the state 218

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INSURANCE MARKETING ISSUES government that bears the burden of the shortfall.

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Though the decision is ultimately a value judgement, there are some compelling reasons for providing state tax credits for assessments paid. These reasons include more appropriate cost sharing, and the effect on the incentive to regulate. There is some logic in spreading the burden in the broadest possible manner. For states, this means distributing costs through their general revenue systems. Using the broadest possible method to spread the burden appears appropriate when the potential payees are neither responsible, nor the primary beneficiaries of the payments. The equity holders, policy holders, and employees of the assessed insurers have as their greatest offense in this scenario, the decisions to affiliate with an insurer that was financially stronger than the insolvent insurer. Therefore, it seems to serve fairness to spread the costs as broadly as possible. There is an additional reason for states to provide credits. Because the states have the primary responsibility for policing solvency, a credit against assessments gives the states a financial interest in improving their regulatory effectiveness. To this end, states would have the greatest incentive to regulate if the credits were applied as they are in South Carolina where assessed insurers are allowed a 100% tax credit. The South Carolina credit minimizes the impact of the insolvency on the federal revenue system. The credit provides for the broadest possible distribution of the burden of insolvency within the state. Short of a reason to penalize a particular group, such as policy holders of assessed insurers, it seems to be a fairer method of allocation. And finally, the state tax credit provides a financial incentive for regulators to be more effective in policing solvency.

THE REASON GUARANTY FUNDS RECEIVE FEDERAL & STATE INCENTIVES

Unless a benefit relationship exists that enables government to charge a price mimicking the market system, expenses are typically distributed in the broadest manner possible, that is, through the general revenue system. The market system allows the beneficiaries of a good or service to choose the product because they perceive the value of the benefits to be greater than the price. The structure of guaranty funds suggests that government does not expect a quid pro from the primary beneficiary of guaranty fund protection, in essence, insureds of the insolvent insurer. Instead, government attempts to finance guaranty protection by spreading costs broadly across the population. Absent guaranty funds, an insolvency has a negative impact primarily on insureds of the insolvent company and third party claimants. Government has deemed it socially desirable to minimize the negative impact on insureds of the insolvent insurer by spreading the burden of insolvency to others. In effect, the existing set of laws relies on taxpayers through the general revenue system, owners and employees of insurance companies, and insurance consumers to pay the costs of insolvency. Additionally, government requires the insurance industry to finance the governments' portion. Rather than rely exclusively on government revenues for funding, guaranty funds rely on insurers for short-term funding needs. That is, guaranty funds pay many of the claims of the insolvent insurer with monies obtained from the assessments on surviving insurers. Then, most states grant a tax credit against state taxes for assessments paid. Essentially, guaranty funds allow the state to compensate victims of an insolvency without budgeting for the anticipated claims expense and without incurring an interest cost for borrowing the required funds. The "loan" made by insurers is repaid in the form of tax credits and deductions. The repayment reduces corporate taxes causing government to rely more heavily on other revenue sources 219

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than it would absent the insolvency. Hence, part of the cost of insolvency is shifted to taxpayers from customers of the insolvent insurer, but part is shifted to its former competitors. The distribution of the portion shifted to taxpayers is determined by the incidence of the federal and state revenue system. The model state tax credit scheme is 20 percent of the assessment for each five years, beginning the year after the assessment. Because the credits are spread over five years after the assessment is paid, and because not all states grant tax credits that sum to 100 percent of the assessment, insurers incur opportunity costs, the so-called time value of money issue, and administrative costs of compliance that may not be shifted. When a state does not offer a tax credit that sums to 100 percent of the assessment, additional offsets are available to insurers. A portion of assessments not offset by a state tax credit may be paid by insureds of the surviving insurer through recoupment provisions allowed under the guaranty fund acts of some states. Finally, of the assessments not recouped or offset by a state tax credit, insurers may offset 34 percent through the federal tax system because the assessment, as a business cost, is deductible from federal corporate income taxes. Placing the focus of insolvency cost on guaranty fund assessments diverts attention from a number of other insolvency costs. For example, unless they have extracted their capital, the owners of the insolvent firm bear a loss of equity. Assessments also require the insurer to determine their correctness, at some positive cost, and to make the payment. Because the payment reduces surplus, the ability to write new business is inhibited. Insureds of the insolvent insurer and third party claimants also bear a cost because guaranty funds limit the amount of coverage with claim caps and deductibles. The cost of insolvency remaining with surviving insurers is likely to have both direct and indirect effects. Among the direct effects, the profits of insurers may be reduced, the taxes paid by insurers will be reduced, and industry concentration may be increased. Among the indirect, or consequent effects, the availability of insurance may be impaired. That is, because the rate of growth of insurance company surplus is positively related to profits, a non-transferable guaranty fund assessment will reduce the profits and the rate of surplus growth. A reduction in the rate of growth of surplus will constrain the growth of insurance availability. Consequently, the quantity of risks undertaken might be reduced and society would suffer a loss of utility from the foregone consumption opportunities. The general revenue system putatively distributes the cost of government in the broadest manner. The reasons a government might deviate from funding in the broadest manner include (1) the group targeted for heavier taxation disproportionately benefits from the activity being funded, (2) there is a desire to penalize the group for culpability in the insolvency, or (3) the distribution will be more/less progressive than the general revenue system and this result is deemed desirable. With respect to the benefit argument, insurers may benefit from a higher level of consumer confidence because guaranty funds exist, but the net benefits are uneven. The best and worst insurers benefit from consumer confidence created by reliance on the existence of a guaranty fund. Indeed, the incentive structure outlined below suggests that the benefits to weaker insurers are greater. With a guaranty, consumers are less sensitive to financial strength, and they are more likely to shop on price alone. Consequently, weak insurers may attempt to cover losses through underpricing to attract revenue. The underpriced risks accepted increase the ultimate cost and likelihood of the insurers insolvency. It is possible that better insurers would benefit from the elimination of the guaranty fund because, while aggregate demand may be lower, consumers would be more likely to choose the products of fiscally sound insurers. It is not clear that the net benefit of guaranty funds to the industry is positive. The culpability argument also seems unlikely to apply to surviving insurers. It is primarily governmental regulators rather than competing insurers, that have responsibility for ensuring the financial integrity of an insurer. It is similarly unlikely that the distribution of costs to shareholders and insurance consumers is a more progressive funding pattern than that incidence of the general revenue system. Because insurance is a normal good, the quantity purchased by consumers is a higher percentage of income for 220

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lower income individuals. Like any tax on a normal commodity, the incidence of the portion borne by consumers is regressive. Absent tax credits, the percentage of insolvency costs borne by consumers would increase. Some suggest that competition will cause the assessment to be paid from shareholders equity, rather than by insurance consumers. This result would be more likely to occur if a subset of the industry were paying the assessment. Costs that are common to all firms in the industry are typically included in the price paid by consumers. While the incentive structure of guaranty funds has been critiqued by many, a viable alternative has not yet surfaced. A number of commentators have suggested excluding large commercial insurance purchasers from guaranty fund protection. Some find this suggestion appealing because it is likely that the external benefits from the monitoring performed by these purchasers would accrue to individuals and small commercial purchasers.

CAN GUARANTY ASSOCIATIONS HANDLE MAJOR INSOLVENCIES?

The answer to this question depends on the authority asked. Following are some relevant issues:

Industry Critics
Association funds, according to the critics, are full of exclusions, qualifications and other stipulations that make it difficult to figure out exactly what is covered. For example, a group annuity purchased by a company pension does not individually name the employees covered under the plan. Although state guaranty fund limits may reach $1 million to $5 million for these group contracts, losses in excess would not cover individual employees. Further, once an insurance company takes over control of a group contract, protection by the Pension Benefit Guaranty Corporation is lost. Guaranteed Investment Contracts, GICs, have similar limitations. Another limitation of the system, say the critics, is how money is raised. In the event of a major loss, most states can assess insurers an average of up to 2 percent of the amount of premiums written for the previous year. Some states may assess as much as 4 percent while others are currently limited to only 1 percent. Where a significant loss has occurred, the low level of these assessments might require several years for full coverage to occur. Further, an insurance company can appeal the amount of the assessment or defer making payment if it would put them at financial distress. Congress has also raised doubts about the system based on recent Government Accounting Office (GAO) report specifically addressing health care reform. The GAO said its survey of insurance departments found wide variations in the way they "monitor insurance solvency and approve health insurance premium rates and respond to consumer complaints. The consequences of an insurance company failure can be catastrophic for policy holders who may be left with millions in unpaid claims and without health insurance, and while states have guaranty funds to protect consumers when an insurance company goes broke, there are gaps in that safety net. Consumers may be left unprotected when an insurer with multi-state operations fails, and in 30 states, the guaranty funds do not cover Blue Cross or Blue Shield plans."

Industry Supporters
According to the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA), the aggregate annual assessment capacity of the life/health guaranty associations is $3.06 billion. This figure does not include the recently-enacted Colorado, Louisiana, or New Jersey guaranty association laws. Broken down by line, the aggregate annual assessment capacity is $1.09 billion for life insurance, $784 million for annuity contracts, and $1.2 billion for accident and health insurance. This capacity far 221

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INSURANCE MARKETING ISSUES exceeds the obligations confronted by the state guaranty association system to date.

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When considering the capacity of the current guaranty association system to handle a major insolvency, it is important to remember that, for many types of losses, guaranty association assessments can be made over many years. For life insurance contracts and annuities, the guaranty associations often simply continue in force or reinsure the business. Thus, the losses will be spread over a number of years as benefits are paid. Because losses are spread over a period of years, the one-year assessment capacity of the guaranty association system is not conclusive in determining the ability of the system to cope with losses from any major insolvencies that might occur. The current system of post-insolvency assessment state guaranty associations has protected consumers well. State guaranty association laws have been easily adapted to changing circumstances over the past five years to ensure timely payment of policy holders' claims. In 1990, the American Council of Life Insurance appointed a Study Group to consider alternatives and enhancements to the current guaranty association mechanism. The Study Group issued its final report in October, 1991. Members of the Study Group concluded that in order to buttress policy holder confidence in our industry in the current economic environment, a universal and more uniformed guaranty mechanism was needed, as well as a strengthened state regulatory system. The Study Group made the following specific recommendations: 1) The Study Group believes the capacity of the guaranty association system is more than adequate 2) to handle insolvencies that may occur; however, if concerns regarding the capacity of the current system persist, the concept of a catastrophic insurance system should receiver further consideration. 3) Enactment of the NAIC Life and Health Insurance Guaranty Association Model Act, modified in 4) accordance with ACLI policy, should be sought in the District of Columbia. 5) Existing guaranty association laws should be amended, where appropriate, to provide for "residents only" coverage, including the exception for non-resident policy holders, consistent with the NAIC Life and Health Insurance Guaranty Association Model Act. Amendments should be sought only where it is possible to do so without jeopardizing existing premium tax offset provisions. 6) The current NAIC Model Act and existing guaranty association laws should be amended, where appropriate, to eliminate coverage for unallocated annuities. Amendments should be sought only where it is possible to do so without jeopardizing existing premium tax offset provisions. 7) Enactment of a full premium tax offset should be sought, where feasible, in all jurisdictions. 8) The NAIC should be encouraged to stipulate the provisions that must be included in a state's guaranty association law in order for that state to be accredited. 9) Enactment of the NAIC Insurers Rehabilitation and Liquidation Model Act and the NAIC 10) Administrative Supervision Model Act should be sought, where appropriate, in all jurisdictions. 11) The NAIC should be encouraged to adopt standards to require receivers to (a) cooperate with guaranty associations to minimize the administrative costs of insolvencies, (b) utilize uniform automated reporting systems to minimize administrative costs, and (c) pursue recovery from affiliates under section 14.E of the NAIC Life and Health Insurance Guaranty Association Model Act. Adoption of these standards ought to be required for accreditation by the NAIC. 12) The legislative committee should appoint a Study Committee including public relations, marketing, 222

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actuarial, and legal experts, to re-examine the issue of advertising and disclosure of guaranty association coverage. The study should cover the questions of advertising and disclosure specificaly in connection with marketing practices of agents.

REINSURANCE
In reading this section, it will become clear that reinsurance plays a vital role in helping all types of insurance companies meet their everyday commitments. The greater frequency of recent insurer downfalls and natural disasters, however, is creating a shakeout in the industry causing many longstanding reinsurers to exit the business. Some insurance companies who also sell reinsurance have suffered the hazards of double exposure by having to pay claims from BOTH their primary and reinsurance divisions. It is also the contention of some industry groups that abuse of the reinsurance system, including some questionable reinsurance schemes by depressed insurers and foreign reinsurers, has been a key factor in almost every insolvency. In response to many of these issues, reinsurance companies have reassessed their own risk/reward underwriting leading to higher prices and in some cases decisions to cease business altogether. Buyers of reinsurance, in turn, have been finding price increases difficult to handle and quality reinsurers harder to come by. Eventually, this has and will limit their ability to write policies causing what some believe to be a "capacity crunch". Given this scenario, it is understandable that reinsurance and insurer safety are closely related and important topics of study.

PURPOSE & PRACTICES OF REINSURANCE

Reinsurance Defined
Reinsurance is often described as the insurance of insurance companies because it provides reimbursement for the insurer's losses under policies covered by the reinsurance contract. Insurance placed with the reinsurer is called the ceded amount , and the company that receives the benefit of the insurance is called the ceding insurer . Insurance purchased by reinsurers to cover their own losses is called retrocession. The process of reinsurance involves a transaction whereby the reinsurer, for a premium, agrees to indemnify the ceding insurer or reinsured against all or part of its losses under policies written. It is a transaction which does not involve the policy holder who looks only to his insurer for defense and indemnity against loss. Reinsurance is purchased by a primary or an excess ceding insurer for its own benefit so that it can spread its risks and limit its own liability from large or catastrophic losses. Reinsurance is often confused with excess or surplus line insurance. However, the two are totally unrelated. Excess and surplus line insurers are primary companies providing direct coverage to insurance consumers. Their function is to supplement the standard admitted insurance markets. Excess and surplus line insurers are, in turn, large purchasers of reinsurance.

Sources & Reasons For Reinsurance

Reinsurance can be obtained through three distinct sources : professional reinsurers, reinsurance departments of primary insurance companies and unauthorized alien reinsurers. The insurance premium charged policy holders by insurers includes the cost of reinsuring the risk. In other words, there is no added charge to the policy holder . The primary company calculates the premium on a gross basis and all reinsurance expenses are incorporated in the premium. The insurer has the responsibility to evaluate the risk in its totality and to price the risk according to the potential loss exposures. The distribution of the reinsurance premium between the insurer and the reinsurer is a separate transaction which does not involve the policy holder . There are many reasons primary insurers purchase reinsurance . The two most important are to limit 223

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their liabilities and to increase their capacity. An insurance company may wish to cap its exposure to losses in one or a combination of three ways: a per risk limitation, a catastrophic loss limitation or an aggregate of loss limitation. Prudent insurance management and certain insurance regulations demand that a company place a limitation commensurate with that company's surplus or equity on any one potential loss exposure, even though the company may provide coverage under an insurance policy in amounts considerably in excess of this prudent "retention". This is where reinsurance comes in. The individual company's retention may be anywhere from a few thousand dollars to several hundred thousand or even in the million dollar range. Whatever the loss exposure may be above the retention, up to the policy limits of the reinsurance contract, if any, becomes the responsibility of the reinsurer. Most companies also seek to protect themselves from a disastrous accumulation of losses arising from a single event. For instance, a hurricane or an earthquake. No one single loss payment arising from the event might be beyond the company's individual risk retention level, but the accumulation of all the losses arising from the incident might be excessive for that company. Generally speaking, an insurer estimates the probable maximum loss to which it may be exposed, based on its business concentration in any particular geographical area, compares that exposure to its surplus and purchases reinsurance to cover the potential losses which exceed a prudent level of catastrophic retention. Another approach often used by companies to limit their potential liabilities attempts to cap the aggregate losses which may be sustained over a specific period -- say one year -- either with respect to its total combined losses for the period or the combined losses for certain lines of insurance. The important reason an insurer may want to purchase aggregate loss reinsurance is to stabilize its operations from year to year. By providing a mechanism whereby companies may limit their loss exposures to levels commensurate with their surplus, reinsurance allows those companies to offer coverage limits considerably in excess of what they could provide otherwise. This is a crucial function for small to medium size companies, allowing them to offer coverage limits which meet the needs of their policy holders. If only the larger insurers could do so, there would ensue considerably less competition and insurance capacity would be much more restricted than it is today. Reinsurance further enhances an enlarged capacity by a variety of other approaches which are related to accounting procedures. When an insurance company issues a policy, the expenses associated with issuing the policy, such as taxes, agent commissions and administrative expenses, become a current charge on surplus, while the premium collected must be set aside as an unearned premium reserve. The premium can only be considered as earned by the company and available to it over the life of the policy. This mismatch in accounting between premium and expenses makes good sense from a regulatory standpoint in that it allows for a more conservative accounting, commensurate with regulation for solvency. But it penalizes insurers to the extent that the more business they write, the more they must draw down on their surplus, thus reducing their capacity. By reinsuring a part of the business written, an insurer is able to limit the impact of the mismatch since the reinsurer must reimburse its client company for its proportionate share of expenses. The reinsurer then is the one which must reduce its surplus by the expenses it absorbs from its reinsured. Similarly, when a claim is presented to an insurance company, a loss reserve must be established for the amount of anticipated claim payment. The reserve also comes from the company's surplus. However, to the extent a reinsurance recovery is anticipated on the claim and the reinsurer qualifies under state regulation, the insurer may limit its loss reserve to the extent of its own estimated "out of pocket" liability. There are other approaches to reinsurance as a mechanism to enhance capacity. One such approach which was used perhaps to excess in the past is known as a "loss portfolio transfer". Under this transaction, the insurer "sells" a portion of its loss reserves to the reinsurer which promises to pay the claims represented by these reserves when they are finally adjusted. Assuming that the loss reserves being transferred to the reinsurer exceed the payment which the insurer makes to the reinsurer, the 224

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INSURANCE MARKETING ISSUES difference may be added to the insurer's surplus, thus, enhancing its capacity.

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Reinsurers provide other services besides financial transactions aimed at limiting an insurer's exposure to losses, stabilizing an insurer's operation or enhancing its surplus to increase capacity. Many reinsurers are equipped to provide guidance to insurers in underwriting, claims reserving and handling, investments and even general management. These services are particularly important to smaller companies or to those which may wish to enter new lines of insurance.

Limitations of Reinsurance
First and foremost, reinsurance does not change the inherent nature of risk being insured. Thus, it does not make a bad risk insurable. Neither is reinsurance, nor can it be made to be, a subsidy allowing underpricing of risks. Finally, reinsurance does not make a risk exposure more predictable or desirable. While it may limit the exposure to a risk from the standpoint of the primary insurer, the total risk exposure is not altered through the presence of reinsurance.

Reinsurance Contracts
There are two basic types of reinsurance contracts. The first, called a "treaty", covers some portion of a particular class or classes of business, e.g., the insurer's entire workers' compensation business or its entire business covering exposures in a state. Treaties are usually expected to remain in force for long durations and are often renewed on a fairly automatic basis unless either party wishes to negotiate a change in terms. The second contract form is called a "facultative agreement". It allows an insurer to reinsure a specified risk under terms and conditions agreed upon between the insurer and reinsurer. Facultative reinsurance contracts are used to supplement treaty arrangements. Treaties may, for instance, contain certain exposure exclusions such as exposure involving long haul trucking, munitions manufacturing, or environmental liability. Risks which are written by the insurer which may have such exposures are then covered separately under facultative reinsurance contracts. The reinsurer which provides the company's treaty coverage may not necessarily be the one providing the facultative reinsurance. There may also be certain classes of risks which are anticipated to develop losses which may adversely affect the treaty experience which, although not excluded from a treaty, may be placed facultatively. A school bus might fit in this category. Risks whose exposure may be catastrophic are often facultatively reinsured as are unusual risks. Prior to the 1950s, there was relatively little use made of facultative reinsurance in the U.S. Lloyd's of London was virtually the sole market. U.S. reinsurers began to compete for the business in the 1950s and today facultative reinsurance has assumed a major role in the domestic reinsurance market. In a survey conducted by the RAA for year end 1987, casualty reinsurance dominated the facultative business. Facultative reinsurance requires a technical expertise not available to all reinsurers. Since risks are reinsured on an individual basis, the reinsurer must have the necessary knowledge to underwrite and price exposures on an individual basis. This resembles, in many ways, the steps which an insurer must take in writing its direct business. Treaty reinsurance underwriting is, on the other hand, very different. Keep in mind that reinsurance treaties automatically cover all risks written by the insured, unless they present exposures which have been specifically excluded. Although treaty reinsurance does not contemplate an individual underwriting risk review by the reinsurer, it demands a careful review of the underwriting philosophy, practice and historical experience of the insurer, a thoughtful evaluation of its management attitude toward claims and engineering control, as well as management's general background, expertise and planned objectives. Both facultative and treaty contracts may be written on a prorata basis or an excess of loss basis and 225

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sometimes on a combination of both. A pro rata contact simply prorates all premium, losses and expenses between the insurer and the reinsurer on a pre agreed basis. Although reinsurers have, of late, avoided the prorata approach in casualty lines, it is still used extensively in property reinsurance. Excess of loss reinsurance which also can be the base of either facultative or treaty reinsurance contracts requires the primary company to assume all losses up to a predetermined amount, called the retention, and for the reinsurer to reimburse the ceding company for any excess over the retention, up to the limits of the reinsurance contract. This arrangement provides the reinsurer with an opportunity to develop a rate commensurate with its exposure and to bargain with the insurer for an adequate share of the total premium.

Reinsurance Marketing
Any insurance company may sell reinsurance. The insurance license issued by a state insurance department designates the lines of business a company may sell, i.e., automobile, workers compensation, etc. Once authorized to do business in a specific line in a state, the company may either provide insurance or reinsurance for that line. Some insurance companies, known as professional reinsurers, specialize in reinsurance. While U.S. licensed professional reinsurers provide approximately 52 percent of the U.S. insurance industry's reinsurance needs, many insurance companies sell reinsurance as an adjunct to their direct insurance activities through reinsurance departments. Approximately ten percent of the domestic reinsurance market is represented by reinsurance departments of U.S. direct insurers. The balance of the U.S. market reinsurance needs are provided by alien companies. It is of interest to note that after having remained stable at around 30 percent for ten or more years, the foreign share of the U.S. reinsurance market has substantially increased in recent years. Reinsurance may be provided by companies either directly or through reinsurance brokers. A small number of larger reinsurers, called direct reinsurers, deal directly with their customers, insurance companies. Those companies provide direct customer assistance on underwriting, claims handling, and management service as well as reinsurance. U.S. direct writing companies write approximately 40 percent of the U.S. reinsurance premium. Other reinsurers deal through reinsurance brokers, known as intermediaries, who place the reinsurance coverage of insurance companies with reinsurers, which are often referred to as "broker reinsurers". Reinsurance brokers may also provide consultative services to insurers as is often done by the direct writing companies. In the broker market, it is customary for the larger broker reinsurance companies to compete for a reinsurance contract and for the smaller broker companies to assume various shares of the contract. Since direct writing reinsurers are usually larger, they often keep large reinsurance contracts for their own accounts. An insurance company will usually have in force simultaneously several reinsurance contracts . Some contracts may cover specific lines of insurance coverage at various limits of coverage. Others, through facultative reinsurance, may cover specific insurance policies. Since the primary purpose of reinsurance is to spread risk exposure to levels commensurate with the financial ability of insurers to pay losses, reinsurance relationships vary from insurer to insurer. Reinsurers themselves purchase reinsurance called retrocession. As with reinsurance purchased by a direct insurer, the amount of retrocession purchased by a reinsurer depends on its capital base and the extent of the risk reinsured.

Reinsurance vs. Insurance

The traditional role of reinsurance has been to serve as the insurance industry "shock absorber". It exists to level individual companies' distortions in year to year operations that result from those relatively few losses larger than they can readily sustain financially. 226

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The premium distribution between insurance and reinsurance has remained fairly stable over the past decade, hovering around ten to one. Of course, the relative premium share between insurance and reinsurance varies by line, with considerably greater reinsurance used in commercial exposure. While it would be helpful to know the size of the capital surplus which supports the net reinsurance premium written in the U.S., this figure is, unfortunately, not available. This results for two major reasons. First, partly because some alien markets do not release surplus information, and partly as a result of major differences in accounting conventions, the surplus supporting the 38 percent of the U.S. net reinsurance premium written by alien companies is unknown. Second, primary insurers assuming reinsurance through reinsurance departments are not required to segregate surplus, and their numbers are not available.

The Pricing of Reinsurance

Many students of insurance economics assume that insurance and reinsurance react similarly to the economic environment in which they operate. Actually, there are important distinctive characteristics which, over the long term, must accommodate reinsurance economic realities. Much of the difference between insurance and reinsurance can be ascribed to factors which must be considered in conjunction with rating and pricing the reinsurance product, particularly with respect to excess of loss reinsurance. The pricing of reinsurance for life companies is quite a bit clearer than for casualty insurers. Life insurance reinsurance only insures the difference between net amount at risk and the net retention of the insurer. The net amount at risk is essentially the policy face amount less its terminal reserve. As the terminal reserve increases throughout the life of the policy, the amount of the policy reinsured continually decreases. Casualty reinsurance pricing is quite similar to the pricing of primary insurance. Its elements must contain sufficient amounts to cover losses, expenses and profits. The most difficult of these elements to develop is "losses". To the extent credible and relevant data is available, ordinary actuarial rate making techniques can be used. The data must, of course, be adjusted to reflect changes which have taken place since the data was developed and the anticipated changes which will occur over time until the last claim on a contract is ultimately paid -- and for reinsurers, this could well be decades in the future. Although this may sound simple, in practice the pricing of excess of loss reinsurance presents extraordinary problems. These stem from three basic facts: 1. Relevant and credible loss data is often unavailable. 2. Reinsurance losses take so long to develop that great reliance must be placed on incurred, but not reported, losses and their evaluations are extremely sensitive to changes in the environment in which the actual claims will be adjudicated. 3. Finally, the impact of inflation on future loss payment -- whether due to changes in the liability system, more generous jury awards, price level changes or whatever -- is more severely felt by reinsurers than insurers. First, lets discuss relevant and credible loss data. Insurance and reinsurance loss costs are functions of a combination of frequency, how many claims per unit; severity, the average cost of each claim; and the total number of units to be insured. Generally speaking, the higher the number of similar units insured, the more reliable the data. Automobile property damage liability is a case in point. There are many automobiles to be insured, and the frequency of claims is relatively stable from year to year. Reinsurance, on the other hand, is characterized by a relatively low and unstable frequency and a very high, but also unstable, severity. Thus, the law of large numbers upon which insurance pricing depends 227

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does not often apply to reinsurance. The reinsurance underwriter is much more dependent on judgement factors, based on experience, to develop an adequate price. The second basic fact about pricing reinsurance is loss development. Because the traditional general liability insurance contract provides for coverage of any loss occurring during the policy, irrespective of when the loss is reported, it leaves the insurer exposed to claims which may be filed many years after the policy has expired. Certain exposures are particularly susceptible to this latency factor, referred to as the "long tail". Although this delay in reporting creates serious problems for all insurers, there are marked differences in loss development patterns between reinsurers and primary insurers. The major reason for these differences lies in the retention feature of excess of loss reinsurance. Since many claims are not valued at ultimate cost initially and the initial reserve is within the primary insurer's retention, the primary insurer may not report such claims to its reinsurer until considerable time has passed. The relative development can be much larger for the reinsurer than the primary insurer since the primary insurer's net loss on any particular claim is limited for annual statement purposes to its retention. In addition, the primary company's claims department has more direct control over the administration and adjudication of each claim. The following information illustrates this point. A recent insurer / reinsurer analysis in the workers compensation are discovered that a particular primary insurer was aware of 67 percent of the losses it would incur at the end of the first year of the insurance policy. The reinsurer, however, only knew of nine percent of its losses by that time. After the fourth year, the primary company knew of all but five percent of the losses it will incur while the reinsurer still did not know 68 percent of its liability. This delay creates major problems for reinsurers in the anticipation of losses and the consequent rating of future business on the basis of accurate loss information. For the past several years, the RAA conducted studies on reinsurance loss development trends. In recent years, loss development factors have become larger. With few exceptions, each year's additional information has proved previous loss development patterns to have been optimistic. Assuming no change in the future loss development pattern, only a bare majority of losses on reinsurance contracts covering general liability exposures issued will be known to the reinsurers. Keep in mind that these losses will be adjudicated in the social, judicial and economic environments which will then prevail, but the premiums to pay those losses must, nevertheless, be collected.

IBNR Reserves
Of course, all insurance companies, insurers and reinsurers must set aside loss reserves for claims which have not as yet, but are anticipated to be, reported. These incurred, but not yet reported (IBNR), reserves are drawn down as losses develop. Companies use a variety of methods to establish IBNR and continuously review these reserves in light of current and anticipated changes. However, since these reserves represent loss payments to be made in the future, they are extremely sensitive to changes in social, economic or legal environments. In effect, they are a " best guess" expectation of future anticipated loss payments. When IBNR reserves represent a small fraction of loss reserves, they may not have a significant influence on total losses reported on past policies, the single most important element used in rating current exposures. However, for reinsurers, particularly in general liability and workers' compensation lines, IBNR reserves are the major data available to rate current exposure. The lack of reliability of this large IBNR reserve creates a major difficulty in rating exposure as environmental liability, some professional liability and others. For reinsurers, this is aggravated by the 228

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fact that reinsurance losses are so much slower to develop and, to the extent they are limited through retention, reinsurance losses are capped at amounts considerably in excess of primary company retentions. Back in the early 1960s, for instance, it was common for a reinsured company to offer $5 million or $10 million coverage limits to a commercial policy holder, but retain only $50,000 or $100,000. All losses in excess of those retentions were then intended to be absorbed by reinsurers and retrocessionaries. However, since it was expected that the retention would suffice to cover the majority of losses, the reinsurance premium paid was relatively small. What has, in fact, happened is that those contract retention limits today are being reached and pierced with unexpected frequency in just about all lines of business as a direct consequence of the unexpected changes in the civil justice system and inflation.

Tort Awards & Reinsurance

The Rand Corporation's Institute of Civil Justice's report, "Trends in Tort Litigation: The Story Behind the Statistics", confirms what reinsurers had suspected all along -- changes in jury award patterns have been concentrated in the excess limit coverage layers, those which so often reach into the reinsurance protection. This should come as no surprise since there appears to exist a general consensus that average awards in tort cases have increased significantly over the past few years. The dispute between consumer and insurance industry advocates is whether the proper measurement of jury liability should be "average" or "mean cost. If we assume that mean costs have remained relatively stable, as claimed by consumer spokesmen, but average costs have increased, it is obvious the coverage layers most affected by changing award patterns are the excess of loss layers -- those which directly impact on reinsurance.

Inflation & Reinsurance

The disproportionate effect of inflation on loss costs of reinsurance is made readily illustrated on the previous page. As mentioned above, the reason for this skewed distribution between insurers and reinsurers inflation effect is the fixed retention limit which protects the ceding company's exposures on those contracts customarily used for casualty lines. That is, excess of loss contracts.

REINSURANCE REGULATION
In a recent Subcommittee report to Congress, the following was said about the regulation of reinsurance, "Basically, reinsurers are not regulated directly because the focus of regulation is on the primary insurance company that writes a policy for a customer." This statement is incorrect with respect to the 62 percent of the reinsurance premium assumed by U.S. reinsurers. Contrary to common belief, U.S. reinsurance companies are regulated. In fact, their regulation is similar to that of primary insurers. The driving force behind regulation of U.S. reinsurers is to safeguard reinsurance insolvency. Reinsurance purchased at the lowest price means nothing if the reinsurance company is no longer in business when the claim payment for indemnification comes due. Therefore, the primary focus of state insurance regulators, with respect to reinsurers, is to ensure that reinsurance companies are able to pay claims. U.S. reinsurers' filing requirements are similar to primary companies', including the same voluminous annual Convention Statement and quarterly financial statements. Reinsurers are likewise subject to similar state and zone examinations. This, however, only applies to companies which are domiciled or 229

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As previously mentioned, a substantial share of U.S. reinsurance is written by unauthorized alien companies which are out of the reach of U.S. regulators. A simplistic approach to overcoming the jurisdictional limitation of state regulators would be to limit the U.S. reinsurance market to U.S. domestic or licensed companies. Traditionally, however, the international reinsurance markets have been the main source of retrocession insurance. The influence of the London markets, in particular Lloyds of London, has been substantial. Unfortunately, recent shakeouts at Lloyds and other London suppliers have dramatically drained the coffers. As a matter of fact, the entire international reinsurance markets are not providing sufficient capacity to supply U.S. reinsurance buyers.

NAIC & Reinsurance

Regulation of reinsurance cannot be so restrictive as to preclude adequate capacity. Alternative, but indirect, regulatory controls over nonadmitted companies have been developed by the National Association of Insurance Commissioners (NAIC) through a Model Act on Credit for Reinsurance. This Model limits the extent to which an insurer may consider reinsurance recoverables from unauthorized insurers to the amount of posted collateral, such as letters of credit, trust funds or funds withheld. Many states have adopted this Model or a version of it. The NAIC has, over the past several years, substantially increased the information required to be reported both by insurers and reinsurers on reinsurance related matters. Beginning with 1987, for instance, all U.S. insurers assuming reinsurance became obligated to report in their Convention Statements the development of reinsurance losses, separately from insurance losses. Prior thereto, companies which wrote both direct and reinsurance premiums could commingle their loss data for financial statement purposes. Accordingly, it was impossible, other than through a case by case examination of a company's files, to determine the extent to which an insurer had recognized the high volatility of reinsurance in loss reserving. Some believe that such a procedure would have provided an early warning to California regulators of the Mission problems. Following this, the NAIC adopted a further major change in its Convention Statement related to reinsurance. Beginning with year end 1989, all companies, insurers and reinsurers, were required to note reinsurance recoverables which are overdue as well as the identity of the responsible reinsurer. When these recoverables are more than 90 days past due, a surplus provision for past due reinsurance must be established segregated from the company's surplus and reported as such. The NAIC has often been criticized for adopting model acts which are viewed with indifference by state legislators. However, the recent changes to reinsurance accounting procedures became effective nationwide because they affect the Convention Statement which has been adopted for use by all states for all U.S. insurers and reinsurers. These modifications will result in more and improved reinsurance data. They were fully supported by the Reinsurance Association of America (RAA) member companies which have concluded that the small additional expenses resulting from compliance will, over time, be well worth the cost, if such changes lead to a more secure and reliable reinsurance environment. It is only recently that the NAIC recognized that reinsurance is different and considerably more volatile than insurance. The steps outlined above are a good beginning, but some feel more needs to be done. For instance, the NAIC long ago developed a series of solvency warning signals, the Insurance Regulatory Information System (IRIS), to assist in the early detection of a company's financial weaknesses. Today, the prevailing permissible leverage ratios under the IRIS program are identical for both insurers and reinsurers. This makes no sense, say the critics, in light of the greater volatility of reinsurance. A study of the NAIC IRIS program, which the RAA conducted, found that many critical ratio results for reinsurers were distinctly different from those for the total industry. In addition, the results of reinsurers 230

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over time differed from those of the total industry. For example, the premium to surplus ratio for all companies was 152.0. For the 139 reinsurers in A.M. Best's data base, the ratio was 112.8. The respective medial values were 117.0 and 88.7.

U.S. vs. International Regulation

While a number of world reinsurance centers apply extensive regulatory controls over their domestic companies, nowhere in the world is reinsurance regulation similar to the U.S. The discounting of loss reserves, a practice generally prohibited in the U.S. under statutory accounting, is widely practiced in other parts of the world. On the other hand, many countries require the establishment of various additional reserve funds, such as catastrophe or tax equalization reserves, prohibited in the U.S. It is sobering to note that probably ten percent or more of the U.S. reinsurance premium is written by alien companies located in countries which are generally "havens" with lax regulation coupled with little or no taxes levied on domestic insurers. Some industry experts feel this will change as higher financial and accounting standards are placed on U.S. Insurers. The National Association of Insurance Commissioners, Congress and the Reinsurance Association of America are examining solvency regulation imposed on alien reinsurers and the U.S. companies ceding business to them. Once determinations and agreement can be hammered out, "Made in the U.S.A." will take on new significance in buying reinsurance.

Letters of Credit
The reliance placed by U.S. regulators on letters of credit (LOC) is an adjunct to regulation. The major criticism is the dependency of the amount of the LOC on the adequacy of the insured's loss reserves. It takes decades for losses to emerge. So, IBNR reserves set today must attempt to identify the economic, judicial and legislative environments which will prevail at the time cases are actually disposed. No matter how refined a company's actuarial techniques are, this is, in some instances, a task beyond any reasonable controls. A specific example will illustrate the problem. For years preceding the enactment of the Federal Superfund legislation, insurers had provided various liability coverages to hazardous waste handlers and disposers. Reinsurers, in turn, had provided substantial support to those policies, some of which provided coverage for "sudden and accidental" environmental accidents. IBNR reserves held by these insurers and reinsurers for environmental incidents were negligible. The Superfund law retroactively materially increased the liability of these handlers and disposers. Still, insurers and reinsurers did not increase their IBNR reserves in light of what they perceived to be a very limited extent of coverage for environmental losses, which, as noted, limited the policy protection to occurrence arising from sudden and accidental events. It was not until thereafter, following judicial interpretation of the policy language in ways never anticipated by insurers, that the significance of the Superfund law to insurers became apparent. Even today, as state and federal courts dissent among themselves on the application to Superfund cleanup requirements of those insurance policies which were issued decades ago, insurers are uncertain as to the amount of reserves which should be established. If we were talking in terms of a few million dollars, the impact on the financial condition of insurers and reinsurers would not be significant. But, hundreds of billions of dollars are involved, amounts many times in excess of the combined insurance industry's capital and surplus. To the extent these potential losses are covered by alien reinsurers, LOCs should be available to guarantee the reinsurance recoverables. However, the extent to which these losses have been adequately reflected in the industry's financial reports is questionable and, consequently, the available LOCs supporting the alien reinsurance recoverables are probably inadequate. LOCs are NOT a substitute for sound regulation. When issued as security on behalf of well managed, 231

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sound alien reinsurers, they are probably not even needed. However, they do represent a minimum security of a guarantee against possible nonpayment due to insolvencies of companies which are not so well regulated or managed.

Alien Reinsurer Regulation

The availability of unregulated offshore reinsurance provided an opportunity for the implementation of questionable reinsurance schemes which ultimately led to many recent insolvencies. The U.S. is one of very few countries in which alien insurers may operate either through wholly owned subsidiaries or through branches or, in fact, both. Those subsidiaries and branches are regulated as other U.S. insurers. They must file financial reports and are similarly examined. These foreign subsidiaries and branches provide substantial reinsurance capacity which is supported by trusteed surplus funds located in the U.S. Furthermore, the NAIC Model Act on Credit for Reinsurance was recently amended to allow credit for reinsurance placed with accredited reinsurers. An insurer may qualify for accreditation by establishing a minimum trusteed surplus in the U.S., by filing annual statements substantially similar to the Convention Statement, and by agreeing to be examined by a U.S. insurance regulator. Several state legislatures are considering adopting these amendments. The NAIC has also recognized the need for higher capital and surplus to support reinsurance underwriting. Although some have questioned whether the new minimum surplus requirements provided in recently adopted Model legislation are adequate, the introduction of the concept is encouraging in itself. The report notes the international nature of insurance and particularly reinsurance. The world distribution of the U.S. reinsurance premium underlines the easy access by alien reinsurers to the U.S. market. The reliability of this alien reinsurance support is very uneven. While it clearly would make sense to encourage the channeling of U.S. reinsurance premiums to the more secure markets, U.S. tax policy tends to defeat this objective. Much of the recent expansion of the foreign penetration of the U.S. reinsurance market has come from countries which combine a relaxed regulatory climate with low or zero taxes on insurance activities. The only tax on U.S. reinsurance premiums ceded to companies domiciled in those countries is the U.S. excise tax, a one percent gross premium tax. U.S. reinsurers, on the other hand, pay income tax equivalent to 7.5 percent of premium. The resulting difference has placed U.S. reinsurers at a major competitive disadvantage which is very real indeed. In a recent press interview, when asked why Bermuda is such an important reinsurance center and whether it could maintain its preeminent position, one of the island's leading reinsurance brokers answered, "because freedom from corporation tax allows reinsurers to offer highly competitive prices". Regulation cannot substitute for good management practices. The placement of reinsurance is a major responsibility of insurance management. It is a responsibility which cannot be substituted by regulation. There are many public and private resources available to check into the security and management of alien reinsurance companies. It is ironic that, while there has been considerable improvement in the quality and quantity of information submitted through efforts like the Convention Statement, there have been very few instances of sanctions levied against executives filing, on behalf of their companies, inaccurate financial statements. A basic weakness of statutory accounting and reporting is the absence of individual and corporate liability for false, inaccurate and negligent compliance with insurance regulations. The difficulties in regulating an international commodity such as insurance and reinsurance are, in part, due to the limited geographic reach of regulators, as noted in the report. However, the major difference is accounting conventions, country to country, are themselves major obstacles which would not disappear under a federal regulatory system. To establish minimum solvency standards for all companies doing business in the U.S. becomes a formidable task when these differences are taken into consideration. 232

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As an example, the required valuation of assets by many Continental reinsurers results in a reported capitalization which would be grossly inadequate to sustain their net written premium, based on U.S. standards. Yet, many of these companies are solid, conservative entities. Currency fluctuation is another element which any international regulatory system must consider. It is suggested that any consideration of the desirability of bilateral agreements to limit access to the U.S. market to companies based in countries where solvency is well regulated, as suggested by the report, be preceded by some attempt at developing a uniform insurance solvency accounting system among world insurance centers. This may yet prove to be an impossible task.

Other Reinsurance Issues & Suggestions

The investigation performed to date leaves little doubt that mismanagement or fraud, even when limited, can lead not only to massive financial losses, but also to a loss of confidence in the integrity of insurance and its regulatory structure. To prevent future similar occurrences without unduly stifling the insurance and reinsurance competitive environment is a challenge which, if successfully attained, will be of great public benefit. Clearly some compromise will need to be achieved between the need for regulation of a broader segment of the business serving the U.S. reinsurance needs and capacity. In addition, all states today demand reinsurance contracts to include certain required clauses which are of overriding public policy. For instance, all contracts must contain an insolvency clause which requires the reinsurer to pay all reinsurance proceeds to the liquidator, in the case of insolvency of the insurer, without diminution resulting from the insolvency. While there is relatively little hands on direct regulation of reinsurance contracts and prices, any restriction of reinsurance contracts and rates has an effect on reinsurance. If, for instance, the rate allowed on primary business develops an inadequate premium, the premium paid the reinsurer will reflect some inadequacy. Taken together, the direct and indirect regulation of U.S. reinsurers and reinsurance contracts is significant, but it is different from that imposed on the primary industry. Simply put, the major thrust of reinsurance regulation should be to influence primary insurers to do business with reinsurers which are well-funded, or which have posted sufficient collateral to ensure payment of claims when due.

INSURANCE COMPANY BUSINESS

Although procedures and techniques change over time, the underlying goal of any insurance company is solvency and growth. Staying focused on this goal is often complicated by the ebb and flow of intense issues like premium rate wars, politically inspired regulatory compliance and even government mandates. Still, insurers must carry on with the business of insurance -- collecting premiums, paying claims and investing capital. Beyond pure financial planning, the business of insurance must contend with the nature of the business itself. Property-casualty insurance, for instance, is a highly cyclical business that does not necessarily coincide with the general economy. The reasons involve factors of competition, fluctuating investment performance, regulatory delays, rate restrictions and, of course, unexpected catastrophes courtesy of mother nature. Life insurance companies too, are experiencing wider swings in business than in years past due to pressures of competition (insurance and non-insurance based), investment troubles and regulatory restrictions. The most significant shift in the way insurers do business, however, involves regulatory and rating agency concentration on operational performance and reinsurance. In essence, how companies make money and how much money they owe is becoming more meaningful indicator of solvency over the singular magnitude of what they own.

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HOW INSURANCE COMPANIES MAKE MONEY

Overview
When laymen think of an insurance company, it is easy to conjure a world of actuarial precision--the uncanny ability to project the future through sophisticated formulas and mathematical prophecy. Few purchasers of insurance, for instance, are knowledgeable on the subjects of mortality tables, experience ratings, the law of large numbers and probability analysis. Given the vast resources and long histories of insurance companies, it is no wonder the average insurance consumer believes that ALL insurers represent "mega-business" conglomerates with unlimited profit potential. Students of how insurance company's make money, however, are more likely to see the industry from a much different perspective -- where uncertainty runs high and where profitability can be wiped out in a blink of an eye. They consider mortality to be an evolving concept and experience rating levels something to be shattered by new, more spectacular catastrophes that bend our imagination beyond all belief. For example, the increased mortality of the flu epidemic of 1918 caused insurance companies of that era to lose an equivalent of one year's annual profit and render some company's temporarily insolvent. One can only imagine how modern day diseases such as AID's will affect the "bottom line" as the fatalities compound and companies are required to take "all comers" regardless of pre-existing conditions. In another instance, property and casualty claims filed from Hurricane Andrew amounted to almost 20 times the annual premium collected by all insurers in the State of Florida combined. This is also equivalent to the amount of premium collected by all property/casualty insurers nationwide for one full year! Other examples include the Midwest Floods, the California earthquakes. Add to this the day to day struggle insurers confront concerning fraud, groundless lawsuits, growing compliance laws and the ups and downs of stock and bond portfolios and it is easy to see that the business of making money is a constant challenge for insurers large and small.

Basic Money Making

For all forms of insurance, the primary source of income is the still the premium. Since most accounting considers insurance contracts to be annual in nature, a company tracks its written premium (an annual figure) versus its earned premium (1/12th the total written premium if collected monthly, if semi-annual, etc). Losses for insurance companies include incurred losses as well as loss adjustments and there are operating expenses (commissions, overhead, taxes, etc). What remains, if anything, is the underwriting gain. Determining profit at any one point in time is difficult because each insurer has thousands of policies with varying maturities. So, companies use estimated "ratios" to measure ongoing performance. There are loss ratios -- the ratio of actual losses and loss adjustments compared to earned premiums--and there are expense ratios -- the ratio of expenses to written premium. In addition to their "book of business", insurance companies make money from investment profits . In the past, an acceptable investment strategy for insurance companies involved moderate mixing of well diversified risks like real estate and some higher risk bonds. Because premium income was predictable, longer maturity investments, with corresponding higher yields, were common in most portfolios. In recent years, however, the need to improve profitability caused insurers to seek the same high yields in shorter term or more liquid investments (junk bonds). Ultimately, these holdings became the subject of regulatory action and in some cases policyowner panic. Needless to say, insurers will have a tough time producing high investment yields in the years ahead. Another consideration affecting profitability is competition. Sometimes, insurers sacrifice their own profits to build business. Since 1985, for example, major price wars between insurers were launched in an attempt to build volume. At times, insurance was so cheap that premiums did not cover claim payments. But for years, such losses hardly mattered because the growing volume of premium dollars coming in to the company were plowed into investments that brought bigger dividends and interest payments. Also, 234

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the losses from operations turned out to be great tax shelters to offset high yielding investments. This is because insurers were able to take a percentage of their losses as a tax credit. Companies at the time were racking up millions in tax credits or so-called "paper profits". In fact, a recent survey among insurance companies found that about 40 percent of all property and casualty companies attributed 68 percent of their operating income to tax credits.

Measuring Profitability
It is apparent, that there are several source of income for insurance companies. And, insurer profitability can be measured through a variety of financial tests. A few used by A.M. Best are as follows: CASUALTY COMPANIES Combined Ratio After Policyholder Dividends : The sum of the loss ratio, expense ratio and dividend ratio. This ratio measure's a companies underwriting profitability. This ratio does not reflect investment income or income taxes. For companies underwriting predominantly property risks, the normal range for this test is from 95 to 105. For companies underwriting predominantly long-tailed liability risks, the normal range is from 100 to 110. A higher than 105 for property insurers and 110 for liability insurers is considered above the accepted norm for this test. Loss Ratio : The ratio of incurred losses and loss adjustment expense to net premiums earned expressed as a percent. Expenses Ratio : The ratio of underwriting expenses (including commissions) to net premiums written expressed as a percent Operating Ratio (IRIS) : The combined ratio less the Net Investment Income Ratio. The Net Investment Income Ratio is the ratio of net investment income to net premiums earned, expressed as a percent. This ratio measures a company's operational profitability. The operating ratio does not reflect realized and unrealized capital gains or income taxes. The normal range for this test for all types of insurers is currently from 85 to 95. Above 95 is considered normal. This is also one of the IRIS tests (Insurance Regulatory Information System), developed by the National Association of Insurance Commissioners in 1974. NOI to NPE Before Taxes : The percent of net operating income to net premiums earned before taxes. The normal range is from 3 percent to 6 percent. A ratio below 3 percent is considered poor profitability. Yield on Invested Assets (IRIS) : Net investment income as a percent of cash and invested assets plus investment income minus borrowed money. This ratio does not reflect realized and unrealized gains or income taxes. The normal range for this test is 6 percent to 8 percent. A poor rating is under 6 percent. This is another IRIS test adopted by the National Association of Insurance Commissioners. Change in PHS (IRIS) : The change in policyholders surplus from the prior year. Lower than 5 percent is considered poor. The normal rage is from 5 percent to 10 percent. Return on PHS : The ratio of all operating income, after taxes and realized gains and unrealized investment gains, to the prior year policyholders surplus. Under 5 percent is considered unacceptable. Normal ranges run from 5 percent to 15 percent. LIFE COMPANIES Benefits Paid to NPW : This ratio takes total benefits paid as a percentage of net premiums written. A range of 45 percent to 70 percent is average. Commissions & Expenses to NPW : Here, commissions and expenses are compared to net premiums written. The average is from 30 percent to 55 percent. 235

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Net Operating Gain to Total Assets : This ratio is the net operating gain (after taxes) as a percentage of the prior year admitted assets. A range from 0.5 percent to 1.5 percent is normal. Return on Equity : This is net operating gain (after taxes) as a percentage of prior year capital and surplus. Companies should average from 8 percent to 14 percent. Net Operating Gain to Net Premiums Written : This test measures earnings (net operating gain after taxes) in relation to a company's current net premiums written. A range of from 3 percent to 7 percent is considered normal. Change in Capital & Surplus : A change in capital and surplus is important to track from year to year. A change lower than 5 percent is below average. Most companies average 5 percent to 15 percent. PROPERTY / CASUALTY PROFITS In the early days, property-casualty companies wrote only property insurance, beginning with marine type insurance and later expanding into fire insurance. Liability insurance was not written until the last half of the 1800's. Today, liability insurance constitutes an increasing proportion of the industry's premium. The shift from property to liability is significant because liability insurance requires higher loss and unearned premium reserves. More reserves, in turn, means more funds to invest and reserves are the industry's largest sources of investment capital. In taking this one step further, the profit and capital gains from investments is an important component of insurer profitability. Another major source of investment earnings comes from policyholder surplus. Surplus is the second largest source of investment capital. Surplus is also critical in determining an insurer's capacity to write insurance and collect premiums. Many states, for instance, require property-casualty carriers to have $1 of surplus for every $2 of net premium written. The National Association of Insurance Commissioners allows $3 premium for every $1 of surplus. It stands to reason then, that having a large surplus permits a higher volume of business to be written, which can mean more profits as well as greater potential earnings from investments. LIFE COMPANY PROFITS Until the 1970's, low inflation and level interest rates helped to stabilize cycles in the life insurance industry. The primary product was whole life insurance. Premiums were predictable and, yielding a steady cash flow. Insurers needed only to invest to keep ahead of the relatively low 3 percent to 5 percent being paid credited to cash values. Higher interest rates, rampant inflation and a more competitive playing field changed all that. Beginning in the late 1970's, new insurance products had to be developed and insurance company managers had to find higher yielding investments. With money market accounts yielding more than 10 percent, it was easy to see why many policyowners "cashed-in" their policies to invest elsewhere. Deregulation in other financial areas, namely banking, caused serious problems for life companies since they could market variable interest accounts that automatically increased when t-bills or other indicators rose. The life industry did not acquire this privilege of "interest sensitive" accounts until 1980 when the National Association of Insurance Commissioners created the Model Standard Valuation and Nonforfeiture Law. This opened the door for universal-type policies which skyrocketed to popularity in the early to mid 1980's -- universal's share of total industry premium during this period went from a low 2 percent to almost 40 percent. Then came variable life, universal-variable life, single premium whole life, a resurgence in annuities and guaranteed investment contracts. (GIC's). All of these policy derivatives changed how life companies made money. For one thing, policyowners have become quite a bit more transient than when whole life was the dominant choice. If another, more competitive rate appears, they may surrender and move. So, company managers have lost the predictability of their premium income. Therefore, they are not able to commit to long term investments as they did in the past. In addition, they now assume greater interest rate risks. A swing in interest rates, for example, may require a life company to sell a portion of their bond portfolio at a bad time. In both instances, investment yields can be significantly lower.

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WHAT INSURANCE COMPANIES OWN AND INVEST IN

Assets
A major restructuring of insurance companies during the late 1980's and 1990's has put an entirely new face on insurer balance sheets. Equally significant is the trends sought by regulators and industry groups concerning how insurer assets are valued and the type and ratio of investments allowed. The story begins with assets. Insurers have admitted assets (investments, real estate owned and data processing equipment) and nonadmitted assets (unsecured loans, prepaid expenses, agent advances, furniture, supplies, office equipment, etc). A solvency analysis of a company would focus on admitted assets which are more easily converted to cash. Nonadmitted assets might take considerably longer to liquidate or they may be entirely unmarketable. An investment analysis would delve into the company's risk/return profile including the desired bond duration, the mix between stocks and bonds, the mix between taxable and tax-exempt bonds, international diversification and real estate (loans and real estate owned). The combination of solvency and investment analysis is the most difficult task now before asset/liability managers. In essence, they walk the fine line between satisfying regulatory requirements and meeting stockholder expectations. The most common tests involving insurer ownership and liquidity include the following A.M. Best formulas and ratios: Quick Liquidity : Quick assets (cash, short term investments, short term bonds, government bonds of five years or less, and 80 percent of common stocks) divided by net liabilities (total liabilities less conditional reserves plus real estate encumbrances less any negative liabilities) PLUS ceded reinsurance balances owed. This ratio measures the proportion of net liabilities covered by cash and investments which can be quickly converted to cash. A normal range for casualty companies is considered to be from 30 percent to 50 percent. Life companies operate at 75 percent to 90 percent levels. Current Liquidity (IRIS) : Cash plus invested assets and encumbrances on other properties compared to net liabilities plus ceded reinsurance owed. This ratio measures the proportion of liabilities covered by cash and investments. A number less than 100 percent means that a company's solvency is dependent on the collectibility or premiums and sale of investments. A ratio lower than 120 percent is considered poor for property insurers. Liability companies, however, can operate at levels between 100 and 120 with normal results. Life companies test in the 95 percent to 110 percent range. Operating Cash Flow : The ratio of funds generated from an insurer's operations, excluding dividends, capital injection, unrealized stock gains/losses and non-insurance gains/losses. This test would measure a company's ability to meet its obligations internally. Any negative balances would be considered poor.

Investments
As a general rule, insurance companies invest only after they have met their surplus and reserve requirements (discussed below). Investments outside reserve and surplus funds lean toward interest bearing or income producing investments that are non-speculative in nature. While most states do not specify where excess funds must be invested the undertone is conservative. The State of New York, for instance, provides a listing, they call Section 1405, of appropriate choices. They include: Government obligations issued by the United States, the District of Columbia, any territory of the United States; obligations and preferred shares of U.S. institutions (corporation, association, trust company, partnership, joint venture); obligations secured by liens on real property located within the United States; investments in real property located in the United States; and personal property located or used in the United States which is held directly or evidenced by partnership interest, stock, trust, etc.; common shares of United States institutions and certain Canadian and other foreign investments. New York also allows some leeway in this scenario, sometimes referred to as the basket provision whereby an insurance company 237

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may invest a certain percentage (no more than 3 percent of admitted assets) in investments that do not quite fit Section 1405 classification. In addition to this, many states have special provisions relating to the amount of investment an insurer may make in a subsidiary or other insurance company. New York Insurance Code 1701 directly prohibits a life insurance company from organizing or acquiring a bank, trust company, savings and loan, credit union, sales finance company or any other company engaged in the business of financing or accepting deposits that may be insurable by any federal or state insuring agency. Further, New York insurers may not invest in any subsidiary where its total aggregate investment would exceed 10 percent of admitted assets. Investments in other insurance companies or insurance subsidiaries are exempt from this limitation. Beyond this, some states restrict insurance company investment by the type of investment. Examples include preferred and common stock, where investments in a single company must not exceed 4 percent of admitted assets. And, not more than a total of 20 percent of all admitted assets can be invested in common stocks (New York).

Surplus
Before insurers can write business or make investments, they must meet minimum capital and surplus. Far and away, the most important measure of an insurer's capacity to function is surplus. Policyholders' surplus is the difference between an insurer's total admitted assets and liabilities -- i.e., net worth. It is also the principal measure of an insurer's financial cushion for policyholders when insurance company results turn sour. Increases in policyholder surplus reflect an insurer's ability to provide security. Each state is different as to the levels of surplus required. Surplus requirements also vary depending on the line or lines of business an insurer is authorized to write. Even once established, regulators strictly control the type of cash or cash equivalents that make up surplus. Typically, these investments are limited to investments in cash, U.S. Government securities, or securities (bonds) of the state in which the insurer is domiciled. In New York State, insurance companies must keep not less than 60 percent of the amount required as capital and surplus in cash or cash equivalents similar to those described above. Once capital and surplus requirements are met, an insurer is permitted to invest its funds in a broader range of securities and investment products. These options range from corporate bonds and preferred and common stocks to real estate and mortgage loans, as well as to the more speculative investments like junk bonds, financial futures and put and call options. Overall, the trend in policyholders surplus is still increasing, but at a very slow pace. For the most part, this decline was due to unprecedented losses suffered by casualty companies (Hurricane Andrew, etc). So great were these catastrophes that in the same year, the industry suffered its first operating losses in over seven years. The fact that surplus increased is directly attributed to the actions that management has vigorously pursued during 1990s. To offset losses, insurers have sought capital contributions from their parent companies, sold real estate holdings and liquidated a large part of their bond portfolios, which prospered well in the late 1980's and early 1990's. The gains on these sales have, for now, "shored-up" company surplus. Of course, this is nothing new. Insurer's have often fallen back on their investments to recover from major underwriting losses. In past situations, however, inflation kept real estate prices and bond yields high. This time around, as the industry recovers from its losses , subsequent profits will be reinvested at lower rates. Further, it may take many years for the real estate market to recover before insurers will again consider it an option. So, there will be fewer investment gains in the years ahead to offset future surplus problems. In essence companies will have to contend with weakened balance sheets.

Reserves
Reserves come in several different flavors. Property and casualty companies maintain unearned premium reserves, loss reserves and voluntary reserves . Life companies maintain policy reserves . The basic premise of a reserve is to "stock-up" capital to cover anticipated losses. Property and casualty companies need unearned premium reserves to provide for the return of premium or pro-rata share 238

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thereof when a policyholder cancels. Reserving for unearned premiums is particularly hard on insurers because they are usually required to show the full amount of the liability and the amount allowed for expenses is usually spread over the term of the policy when, in fat, it is all paid within the first year. For these reasons, unearned premium reserves are generally an overstated. Loss reserves, on the other hand, are a little more practical in application. They cover claims that have been reported, both adjusted and unadjusted, and claims that have happened but not reported. The size of the loss reserve is relative to the type of coverage and experience. Some insurers, are even required to use projections and estimates to reflect the many contingencies that can affect loss reserves. Health insurance companies, for example, estimate claims that might occur after the policy expires. Worker compensation insurers budget on-going litigation. And life insurers generally use discount factors to reflect the time value of money and changing mortality concerning policies of potentially long duration. Insurance companies are constantly modifying their loss reserves to meet minimum regulatory requirements yet not exceed IRS guidelines for maximum deductibility. A high level of reserves also depresses profit which highly concerns shareholders. Policy reserves are used primarily by life insurers to insure that policy obligations will be available when they are due. Policy reserves are measured by calculating net premiums received over the life of the policy (total premiums received less expenses) and the assumed interest that will help build cash value to pay death benefits. Mortality rates and reserve requirements change over the space of time which permit these figures to be modified. Policy reserves are usually grouped by block of business. In other words, policies issued in the same year, with similar face amounts, interest assumptions, age and risk level of insured. Uniformity makes it easier to group and calculate policy reserves. Over the years, the size of the policy reserves builds until the mortality cost for the particular block of business is covered. Then, the holding of reserves decreases until reaching zero when final claims are paid. Specific A.M. Best formulas to calculate surplus and reserves include the following: CASUALTY COMPANIES Non-Investment Grade Bonds to Policyholders' Surplus : This test is vastly more popular due to the junk bond rush of the late 1980's. This ratio measure's a company's exposure to non-investment grade bonds as percentage of policyholder's surplus. Typically, bonds rated less than BBB are consider non-investment grade. The normal range for companies is from 0 percent to 10 percent. Above 10 percent is considered risky. Loss Reserves to Policyholder Surplus : This ratio measures the potential impact that deficiencies in loss reserves have against surplus. The higher the ratio, the more reserves should be scrutinized. Casualty companies typically score from 50 percent to 150 percent. Development Reserves to Policyholder Surplus : This reflects the change in loss reserve, as a percentage of surplus, from one period to another. The normal range is from 0 percent to 25 percent. Developed Reserves to Net Premiums Earned : This test measures whether or not a company's loss reserves are keeping pace with premium growth. For the industry as a whole, the ratio is rising. LIFE COMPANIES Non-Investment Grade Bonds to Capital Surplus For purposes of this test, Class three bonds are considered below investment grade. The usual range for this category is 20 percent to 70 percent. Mortgages & Real Estate to Capital & Surplus : The usual range for this test is 150 percent to 350 percent. Delinquent & Foreclosed Mortgages to Capital & Surplus : Delinquent mortgages are those over three months past due. Normal operating ranges for this test are between 5 percent and 35 percent. Affiliated Investments To Capital & Surplus : A ratio higher than 35 percent is considered risky.

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WHO INSURANCE COMPANIES OWE

If there is anything the industry can learn from recent insurer liquidations and consolidations it is that financial statements can be misleading. As we have just discovered, a company's earnings and surplus can appear to look good even when insurance sales are poor. Capital contributions or the sale of investments can easily make the bottom line seem profitable. Now, another factor must be considered -- who insurer's owe -- leverage. In the insurance industry, leverage is typically incurred through the process of reinsurance. Insurers often find it necessary or at least advantageous to reinsure risks that they insure. For the most part, reinsurance remains as negotiated contracts between a reinsurer and the ceding company (original insurer). Reinsurance is important in that it contributes strength to an insurer by taking over part of its financial burden. This added strength, however, does not come without a price tag. The high cost of reinsurance and the safety and strength of the reinsurers themselves are now issues of concern to regulators and the industry. Reinsurance plays a particularly vital role in the support of new companies and new policies. For new insurance companies, reinsurance is necessary to "selling" financial stability. No one wants to do business with a new company with no track record. Put a large established company guaranteeing the claims against the new company, however, and customers are more easily convinced. Leverage, or reinsurance, is also needed by many established companies who have had big spurts in business. A specific problem that all insurers have is the need to bolster their surplus during high volume periods, particularly during the first policy year. Accounting valuation of the policy and high costs to issue the policy (commissions, etc) in the first policy year post a loss and a reduction in company surplus. A strain on surplus can create problems with regulators and lenders, so insurers go to great lengths to "shore up" their surplus from first year losses. In some cases this is accomplished using additional capital contributions, but more often, the company will buy surplus relief reinsurance. This has the same affect to the balance sheet as adding capital and surplus is not reduced. In the process, however, a liability to the reinsurer is created. One test to determine if the amount of leverage is within accepted norms is as follows: Ceded Reinsurance Leverage : This test measures a company's dependence on reinsurer stability. It is the ratio of reinsurance premiums ceded plus net reinsurance balances owed to policyholders surplus. The normal range for this test is from 0.5 to 1.3. Companies with higher ratios are considered to be too dependent on reinsurers.

REASONS WHY INSURANCE COMPANIES FAIL

Whenever a major financial institution is known to be underperforming or worse, "seized" by a regulator, there are accusations leveled about how and why this could happen. Investigations first seem to focus on "who" was at fault and the many sorted details on innocent customers who will be affected. Almost always, someone is next presenting a case on the "incompetence" of regulators, the greedy industry without compassion for its customers and some kind of comparison on how this same kind of problem happened somewhere else with devastating results. That is why, the current problems in the insurance industry are compared, ad nauseam, to recent calamities in the savings and loan industry. Some have gone so far as to label the insurance industry a savings and loan debacle waiting to happen. Regulators of both industries are being chastised for their lack of controls and need for faster response and early warning systems to alert the consumer.

Lack of Confidence
No one could say that these charges are entirely false. Every industry has its rogues and less than ethical players. What is often forgotten, however, is the fact that consumers create many of their own problems by choosing to ignore risks, even when they are told (or supposed to know) what could go wrong. It was fairly common knowledge, for example, that Executive Life was able to pay higher rates on annuities 240

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because they invested in higher risk investments. Basic economics tell us that the demand for a product or service is a "derived demand" -- derived, that is from the customers demand for those goods and services. Clients for Executive Life demanded higher rates. This does not excuse any alleged wrongdoing that may have been perpetrated by Executive Life, but policyholders who want higher than market returns should share in the risk of loss. Another interesting point about consumers is their sometimes unrealistic expectations. What consumers expect and anticipate may be the very thing that creates the problem. For example, when bond rating agencies dropped the portfolio ratio of Mutual Benefit Life, policyholders anticipated a faltering company. The eventual "run on the bank" actually created or accelerated the liquidation. Also, every casualty agent can attest to client demands for cheap coverage -- any coverage -- to meet some licensing or contract requirement. When something goes wrong and a non-admitted insurer is not capable of fulfilling its promises, one can only imagine how these clients will steam over the incompetence and lack of due care exercised by the agent.

Free Market Failures

Sometimes, the reason companies or insurers fail can only be explained as a consequence of free-market forces. They result in cases where large survives small, a new concept makes an old one unattractive, an unexpected event is just too large to recoup losses, lower prices prevail over benefits, higher interest rates win over lower rates or the economic climate is simply not conducive to making a profit. It is suggested that a combination of ALL these factors are responsible for reasons why some insurance companies fail in a free market.

Slim Profits
Declining profits are still another explanation for insurance failures. Premium wars and unusual natural disasters have whittled profits in property-casualty companies to levels lower than most other industries, while risk remains high. Life insurers have suffered from thinning margins of profits and greater exposure to interest rate cycles. In severe situations, either of these problems could cause a company to operate below accepted levels or force a conservatorship.

Management Mistakes
In 1990, the Government Accounting Office compared the failures in the insurance industry with 20 of the largest savings and loan institution failures. Of the eleven root causes identified for the failures, ten were the same for both the insurance companies and the thrift institutions. These included multiple regulators and infrequent examinations, rapid growth in risky business areas, poor underwriting, extensive underpricing, excessive reinsurance or loan participations, bad management, and inadequate loss reserves. Only time will tell if there were, indeed, intentional or negligent abuses in the insurance industry similar to those found in the savings and loan shake out. An ongoing investigation into insurance fraud is underway by the Justice Department and the Senate has held at least two different investigations of insurance fraud since 1990. Certainly, violations will be found, but it is not likely to be as widespread a problem as the savings and loan fiasco since insurance companies are, by design, better able to "pay" for their mistakes since they are financially diversified, more liquid and quite a bit larger (most insurance companies are national in scope). Critics will point out, however, that while these differences may be true, insurance companies DO NOT have any federal backing, such as Federal Deposit Insurance as a backup. This would suggest that a failure by an insurer could be a greater downside for policyholders -especially if the state guaranty funds backing insurers failed to function as promised. A major discussion of state guaranty funds can be found in a later chapter. The savings and loan debacle will probably outshine the "fallen angels" of the insurance industry for another reason -- people. Many prominent savings and loan executives took big falls in the thrift shakeout, including civil and criminal charges. The spotlight was intense and involved some of the nation's most prominent figures -- Charles Keating, Gerald Ford's son, etc. Similar actions are now being 241

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pursued against insurance executives without as much fanfare. As case in point is the suit by the State of New Jersey against former officers and directors of failed Mutual Benefit Life. Charges allege negligence by these individuals that permitted Mutual Benefit to pursue shaky real estate investments and leveraged buyouts. Some of the investments, as charged, involved conflicts of interest for top officers who purportedly profited from the deals. A list of the parties named is like a Who's Who in America, including a U.S. Senator, a top official of American Express, the owner of a pro football team and more. A similar drama is being played out in a suit filed by the State of California regarding Executive Life. This action (Garamendi v. Carr, etal) names Fred Carr, several corporate offices, former auditors Deloitte & Touche, ratings services A.M. Best Co., Moody's and Standard & Poors. The liquidator may also sue the insurer's managing general agents and reinsurers who were believed to have inside information on mismanagement within the company.

Junk Bond Investments

The search for higher yields seemed to dominate investment manager thinking in the 1980's. In part, it was driven by consumer demands for higher earnings. At one time, for example, single premium deferred annuities were yielding as much as 14 and 15 percent (tax deferred). Then came single premium life, structured settlement annuities and guaranteed investment contracts (GIC's). Once a company offered high rates, others followed suit in an effort to remain competitive. In order to pay these higher rates, insurers needed to invest at higher rates. At about the same time, brokers like Drexel Burnham were heavily involved in funding major corporate takeovers and mergers. Insurance companies were the perfect entity to finance these transactions through the purchase of bonds. A single transaction, such as the 1986 Maxxom takeover of Pacific Lumber Company, could involve as much as $900 million. It wasn't until Michael Milken took a fall that bond issues such as these became a sore issue in the financial dealings of insurance companies. Companies with more than 20 percent invested "junk bonds" were under heavy criticism, by agents, regulators and consumers alike. Executive Life of New York and Executive Life of California were over 60 percent invested in junk issues. And, it took even longer for regulators to take action because for years, these bonds were held on the books at their purchase cost, not market value. So, insurer's financial statements still looked reasonable. In addition, regulators were not as harsh in classifying what is a "low grade" bond as were the rating services like Moody's and Standard and Poors. In 1990, standards were laid down by the National Association of Insurance Commissioners ranking the quality of issues. A numeric classification is assigned to all bond holdings as follows: Class 1 (highest quality), Class 2 (high quality), Class 3 (medium quality), Class 4 (low quality), Class 5 (lower quality) and Class 6 (poor quality). Investment grade securities now may only qualify as Class 1 or Class 2 bonds. Classes 3 through 6 are categorized as non-investment grade or "junk" bonds. Obviously, companies that maintain a high concentration of non-investment grade bonds will be scrutinized more closely than in the past. Further, regulators and rating agencies alike are also giving attention to the types of investments made and the ability to "match" assets and liabilities (the concern is that where assets are not linked to liabilities, fluctuations in interest rates can negatively impact cashflow and surplus. With these precautions in place and with promise of stepped-up regulatory monitoring, a decline in non-investment grade securities has occurred during the early 1990's. Much of this through a "controlled liquidation" to help shore up and clean up insurer balance sheets. Industry wide holdings in 1993 were estimated at only 3.8 percent of invested assets compared to 7.2 percent in 1990.

Real Estate Investment Losses

Without a doubt, another contributor in the insurance insolvency war is real estate. Specifically, nonperforming and underperforming commercial real estate. Most insurer's hold over 90 percent of their real estate mortgages in commercial properties. It is the nature of these loans, not delinquencies that has caused problems. Delinquent real estate loans reached a peak of only 7 percent of the industry's total 1993 loan portfolio -- mostly commercial projects that started unwinding around 1990. Problems with insurer real estate and loans took root in purchases and loaning in the "oil patch" areas (before the oil 242

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industry buckled under) and the building boom of the 1980's. During this latter, banks and thrifts maintained their role as construction lenders while insurers competed more heavily in the "mini-perm" market. Mini-perms are loans of from five to seven years designed to fill the gap between construction financing and long-term financing. As longer, permanent loans became harder to get in the 1980's so grew the mini-perm market. And, as luck would have it, many of these same loans are coming due in the early 1990 recession at the same time that the demand for commercial space is down and the ability to refinance or replace these maturing loans is practically nonexistent. Specifically, this is the reason why public rating services have downgraded so many life insurers with large mortgage loan portfolios. Concurrently, commercial property owners have encountered great difficulty in generating sufficient operating revenues, on the heels of major rental rate deals and other tenant concessions, to keep mortgage loans current. Thus, a rise in loan delinquencies has also occurred, again, mostly among office and commercial real estate. To date, the effects of loan delinquencies on insurer balance sheets has been minimal since real estate owned and mortgages typically represents less than 3 percent of the industry's assets (about 19 percent for life companies). However, with the advent of new Risked Based Capital requirements, "down rating " by major services for insurers with large real estate portfolios and poor public perception about insurer real estate owned, the negative impact of delinquent real estate has intensified. The threat of "bad press" has prompted many insurers to "sell short" or restructure underperforming real estate and real estate loans -- sometimes prematurely -- to avoid rating write downs. Further, a company with slightly higher than normal mortgage delinquencies or an above average volume of real estate loans could now be subject to regulatory control or corrective action under new National Organization of Insurance Commissioners guidelines. Under these standards, regulators could force companies with a low risk capital base to raise capital and take other steps to avoid failures. In more severe cases, reserves for expected real estate losses could be mandated. Also, an insurer must calculate whether capital deficiencies under the NAIC rules, based on the mix of their real estate portfolios and real estate owned. When deficiencies are present, the insurer may be forced to consider changing its asset mix -- selling nonperforming real estate in exchange for bonds. In the late 1990s, nonperforming real estate mortgages have declined from their peak of about 8 percent in 1992 to just under 6 percent. However, this does NOT account for money raised through guaranteed investment contracts which are essentially mortgage backed bonds. These contracts continue to mature and exert added pressure for performance. Reductions of nonperforming mortgages have also been attained by restructuring or refinancing troubled loans or providing new loans for new buyers on foreclosed real estate. With a stroke of the pen, these new loans or newly structured loans are no longer nonperforming. Yet, the real estate tied to these loans is the same. Further, insurance companies may own problem real estate through partnerships. Again, this nonperformance is not reflected in Industry wide statistics. Another significant trend of the early 1990's is the "bulk-sale" of real estate owned . An appetite for non-performing real estate developed as a result of the banking industry fallout. Agencies like the Resolution Trust Corporation found plenty of buyers for foreclosed real estate and underperforming mortgage loans. At a time when the Resolution Trust was running out of investor, insurance companies were in the mood or required to let go of some large, but less than spectacular real estate properties. Sales prices like $634 million (Travelers) and $1 billion (Prudential) have been commonplace. While some these properties were sold at somewhat competitive prices, the hardest financial pill to swallow was the time period between the default of payment and actual foreclosure. Liberal tort laws allowed owners lengthy bankruptcy protection which cost insurers dearly or forced them to restructure loans at the last minute. In many cases, insurers had to be involved and stand the cost for managing these properties until an agreement could be reached. Not all of the "moves" to reduce nonperforming real estate have been accomplished voluntarily by insurers. Even before NAIC risked based capital ratios, insurers were feeling regulatory heat to restructure or move nonperforming loans off the books to avoid capital deficiencies or substantial write-downs under generally accepted accounting principles (GAAP). An insurer typically carries real estate assets at historical costs. Under GAAP guidelines, however, collateral received as a result of a foreclosure is returned to the insurer at its fair market value. Because commercial property values have declined so rapidly, fair market values on foreclosed properties could be substantially less than the historical value. This can result in substantial GAAP write-downs at foreclosure. Owning and managing 243

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foreclosed real estate can also drain an insurer resources. A decision must be made whether to continue holding the asset until the economy rebounds or risk further deterioration if the economy goes the other way. Holding on may also involve setting aside reserves under NAIC rules. Selling foreclosed real estate may also be difficult to accomplish in today's depressed market. With many other lenders and insurers selling nonperforming real estate, a deep discount may be required to unload a problem property. This can result in further write-downs from the value carried on the books. In either case, holding or selling depressed real estate, the process can adversely affect earnings, capital requirements, dividends and ratings. An option for an insurer may be to package multiple properties and mortgages as collateral for a new securities offering to raise new capital. This will aid an insurers liquidity, but the original real estate asset or loan would remain on the books, perhaps at a deep discount. Again, the need for additional reserves exists and the condition still "muddies" the balance sheet. A more creative approach involves "spinning off" or selling problem real estate and loans to a new entity (created by the insurer). The new entity sells bonds or stock to the public to buy the problem assets. Since this is considered a sale, the asset gets off the books, the need for reserves can be eliminated and the insurer's balance sheet is cleaned up. This helps the company meet GAAP, statutory capital requirements and improves the "rating picture". In addition, the real estate assets are, in a manner of speaking, retained to take advantage of any real estate turnaround. As with any strategy, there are pitfalls to the "spin-off" including deep discounts, the cash drain to start a new entity and the possibility that the transfer may be a taxable event. By all standards, the handling of problem real estate and mortgage loans is part of doing business in today's insurance world. Realistically, this has been the cycle of real estate and most investing for as many years as insurers have been around. One must wonder, however, if the popularity of "real estate bashing" has promoted a wide scale purging of real estate assets beyond reason. Real estate has been a traditional sound and profitable investment for insurance companies since their inception. It has been the policy of insurance companies to invest in real estate for income and hold these assets to maturity. Therefore, the industry feels that only an assessment of how these assets perform over time is important -- not a temporary drop in book value reflecting some current market condition. While this may be a sound investment practice it is unfortunate that regulatory measures and rating standards related to real estate are so closely influenced by public perception of the moment. Fortunately, and, for the meantime, most mortgage loan delinquencies and problem real estate have settled with the large insurers. Analysts do not expect this to create an industry crisis similar to the savings and loan debacle. Moreover, most insurers have substantial cushions against real estate losses and/or have raised new capital offsets.

Regulatory Guidelines
The outcry to limit insurer's holding of junk bonds and real estate has forced many companies to restructure their portfolios by divesting these assets . In the case of bonds, a very low interest rate cycle during the 1990's greatly favored the sale of bonds, and, in fact, created large capital gains for many companies to offset losses elsewhere. In the case of real estate and commercial loans, divesture has NOT been as easy considering difficult market conditions. In response, the rating agencies and regulators are fast developing new criteria to assess the ratio of junk bonds or high risk issues and less favored assets like real estate, common stocks and real estate owned by the insurer. Examples include the WAR (Weighted Asset Risk) Formula developed by Townsend and Schupp, Risked Based Capital and Bond Classification developed by the National Association of Insurance Commissioners. The details of these programs are best left to later sections, but the importance of these tools is that each analyzes insurer assets by breaking down the various levels of risk they present. In essence, B rated bonds are assigned a higher risk than AAA bonds. Using historical simulations, formulas such as these may have raised "red flags" years before the downfall of companies like Executive Life, First Capital Life, Fidelity Bankers Life and Mutual Benefit Life.

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SOURCES & USES OF INSURANCE COMPANY ANALYSIS

An agent is engaged by a client because he or she is an insurance professional. Clients should rightfully expect to be placed with financially reliable insurers, matched to appropriate insurance products which are accurately and completely presented by way of an illustration or financial plan. In accomplishing these tasks, it is hoped that at least a few of the following sources and considerations will have application and involve the agent in these areas of due care -- some of which are largely ignored by the agent population. If this is considered too time consuming, an agent would be advised to concentrate only on those companies where this information can be acquired. The story "behind" the numbers is often as important. This may involve some digging and use of sources outside rating services and insurance company literature.

QUALITATIVE CONSIDERATIONS
Agent Representations
Basic agency law demonstrates that agent liability can exist where the agent has offered a personal warranty. Providing clients with any methodologies or procedures used in evaluating companies, may be construed as a warranty in that the agent has "vouched" for a company or product. Written and oral declarations made by the agent are admissible evidence in this matter. Therefore, even though analysis is considered important to "agent due care", a malpractice attorney may advise agents to conduct due diligence, document his or her findings for the file and use only published rating information or third-party testimonials to demonstrate the recommendation. Beyond this, the advice of an attorney to prepare a proper disclosure concerning the risks of using a specific carrier or the inability to guarantee ongoing solvency might be appropriate to mitigate any potential problems down the road. In a similar vein, illustrations and quotes as sales tools have triggered agent liability. While projecting detailed client results over 20 or 30 years can be impressive and confirm a sale, they are also potential warranties of expected results which may subject agents to a shortfall dispute. The classic example is an annuity proposal which assumes a rate of interest of 10 percent. When interest rates drop to 6 percent, projections in the proposal are no longer valid. In addition, even though quotes show guaranteed results, a change in mortality tables or experience ratings could totally re-arrange an illustration or quote. An agent might be advised to run a range of illustrations and counsel clients on these potential changes which could effect ultimate policy results. Recent laws in some states now require the agent to highlight or bold the "guaranteed" portion of an illustration or proposal.

On-Going Monitoring of Companies

There are several recent court cases involving agents and insolvent insurance companies. In Higginbotham v. Greer, it is suggested that agents need to keep clients informed about significant changes in the financial condition of the company after the sale. Again, attorney's might advise that an agent conduct any and all on-going due diligence, document files and utilize published and third party testimonials to make a case for maintaining, switching or surrender of a policy.

Policy Replacement
Where an agent is recommending replacement of an existing policy due to deteriorating carrier finances, it is important to also evaluate factors of the client's health, condition of property, penalty charges that 245

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might be levied to surrender the original policy, tax considerations, pre-existing conditions that have already passed on the original policy must be started again on a new one, the incontestability provisions may have already expired on an old policy while a new one starts a new contestibility period and more. In addition, agents must carefully consider any recommended move of client's coverage from a company rated "A" or better to a lesser rated carrier. Even if the intent was to provide superior coverage, the client's security position has technically downgraded. Agents might be advised to fully document files on why this recommendation was made.

Too Good To Be True

It is an old-age adage, but it has never taken on more meaning. Agents might be advised to at least be suspicious of a company offering a "better deal" than anyone else. It is common sense that something along the way will suffer as it did in the case of some life companies that invested in junk bonds and many casualty companies who participated in deep discount premium wars where expenses and claim costs at times exceeded income. This can only represent a degenerative financial condition for the insurer. Also remember that insurance professionals, as salesmen, want to believe something is a better product or a better company. By their very nature salesmen often "get sold" as easy as some clients. It would be wise to be critical of all brochures and analysis distributed by a carrier which portray it to be the "best" or "safest".

Diversification
In the quest to satisfy solvency due care, perhaps a strategy of multiple-company coverage is the answer. For a client's life insurance needs, some combination of term, whole life, variable life or universal life may be employed to spread the risks among many different insurers and product lines. The variable life component could be diversified even more by using multiple asset purchases. On the casualty side, similar diversification might be employed between business and homeowners policies, worker's compensation, professional liability, etc.

Conflicts of Interest
Agents receive a commission for their expertise in selecting a suitable product and company. The fact that the agent receives this commission back from the same company represents a definite conflict of interest. An ethical agent should disclose this fact in reference to the choice of the company selected. Where the commission is higher than normal, one might question the specific policy elements that will be affected (higher surrender or cancellation charges, etc) or considerations about the financial qualifications of the insurer and include these facts in any disclosure. An insurer recently placed in liquidation, for instance, had a known history of paying higher than prevailing commissions.

Basic Reinsurance
Reinsurance is an effective tool for spreading risk and expanding capacity in the insurance marketplace. The strength of the guarantees backing the primary policy, however, is only as strong as the financial strength of the reinsurer. Abuses have occurred where the levels of reinsurance have been too high, the quality poor and the controls nonexistent. Industry analysts suggest that the total amount of reinsurance should not exceed 0.5 to 1.3 times a companies surplus. Agents should also be concerned about foreign reinsurance since U.S. regulator control and jurisdiction is difficult. See how much of the foreign reinsurer's assets are held in the United States. Ask if the reinsurer has directly guaranteed the ceding company or using bank letters of credit for this purpose. These credit letters have not been effective guarantees in the past. Also, under terms of the ceding contracts, can the reinsurance be "retroceded" or assumed by another reinsurance company -- it is possible to have layers of reinsurance which could 246

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create difficult legal maneuvering during a liquidation. Does the ceding contract have a "cut-through" clause which allows the reinsurer to pay deficient policyowners or insureds direct, rather than to the liquidator? Is the insurer writing a significant amount of new business that may require costly amounts of first year reinsurance?

First-Year Reinsurance
The first year that an insurance policy goes on the "books", the insurance company suffers a loss. This is attributed to laws related to the accounting valuation of the policy and the high costs or expenses paid in the first year (commissions, etc). A loss to an insurer, is also reduces a company's surplus. A strain on surplus can create all kinds of problems with regulators and lenders, so insurance companies go to great lengths to shore up their surplus from the losses of first year policies. This may be accomplished by raising additional capital or through some form of financing. More often than not, however, an insurance company will simply call up the local reinsurance company and obtain surplus relief reinsurance. Once in place, surplus reinsurance provides the ceding company (the insurer who uses the reinsurance funds) with assets or reserve credits which improve the insurers earnings and surplus position. The major difference between using reinsurance to cover first year losses and a loan is how the transaction is reported. When an insurer obtains a loan, the accountant must record a liability. Reinsurance for surplus relief, however, is NOT considered a liability under statutory accounting because the repayment is tied to future profits of the policy or policies being reinsured. Collateral for the reinsurance, in essence, is future profits. Thus, reinsurers run substantial risks when the ceding company cannot pay. The fee or interest for providing the reinsurance is typically from 1 percent to 5 percent of the amount provided. Regulators are well aware of reinsurance surplus relief practices. Over the years, they have introduced rules which attempted to minimize abuses. The 1992 Life and Health Reinsurance Agreements Model Regulation was adopted by the National Association of Insurance Commissioners for implementation in 1994. The National Association of Insurance Commissioners also adopted a 1988 regulation which reads as follows: " . . . If the reinsurance agreement is entered into for the principal purpose of providing significant surplus aid for the ceding insurer, typically on a temporary basis, while not transferring all of the significant risks inherent in the business reinsured and, in substance or effect, the unexpected potential liability to the ceding insurer remains basically unchanged".

Restructured Loans
What percent of an insurer's nonperforming or underperforming real estate projects have been "restructured" -- sold and self-financed to a new owner at favorable terms to eliminate a "drag" on surplus.

Size of Company
Statistically, fewer failures have hit companies with assets greater than $50 million. It is thought that larger companies have more diverse product lines, big sales forces, better management talent--in essence, they are better equipped to ride out financial cycles. In recent wide scale downgrading of insurers, A.M. Best seems to have favored significantly larger companies in the over $600 million category. However, another advisor feels that a small, well capitalized company can deliver as more or more solvency protection as a large one suffering from capital anemia.

Lines of Business
An agent may not have many choices over the company he writes, e.g., worker's comp coverage can only be secured with a carrier willing to write worker's comp. It has been suggested, however, that agents may consider evaluating multi-line companies to determine if one of the lines is weak enough to "down-drag" a profitable line. An example could be a life company that also writes health insurance as a direct line 247

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or business or by affiliation. If health carriers become threatened under a new national health care proposal, it could spell trouble for an insurer's health line which can affect ALL lines of business written. Of course, this is not to say that a multi-line carrier cannot be profitable and solvent.

State Admitted
Checking that an insurer is licensed or admitted to do business in the state at least assures that the company has met solvency and financial reporting standards. Most states offer toll free numbers for these inquiries. Some states will also divulge the rank of an insurer by the number of complaints per premium volume.

Mergers
Insurance ratings are sacred territory. A rating drop against Mutual Benefit Life triggered a run on that insurer which caused its conservatorship. This news and the overall crisis of confidence surrounding the insurance industry has prompted insurers to consider many options to shore up these ratings. One option is the merger. The combining of companies can be critical to retaining policyholders, attracting new customers and maintaining investment capital sources. Some experts believe that consolidations in the insurance industry will become more commonplace in the future. One source estimated that the current number of life insurance companies--estimated at 2,000--will merge down to an eventual 200 insurers during the next 25 years.

Parent & Holding Company Affiliation

Who or what kind of company owns the insurer that is considered. Is the parent sufficiently solvent that it will not recruit or siphon funds from the insurer? In a like manner, does the insurer own an affiliate that may likely need capital infusion from the insurer? Has the agent's insurer recently created an affiliate and are the assets in this affiliate some of the non performing or underperforming investments of the original insurer? Is a merger in the offing that might mingle your client's A-rated company with a larger B+ company? In what partnerships or joint ventures does the insurer participate? Do these entities own problem real estate properties of the original insurer? Has the insurer invested in other insurance companies and have those companies, in turn, invested back in the original insurer or one of its affiliates? Name recognition can go a long way in giving a client a high level of comfort. In the early 1980's, for example, Cal Farm Insurance, a B rated company, was proud to point out that it was owned by the California Farm Bureau, a 100 year old company. By the mid 1980's, however, Cal Farm Insurance was liquidated by the California Department of Insurance for overextending itself on financial guarantee bonds that it could not pay. Because the claimants were considered to be sophisticated investors, they received only 25 cents on the dollar and forced to foreclose on the properties behind the financial guarantee bonds by themselves. The California Farm Bureau was not considered as a source to pay any deficiencies. Other abuses have occurred with a slightly different twist. For example, Senate investigations have revealed that the failure of many insurers can be directly tied to the "milking" of these companies by a "non-insurance" parent. Further, not all abuses have been on the side of the parent. Insurance companies themselves have been known to tap huge sums of capital from their parents, commingle assets and devise elaborate schemes including sale and leaseback arrangements and the securitization of future revenues.

GAAP Bending (Generally Accepted Accounting Principles)

Even before the National Association of Insurance Commissioners' risked based capital proposal, insurance companies were feeling regulatory heat for a fairly common practice involving underperforming and nonperforming real estate. In the past, insurance companies have simply carried the value of their 248

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real estate at its historical cost--no matter what! Yet, its makes sense that property that is not economically viable is worth less. This is especially true in the early 1990's where the fair market value of commercial property have decline rapidly and perhaps below historical cost. However, showing lower valuations would mean that insurers might develop capital deficiencies or incur substantial write downs. Either situation is hard to swallow. Now, new GAAP (Generally Accepted Accounting Principles) rules are being used by auditors which require foreclosed property or underperforming real estate to be valued at its current fair market value. Insurers must decide whether to continue holding an asset until the economy rebounds or risk further deterioration. Further, now that risked based capital is on their doorstep, holding nonperforming real estate may require companies to set aside additional reserves. In the past, if regulators started complaining, insurers would increase their capital, either from a parent company or through security offerings. While this would aid the insurer's liquidity, the original asset would remain on the books, perhaps at a deep discount. A more creative approach involves "spin offs" (below).

Asset Spin Offs

Insurer balance sheets can easily get out of whack if they hold underperforming or nonperforming real estate. As mentioned above, new GAAP write down rules would require a valuation of this real estate at its current fair market value, which may be extremely depressed. To help "clean-up" their balance sheets and possibly avoid strict risked based capital requirements, some insurers transfer or "spin off" the foreclosed or underperforming asset to a new entity which they create. This entity sells bonds or stock to the general public to buy the problem asset(s) from the insurer. Since this is considered a sale, the asset gets off the books. The need to set aside reserves and meet GAAP rules is eased. And, company ratings are maintained. In all fairness to insurers, what appears to be a deception is often a sound business strategy to "hold" an asset that is not performing today but is expected to rebound when the economy improves. So long as this can be accomplished and NOT hamper current operations, the insurer may be making a smart move since significant appreciation in the asset down the road could later improve the company's balance sheet by leaps and bounds. Also, "spin offs" are not without their risks. There is the cash drain of starting a new entity, the deep discount of the sale and the possibility of a taxable event.

Collateralized Mortgage Obligations & Derivatives

In the past, when insurance companies wanted higher investment yields they turned to real estate and non-investment grade bonds. New risked based capital rules, however, make these types of investments difficult to "book". Insurers, however, have found ways to still participate in the yield of these investments without owning the actual product--they are called collateralized mortgages and derivatives. In simplest terms, collateralized mortgage obligations and derivative are like stock certificates backed by mortgages or bonds. The "slant", however, is that they are owned by a trust and then sliced into pieces of various maturities consisting of principal and interest payments. They are also further divided into issue classes called "tranches". The first principal payment, for example, would go to tranche 1; and so on. Tranch 2 might be "interest only" strips. Investors will jockey for particular tranches based on their rate of interest, their individual requirements and their outlook on where interest rates are going. Investments in the junior tranches offer significant yields, yet come with the risk of prepayment. Senior tranches generally minimize market risks since cash flows are more predictable. Suffice to say, CMO's and derivatives are highly sophisticated, higher risk investments that require sophisticated monitoring and significant hedging capability.

Tax Angles
Regulators and accounting practices appear to be getting stiffer for insurance companies. One thing the industry can still count on is certain tax advantages. In essence, losses from insurance operations can be used to lower taxes elsewhere (such as capital gains from the sale of bonds or real estate). Multi line companies, can use losses from property and casualty claims to offset profits from health and life 249

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insurance divisions. And, surprisingly, companies can sometime take a percentage of their losses as a "tax credit" and write it up as an asset on the theory that the tax credit will be worth something to them in a profitable year. This practice is acceptable as long as the company can show beyond all doubt that it will be able to use the credit sometime in the future. Critics, feel that the tax credits are actually "paper profits" which can hardly be used to pay claims. In periods where insurers are posting major losses--such as the mid 1980's and early 1990's--tax credits such as these may account for up to 70 percent of a firms operating income. How much of an insurer's operating income consists of tax credits generated from claim losses or guaranty fund? How much of an insurer's operating income comes from capital gains earned from the "bulk sale" of longstanding bonds or real estate?

Restructuring Loans & Partnership Deals

The last thing an insurer want's of the books is foreclosed or underperforming real estate. New risked based capital and GAAP accounting standards deal harshly with this type of asset. This is exactly the type of asset, however, that many insurers are "knee-deep" in handling, especially on the heels of big real estate purchases in the late 1980's with money raised from guaranteed investment contracts (GIC's). A way to alleviate the underperforming properties is to convert them to new loans--essentially refinance them for the owners at new, easier to handle payments--or restructure the existing loans by temporarily dropping the payment. It is also interesting to note that many insurance companies own problem properties that regulators do not see because they are owned through a partnership between the insurer and a joint venture entity.

Liability Adjustments
Reducing liabilities is always desirable since surplus will be enhanced. Some companies make small adjustments to their liabilities to make them appear smaller. One such adjustment can be accomplished by deducting the surrender charges policyholders would pay if they cashed their policies in early. Companies have been known to take this deduction knowing full well that NOT all policyholders will require early withdrawals or full surrenders of their policies. Some insurance regulators still allow this accounting method.

Cash/Stock Swaps
When things get tight, some insurance companies invest in each other or among their subsidiaries using a system of complicated cash and stock swaps. Not too long, Charter Life was entering bankruptcy. Working together with Capitol Life and Providence Life, Charter paid $37.5 million in cash to Providence for preferred stock issued by Capitol Life. Capitol Life paid $35 million in cash to Charter for newly issued Charter preferred stock. Capitol Life, in turn, transferred the Charter preferred stock to another Providence subsidiary which, in effect, absorbed a $28.6 million loss on the stock so that Capitol Life wouldn't be effected by Charter's bankruptcy law filing. Capitol Life continued to pay dividends on its preferred stock held by Charter's insurance unit.

Selling Loss Reserves

Under pressure to improve earnings insurers have used the somewhat questionable technique of "selling loss reserves". How does an insurer sell losses? Generally, it involves paying another insurer now for its promise to pay certain claims in the future. A few years back, for example, Aetna passed the liability for an estimated $80 million of unpaid medical malpractice insurance claims to Fireman's Fund Insurance Co in return for an agreement to eventually pay those claims. Fireman's received a steep discount on the claims for a profit of approximately $22 million. Aetna relieved itself of $80 million in liability. Reinsurers are also big buyers of loss reserves. Critics say its an accounting gimmick. Industry spokesmen claim it is merely a method of transferring risk. 250

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Assumption Reinsurance
Reinsurers assume the risk(s) of a ceded company on a regular basis. Congress, however, is very disturbed that this practice is continuing without policyholder knowledge--assumption reinsurance. Put simply, insurers seeking to deploy their assets more profitably, "jettison" blocks of policies to reinsurers. Critics believe that policyholders should be advised in advance when a reinsurer is considered.

QUANTITATIVE CONSIDERATIONS
Using the Rating Services
There are many different ways to develop rules of thumb using rating service information. One approach might be to delineate a "range of acceptability" among specific rating companies. For example, if an agent were ultra conservative, he or she may set a rule that all his chosen companies must be in the top two categories of the four major rating services: A++ or A+ from A.M. Best AAA or AA+ from Standard & Poors Aaa or Aa1 from Moody's AAA or AA+ form Duff & Phelps A slightly less rigid approach would establish a minimum rating requirement of NOT lower than the fourth category from any of the major companies: A- from A.M. best AA- from Standard & Poors Aa3 from Moody's AA- from Duff & Phelps Or perhaps, an agent might decide that a company must only meet one or more requirements from three of the four major rating companies. A word of caution is in order regarding ratings. Agents who do not find a company rated must investigate the reason. If the company has not been around long enough to rate, it may be better to avoid doing business unless a reinsurance contract with respectable contract is in force. Or, it may be necessary to ask the insurer or the rating company is a rating was issued but suppressed from being published. Currently, only Standard & Poors and Duff & Phelps will suppress a rating.

Variations in Ratings
One major rating agency suggests a way to determine if an insurer is running into difficulty is to monitor several ratings. If the ratings vary widely, this should send a signal that there are other factors of concern regarding the insurer. A recent example is United Pacific Life. In 1992 they were rated A-plus by Duff and Phelps, BBB by Standard & Poors and Ba-1 by Moody's.

Commisioners Analysis
In the mid 1980's, then Insurance Commissioner of California, Bruce Bunner, offered agents a unique opportunity. He proposed five financial formulas producers could use themselves to test for carrier solvency. In his presentation, through a monthly newsletter distributed to all California agents, Bunner noted that agents and brokers are not expected to be experts in the financial analysis. "Nevertheless, a producer does have a moral response", said Bunner, "to perform reasonable due diligence procedures with respect to the financial credibility of insurance companies being used to underwrite clients' risks. 251

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Bunner feels that financial ratios in and of themselves are not a panacea. They can, nevertheless, serve as guideposts to identify positive and negative financial trends and the comparative health and stability of a company within the industry. Further, "when the evidence clearly indicates that a company's financial condition is deteriorating, too many agents and brokers continue to place their customer's risk with the same company. When price alone is the only marketing consideration and the producer disregards emerging negative financial signals, the agent is doing an extreme disservice to his client, and as such, must morally share some culpability with company management when and ensuing financial debacle occurs." Bunner's five ratios are simple to calculate and the necessary company financial data is readily available to the public in the annual statements on file at each state's department of insurance. The suggested formulas are: Gross premiums written to surplus; Two Year operating ratio; Surplus to admitted assets; Loss and expense reserves to surplus; and, The acid test. Gross Premiums Written to Surplus: This is a variation on the National Association of Insurance Commissioner's IRIS test ratio (Insurance Regulatory Information System) which compares net premiums written to surplus. The National Association of Insurance Commissioner's IRIS test guideline considers a result of 3 to 1 as acceptable. Bunner feels 2.5 to 1 as preferable. Further, he believes that the IRIS test ratio should be expanded to compare gross premiums written to surplus rather than net premiums written to surplus. Gross premiums written in excess of 4 to 1 surplus should be considered unacceptable. Further, Bunner feels that the relationship of gross written premiums to surplus is more important because the National Association of Insurance Commissioners IRIS test fails to consider the effect of disproportionate reinsurance activity. Reinsurance transactions, therefore, can grossly distort results. As an example, an admitted insurance carrier domiciled outside the state was writing in excess of 20 to 1 surplus on gross premium written basis. On a net premium written basis, their ratio was approximately 3 to 1. Bunner requested the company either reduce its gross writings or voluntarily leave the state. The company chose to ignore the request and was eventually issued a cease and desist order. This example is an extreme case. However, evaluating this company on a gross premiums written basis did uncover that the company had some problems. To account for reinsurance activity, Bunner suggests that a ratio of 4 to 1 for gross premiums written to surplus allows for up to 25 percent reinsurance premium credit to achieve the 3 to 1 National Association of Insurance Commissioner ratio benchmark. If a company has to reinsure more than 25 percent of its direct premium business, Bunner, suggests an agent ask why, and then verify the financial security of the applicable reinsurance company or companies. "I would question closely", says Bunner, "companies that are in effect using reinsurance to broker significant amounts of direct business (25 percent or more of direct premiums) and, particularly if the direct business is being channeled to the non admitted market. Two Year Operating Ratio : The two year operating ratio is an IRIS test that is basically an expansion of the combined loss and expense ratio where the ratio of the investment income to premiums earned is deducted from the combined ratio. Using financial figures for two years helps to level possible aberrations. Bunner says, "we traditionally have expected the two year operating ratio to be a result of 100 or less . A result in excess of 100 suggests that the company is not achieving an underwriting profit, but relying on investment income to offset underwriting losses and to achieve a reasonable return on equity". A quick calculation that can be done on a quarterly basis to achieve the same conclusion is to compare net income (exclusive of realized gains and losses) to prior years surplus. A result of less than 10 percent generally may be indicative of potential problems. A return on statutory equity of 10 percent or less hardly justifies the opportunity cost of the company's investment in statutory surplus. If the stockholder(s) are not willing to insist on an adequate return on equity, you may want to make some further inquiries. For both these tests, realized investment gains and losses should be excluded from investment income. This is a modification of the IRIS test which Bunner believes is appropriate because such gains and losses are non-recurring transactions and largely discretionary. From time to time, companies have been known to selectively sell appreciated assets to improve the appearance of operating results. Surplus to Admitted Assets : Surplus to admitted assets generally exceed 25 percent for most 252

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insurance companies. A ratio of less than 20 percent for an individual insurance company should be consider questionable. According to Bunner, "surplus provides a cushion for absorbing potential above-average losses". As discussed in the next section, deficiency in loss reserves usually carries over into higher multiples when related to surplus. If the company under evaluation is a member of a holding company system and fails this surplus ratio, Bunner suggests an agent should not be dissuaded by any arguments from management that the company's surplus is reinforced by the adequacy of the surplus of the parent or affiliated companies. Bunner states, "I strongly believe that every company granted a charter should be financially independent and its economic viability should NOT be dependent on other related entities." Reserves to Surplus : The ratio of loss and loss expense reserves to surplus is not an IRIS test. However, Bunner thinks the ratio deserves more consideration by the National Association of Insurance Commissioners because of the extreme leveraging that is becoming more common in the insurance industry. It would be preferable if this ratio could also be calculated on a gross basis (before reinsurance) rather than on a net basis (after reinsurance). The problem company discussed earlier, for example, had a ratio of gross case basis reserves to surplus of 16 to 1 and most of its loss reserves were ceded to non-admitted insurers. If gross reserves were included, the ratio would increase to 32 to 1 or more. This degree of leverage is not prudent despite the adequacy of the security of any reinsurance. Bunner believes that a net loss and loss expenses reserves to surplus should not exceed 3 to 1. The Acid Test : This is Bunner's own formula for a quickly evaluating company liquidity or ascertain what he refers to as "hard surplus". Obviously, the formula can be refined but it does adjust for some of the weaknesses of statutory accounting. For this test, subtract from surplus the home office building(s), computer equipment, and any non-insurance receivables and other non-insurance assets that are reported as admitted assets by the company. This adjustment separates from surplus that part of surplus which is basically applicable to the operating assets of the company. From this adjusted surplus amount subtract any affiliated investments and advances; unrealized losses on investments in bonds and preferred stocks; and any contribution certificates, surplus notes and subordinated debentures; and add back the surplus appropriation for accumulated excess Schedule P reserves. The adjustment for affiliated investments and advances is to remove from surplus the effect of any pyramiding of assets which in extreme situations often contributes to insurer solvency. Unrealized losses on bonds and preferred stocks are typically disclosed in report supplements included with a company's annual statement on file at state insurance departments. Bunner is of the school that all investments held by an insurer should be reported at their current value. "The current accounting model", he says, "using amortized costs for fixed yield securities is too forgiving to company management. Statutory accounting obscures the effect of lost investment opportunities and encourages investment decisions (particularly investment hold or sell decisions) to be driving by accounting rather than economic conditions. Once all the adjustments above have been made, a surplus of LESS than zero, suggests that the company may have liquidity problems or be over leveraged. In closing, Bunner suggests that the failure of any one or more than one of these tests is not necessarily indicative of a company financial problem. Further, these tests do not adequately consider some complex financial issues associated with reinsurance, security of letters of credits, off balance sheet commitments and issues related to specialty companies writing insurance products as earthquake, professional malpractice, financial guarantee bonds and so forth. However, prolonged failure of any of these tests might suggest that company management is choosing to operate outside the boundaries of sound financial guidelines and should be suspect. As such, the producer agent should not be reluctant to demand satisfactory answers from the management of the insurance company. Bunner states, "some agents and brokers too often compromise themselves and their clients by accepting unrealistic insurance rates from marginal insurers to the exclusion of financial soundness and prudent management. Time and time again we have learned that this scenario will ultimately prove to be a disservice to the producer, the client and our industry at large."

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An Authors Advice
The author of a popular selling book on investing offers some words of caution concerning annuity investment companies. He believes an agent should "bail out" his client if the insurer involved has been rated downward more than once within a one year period. He prefers a threshold rating of AA or Aa (Standard & Poors & Moody's) to stay involved with a company. Favorite ratios to analyze involves capital cushion. -- divide the company's statutory surplus (capital) by its assets. The more capital the better with an average industry ratio of 7 percent. Avoid high concentrations of junk bonds, repossessed real estate and nonperforming real estate mortgages. When the combination of these exceed two or more times the company's capital be careful. Finally, always be suspicious of a company that offers a much better deal than its competitors.

Townsend & Schupp WAR Ratios

Townsend & Schupp (Hartford, Conn) is an investment banking and credit research firm specializing in the insurance industry. The company garnered the spotlight when it released its WAR (Weighted Asset Risk) Ratios in 1990. The study produced an outcry from four major insurers--Executive Life of California, Executive Life of New York, First Capital Life and Fidelity Bankers Life--who refuted the notion that their investment mix, using high ratios of junk bonds, represented a high risk. Less than one year later, all four companies were in conservatorship. Although agents might attempt his own WAR ratio, it is only one aspect of how Townsend & Schupp analyses insurer safety. In WAR ratio analysis, assets are assigned risk factors (expected losses) for all classes, except mortgages and real estate where default and loss ratios are quantified based on interviews with major insurers. Risk factors are delineated by the following classes: WAR RATIO EXPECTED LOSS FACTORS Asset Class Risk Factor

Bonds Rated AAA, AA, A 0.5% Bonds Rated BBB 1.0% Bonds Rated BB (2.5% Bonds Rated BB) 5.0% Bonds Rated Lower 10.0% Stocks / Preferred 2.5% Stocks / Common 25.0% Mortgage Loans/Current 5.0% Mortgage Loans/Delinquent 20.0% Real Estate Company Owned 5.0% Real Estate Good Standing 5.0% Real Estate Foreclosed 20.0% Other Invested Assets 10.0% Townsend & Schupp apply these risk factors to actual insurer investments and arrive at an aggregate total which is divided by the sum of composite surplus--statutory surplus PLUS MSVR (mandatory securities valuation reserve) PLUS voluntary loss reserves. The lower the WAR ratio the better a company's ability to recover or cover a liquidity crunch. A recent survey by Townsend & Schupp of 130 insurance companies found an average "expected loss" or WAR ratio of 40 percent of composite surplus. Top companies rate in the under 20 percent range while a few dangerously exceed 100 percent.

ANALYSIS SOURCES
A.M.Best Company 254

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INSURANCE MARKETING ISSUES Ambest Road, Oldwick, NJ 08858 (908) 439-2200 Bestline 900 (automated current rating--$2.50 per Bests Insurance Reports Best's Insurance Reports Best's Key Rating Guide Best's Advance Company Records Best's Aggregates & Averages Best's Review Magazine Best's Insurance Management Reports Best's Agents Guide Best's ESP (Electronic Statement Preparation) Best's Retirement Income Guide Best's Market Guide (Insurer Portfolios) Best's Reproductions (Annual Statements) Best's Underwriting Guide Best's Underwriting Newsletter Annuity Review Board 3835 North 32nd Street, Suite 6, Phoenix, AZ 85018 (602) 953-0599

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minute) (900) 420-0400 / Key in AMB # from

Provides detailed financial information on well-known insurers and reviews policy provisions for individual annuity policies. Duff & Phelps 55 East Monroe St, Chicago, IL 60603 / (312) 368-3157 "Insurance Company Claims Paying Ability Rating Guide" / Quarterly report on financial findings and ratings. "Rating Guide" / Monthly claims paying ability The Insurance Forum Joseph Belth PO Box 245, Ellettsville, IN 47429 Publishes a "watch list" of underperforming companies based on IRIS (Insurance Regulatory Information System) statistics. Journal of American Society of CLU & ChFC 270 S. Bryn Mawr Ave, Bryn Mawr, PA 19010 (215) 526-2524 Bimonthly publication on current issues Money Magazine Insurer Safety Watch / Major downgrades / Various issues Moody's Investor Services 99 Church Street, New York, NY 10007 / (212) 553-1658 Insurance Rating Desk / 212-553-0377 "Moody's Life Insurance Credit Report" / Quarterly handbook with detailed reports on companies, special comments on industry issues, "flash reports" of rating actions and access to analysts and briefings. 255

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INSURANCE MARKETING ISSUES Moody's Quarterly "Life Insurance Handbook" / summaries.

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Gives ratings, explains rationale and executive

National Association of Insurance Commissioners 120 W. 12th Street, Suite 1100, Kansas City, MO 64105 (816)842-3600 National Insurance Consumer Organization 121 N. Payne St, Alexandria, VA 22314 Consumer oriented manuals and advice concerning insurance products and insurance companies. Standard & Poor's 25 Broadway, New York, NY 10004 Insurance Rating Desk / 212-208-1527 "Standard & Poors Insurance Book" / In-depth reports on each rated insurer including charts and graphs "Standard & Poors Insurance Digest" / Quarterly publications containing the company's letter rating and basic rationale. "Standard & Poor's Insurer Rating List" / A monthly list of insurers and their letter rating. "Standard & Poors Insurer Solvency Rating" / Qualified solvency and claims-paying ratings for 1,600 insurers. "Standard & Poors Select Reports" / Four-page reports excerpted from S&P's Insurance Book. State Insurance Departments Annual reports for each company filed with the state are public record. In most cities where reports are kept, a private "copy service" will go to the insurance department, copy specific reports and mail them to you for a fee. Townsend & Schupp 100 Wells Street, Suite 802, Hartford, Conn 06103 / (203) 522-2214 Detailed and personalized quantitative analysis and comparisons of life insurance companies using proprietory ratios, e.g., Townsend & Schupp WAR Ratio, etc. Some services allow direct telephone access to top T&S analysts. Weiss Research 2200 N. Florida Mango Rd, West Palm Beach, FL 33409 / (800) 289-9222 "Letter Grade" / Available by phone for about $15 "Personal Safety Brief" / One page analysis for about $25. "Insurance Safety Directory" / Quarterly findings for life and health companies. Weiss is also one of the few rating agencies to rank the nation's 72 Blue Cross and Blue Shield plans.

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CHAPTER 4 BEYOND THE INSURANCE SALE

The most important advice that financial planners give their clients concerning insurance is to buy insurance that really insures. The meaning behind this advice is that insurance can fail to insure for many reasons. The purpose of this chapter is to explore how insurance can fail, the exposure this creates for you and your client, and why you need to help prepare your clients for this contingency. This is a new area of planning that few agents practice. However, it can also be the most critical service you offer.

The Need to Look Beyond Insurance

Risk is a fact of life to be constantly analyzed and managed. Unfortunately, the time most people devote to this process is less than the time they spend planning a summer vacation. So, who assumes the role of unofficial risk manager; preserving worldly goods and family security? You guessed it . . . insurance agents. Like it or not, you are in the asset protection business. But, just how far can you expect your product (insurance policies) to go. Every agent knows that insurance has its limitations. There are times when clients are underinsured; there are clients who cannot be fully insured; and there are times when insurance simply fails to insure. Add to this a bevy of carriers, who withdraw or are unwillingly forced from the marketplace, a few insolvencies here an there, and you know why a growing band of attorneys and financial advisers are starting to look beyond insurance; supplementing insurance coverage with multiple legal strategies, i.e., asset protection planning. The next time you are assessing a clients real need for coverage, consider the following possibilities; all of which point to the need for back-up protection: The need for a protection structure which can be used as a replacement to insurance when premiums rise beyond a client's ability to pay. The need for a protection system that can supplement current insurance, covering gaps in protection like punitive damages or an underinsured health condition. The need for a protection structure that will become a back up for times when, for whatever reason, a lapse in insurance coverage occurs. The need for a protection structure as back-up when an insurer fails to pay or becomes insolvent When coordinated with estate planning, the need for a structure to protect inheritances and estates from frivolous claims and plaintiff attacks. The need for a structure to protect business and property owners from new and exotic environmental liability which may be excluded by their insurance or entirely unknown by present standards.

Few would argue that when clients are provided safe, appropriate and sufficient levels of coverage, insurance is the worlds most efficient asset protector . . . a first line of defense . . . a shock absorber taking the brunt of economic and legal catastrophe. Today, however, insurance by itself may not be the sole solution to protecting all assets because there are pressures at work, both legal and moral, that go beyond the resolution of good coverage.

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Cost of living
It costs a lot to live today and it will cost a lot more tomorrow. The question is: Will you miss something? Will you guess wrong? Will you place more emphasis on covering one area of need to the deferment of another? There are many rules of thumb you can use to gauge the amount of life or medical coverage needed to cover loss of life or a major health condition. But, will the $250,000 life policy you sold last month leave enough to cover an additional eight years of medical school for the surviving dependant who suddenly finds out he wants to be a doctor? Will the health policy you delivered this morning cover new treatment options that might be considered experimental today, but standard procedure years from now? If not, there will be a huge coverage shortfall. How about the long term care policy you sold to a middle-aged couple. Will the $92 daily nursing home care coverage do any good when inflation has bumped the cost of nursing homes to $250 per day in 20 years? All of these examples are possible outcomes that you or your clients cannot anticipate; or, perhaps you did but the cost to cover them is NOT currently affordable.

EXPANDING LIABILITY
The idea of using and needing additional methods to replace or augment insurance coverage has more chance to grow today than ever before. Why? Because the ways to get to you or your clients are constantly expanding. Consider this partial list: Direct liability Imputed liability Joint liability Excessive debt Negligence Contract disputes (oral and written) Ownership related liability Environmental hazard Safety issues High risk occupation Status (Officer or Director) Business risk Employees Market trends Unfair trade practices Partnership obligation Government obligations Code violations Taxes Face it, your best efforts to limit a clients financial and legal exposure cannot insure that policy limits will be breached or, by exclusion or technicality, completely fail. Furthermore, our countrys expanding liability policy almost guarantees that along the way you will miss something. Just think about the thousands of legal decisions each year based on precedent. A new case borrows something from a previous case; another viewpoint is borrowed from a different case; and so on and so on. Soon you have a completely different spin on the original decision. Undoubtedly, someone will tie the McDonalds too hot coffee case to hot soup or hot egg rolls. These cases could be the springboard to too cold food or even bad tasting food. Under conditions like this, it will be difficult if not impossible to cover your clients for every possibility or problem.

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COST OF DEFENSE
Just as important as expanding liability is the outrageous cost of defense. A single mistake or accident that exceeds policy coverage can bury a client. And, in cases where punitive damages are involved, there may be no coverage at all. Quite simply, our tort system does not favor defendants. It has been said that once you have been sued, youve already lost. A defendant can incur years of legal fees simply responding to a lawsuit -- even if he is found completely free of any liability. In his book The Litigation Explosion, Walter Olsen argues that a litigator can come around, dump a pile of papers on your front lawn and you can go literally broke trying to respond to it.

Courts make legal decisions based on precedent. Most attorneys and students of law believe ours is a system destined to expand liability because each decision in the chain sets the stage for the next step of expansion. This, coupled with the willingness of judges and juries to expand legal theories of liability, leaves uncertainty and exposure for anyone who relies on traditional methods of protection planning. Deep pocket pursuit
People work the first half of their life to build an estate. During the last half, they are constantly worrying about someone trying to take it away from them. Its called deep pockets and it is the single greatest reason that people get sued. Today, there are lawyers and other legal pirates who only get paid if they find a deep pocket: be they yours, a clients or the deep wells of an insurance company. This is the day of the frivolous claim, the class action, the suppressed childhood memory and the too hot coffee. If your client has deep pockets, someone will be looking for a way to get at them and your policy may fall short or fail.

When Insurance Fails to Insure

Many of the risks we have discussed can be and are routinely insured by agents. However, there are conditions where this coverage is less than adequate or it simply fails to cover for one or more reasons. Insurance can fail to insure in many ways. The source can be an agent's negligence in not providing essential coverage or it can involve deeper issues such as inadequate or defective protection, coverage disputes, or the clear inability of the insurance company to pay, e.g. insolvency of the insurer. In any instance, the result is bound to disappoint a client and cause potentially harmful exposure to personal assets as well as liability for the agent.

Coverage shortfalls
Many Americans consider themselves dutiful to purchase and maintain insurance often buying multiple policies with varying features and limits. Occasionally, situations arise where a liability surfaces from an unanticipated source, beyond the scope of these features and limits, resulting in an insurance shortfall. Such is the case where a breadwinner who bought a $50,000 whole life policy dies prematurely leaving a family with young children. Or consider a high wage earner who is the cause of a serious auto accident that disables a neurosurgeon for life. Obviously a $300,000 policy limit may not satisfy the surgeons 259

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family and their attorney. When events like this occur, the agent may find himself in the position of breaking the bad news or worse, liable for the shortfall. Sometimes, insurance shortfall cannot be helped. After all, nothing in life is guaranteed to work out right every time, and unexpected, freakish accidents and events can occur without warning. Unfortunately, there are also instances where the coverage provided by an agent was significantly less than needed and the agent paid the difference Then too, there are times when the coverage purchased or sold to a client exceeded what was needed in one type of insurance at the expense of another insurance coverage being under funded and under covered, e.g., a high premium whole life policy leaves no monthly budget for health insurance, or an auto policy with low deductibles is chosen or sold instead of a higher deductible policy permitting the additional purchase of umbrella coverage. Where clients depend on an agent for multiple lines of insurance or simply because its right to do so, agents need to consider the balancing of coverage to avoid critical shortfalls.

Coverage disputes
In the midst of the litigation explosion, the stakes are high. Insurers are offering increasingly high policy limits, and insureds, who cannot secure coverage or who fail to be awarded coverage, risk losing a lifetime of assets. Given this scenario, conflicts between insureds and insurers and agents can easily gather steam. To further confuse the issue, the courts are constantly bending statutes while public attitudes produce more and larger plaintiff verdicts, this despite the fact that the industry operates under fairly standard contracts. In essence, there has never been a time for greater disputes in coverage. One form of coverage dispute results when the agent fails to secure the promised coverage The result can be disappointing to BOTH client and agent. The courts have found that when an insurance broker agrees to obtain insurance for a client, with a view to earning a commission, the broker becomes the clients agent and owes a duty to the client to act with reasonable care, skill and diligence. As you may already know, agents have been sued for neglecting to secure the requested coverage, failure to notify the client that the insurance is not available, failure to forward premiums on policies which then lapsed, unintentionally omitting a specific type of coverage, providing unsuitable coverage, failure to properly bind the client and much more! A more common form of dispute occurs when the insured and the insurance company simply do not agree on the interpretation of coverage provided. In practice, insurance coverage cases can be extremely complex. It is not unusual for these cases to involve numerous parties on both sides of the litigation. And, since policyholders usually buy insurance in many layers of coverage, i.e., life, health, casualty, excess, umbrella, from many different insurance companies over many years, the number of companies brought into one insurance coverage case can be quite large. Coverage cases are also being consolidated by the courts where numerous policy holders and insurance companies have been found to be litigating coverage for the same underlying claims or addressing the same coverage issues. In one instance, a group of independent environmental coverage actions were ordered to collectively resolve many common contract issues and cooperate in case management and discovery procedures simply because they were similar.

Insurance Litigation
Although most insurance conflicts settle prior to trial, some disintegrate into protracted and unnecessary litigation, Some areas of specific conflict include the following: Triggers of Coverage The term "trigger" is merely a label for the event or events that, under the terms of an insurance policy, determine whether a policy must respond to a claim in a given set of circumstances. While this definition seems clear, "trigger of coverage" disputes have been raging for decades and have been the source of much confusion. 260

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In a life policy, the trigger seems clear: death. However, issues of whether the death was an accident or suicide within the incontestable period is often up for debate. Disability and health policies, however, have a higher propensity for dispute: What is a permanent disability? Are there waivers and if so, how long? What is a major illness? Has the deductible been met? Are there additional policy exclusions? In long term care policies, trigger of coverage is even more acute where a written declaration by a physician may be required to solidify a patients inability to care for himself: the prerequisite for insurance benefits. Policy language in most casualty policies center around three primary "trigger of coverage" issues. First, the carrier agrees to provide coverage for "all sums which the insured shall become legally obligated to pay as damages because of bodily injury or property damage to which this insurance applies, caused by an occurrence." Second, an "occurrence" is defined in the policies as "an accident, including continuous or repeated exposure to conditions, which results in bodily injury or property damage neither expected or intended from the standpoint of the insured..." Third, "bodily injury" is defined as "bodily injury, sickness or disease sustained by any person which occurs during the policy period", and "property damage" is defined as "injury to property which occurs during the policy period...". The "trigger" is plain under these three policy provisions when property damage or bodily injury "occurs" during the policy period. But, the trigger question becomes somewhat complicated when a long period of time has elapsed between the act giving rise to liability. Examples include a leak or spill involving hazardous waste or exposure to asbestos or lead which may result in problems years later. Most of the litigation concerning coverage for latent injuries have raised at least four different explanations of when damage "occurs" and thus "triggers" coverage. 1) The date of exposure to the toxic substance (the "exposure" theory); 2) the years in which the claimant incurred tangible injury ("injury in fact" theory); 3) the date of manifestation of injury (the "manifestation" theory) and 4) the year in which damage "occurs" or "could have occurred ( the "continuous trigger" theory). The "continuous trigger" theory has received considerable attention during the past twenty years surrounding property damage or bodily injury due to hazardous waste/environmental contamination. In essence, the courts have generally ruled that casualty insurance policies can be "triggered continuously" from the initial exposure to the contamination to the manifestation of any injury, disease or damage of property. By far, most policy holder attorneys adopt a "continuous trigger" approach to litigation. Insurance companies continue to argue, sometimes to no avail, that insurance policies cover an "occurrence" and NOT A "REOCCURRENCE". Definitions The following are terms that often become the focus of coverage disputes: Bodily Injury - bodily injury, sickness or disease sustained by a person, including death resulting from any of these at any time. Property Damage - physical injury to or destruction of tangible property which occurs during the policy period. Loss of use of tangible property which has not been physically injured or destroyed, provided such loss of use is caused by an occurrence during the policy period. Occurrence - an accident, including continuous or repeated exposure to conditions, which results in bodily injury or property damage neither expected nor intended from the standpoint of the insured. Conditions In addition to standard provisions and definitions, coverage is further defined in a "conditions" section where the duties and legal requirements of the insured and insurer are established. Typical conditions are the insurer's right to inspect, and the insured's duty to cooperate with the insurer and the notice provision. The notice provision is the most frequently litigated condition. A sample notice provision might include the following language: "In the event of an occurrence, written notice containing particulars sufficient to identify the insured, the time, the place and circumstances thereof, and the names and addresses of the 261

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INSURANCE MARKETING ISSUES injured and of available witnesses, shall be given by or for the insured to the company".

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Some courts have relieved the insured of its notice of obligation unless the insured was in some way prejudiced or harmed by the insured's delay in providing notice. The insurance company usually has the burden to prove that it was harmed by the insured's failure to comply with the notice requirement. Exclusions There are many standard policy exclusions as well as those relating to high risk issues such as partial disability, pollution, nuclear attack, "owned property", aircraft and liquor liability. The purpose of these types of exclusions is to limit the policy coverage to contemplated risks only. The burden of proving that an exclusion applies generally falls on the insurer in coverage disputes. Named Insured The definition of a "named insured" varies from policy to policy. Some define it in broad terms, while others insist on a more narrow description. Often, standard policy formats will provide a "listing" which has resulted in legal conflicts where coverage was denied a party on the listing who is no longer associated with the primary insured. The burden to prove continued association is with the insured. Assignments Conditions of most standard policies prohibit assignments without written consent of the insurer. Such provisions are enforceable because they ensure that the risk the insurance company agreed to insure remains the same. In fact, the majority of courts have refused to hold an insurer liable for an occurrence derived from a risk not contemplated by the insurer at the time the policy was issued. It is important to note, however, that prohibiting assignments does not bar the assignment of insurance proceeds. Rules of Construction The rules governing the construction of insurance contracts are usually the same as those for other contracts -- the policy language is to be interpreted given its plain and ordinary meaning. If a court determines that an ambiguity exists in an insurance policy, it will look to any outside factors or evidence that may help determine the parties' intentions. Where an ambiguity is not capable of resolution, most courts have construed the ambiguity in favor of the insured. Other courts have applied a "reasonable expectations" test and construed ambiguous policy language based on what a reasonable person in the position of the insured would understand the language to mean. Duty to Defend The prevalent view by the courts is that an insurer has the duty to defend an insured where the policy language gives the insured a reasonable expectation that the insurer will provide a defense. Standard policies employ language reading: the company shall have the right and duty to defend any suit against the insured seeking damages on the account of bodily injury or property damage even if the allegations of the suit are groundless, false, or fraudulent. Insurers maintain the position that they may be contractually bound to defend, but may NOT be bound to pay, either because its insured is not factually or legally liable or because the occurrence is later proven to be outside the policy's coverage. Coverage disputes are likely to develop and do, when an insurance company attempts to shield itself from any defense of an insured whatsoever, or when it withdraws from an action after it determines there is no basis for recovery. Other conflicts center around whether an insurer must defend only against an action that is a actual lawsuit seeking damages or be required to defend against all claims which may result in liability. In general, courts assume a connection between the filing of a complaint and the triggering of a duty to defend by an insurer. A PRP letter (Potentially Responsible Party), received by a client although not an actual claim, has also been interpreted by the courts to be a serious event that could, in fact, represent a new legal action against the insured. The duty to defend is typically established here, but not in the case of a simple demand letter which only exposes one to a potential threat of future litigation. If there is any doubt as to whether the facts give rise to a duty to defend, it is usually resolved in favor of the insured, but it is the insured's burden to show that the claims come within the coverage. Claims related to acts of an insured in the area of crime, sexual misconduct, wrongful termination, contractual obligation, loss of profits or goodwill etc., have been ruled unacceptable ways to 262

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INSURANCE MARKETING ISSUES force an insurer's duty to defend.

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Breach of Contract / Refusal of Coverage Breach of contract claims typically allege that an insurance company failed to defend or indemnify the policy holder under terms of the insurance contract. To a great extent, public policy supports the policy holder in most breach of contract allegations in an effort to solidify the "strict enforcement of insurance contracts". This is why state insurance regulators will typically be involved or called upon to rule on an insurer's potential or actual violation of codes. Many times, an insured is denied protection because the insurer knows facts which would defeat coverage. A majority of different courts have ruled that under such conditions, an insurance company is not bound to "defend" such claims simply because it cannot be bound to indemnify -- in essence, the duty to defend can be disputed. Here, the insurer has the burden to prove that the facts of the insured's claim fall squarely within a policy exclusion. Bad Faith There is increasing judicial recognition that the relationship between an insurer and its policy holder is fiduciary in nature. Courts have compared the relationship of an insurance company to its policy holder to that of a "trustee for the benefit of its insured". Where an insurance company allegedly has violated its fiduciary duties owed its policy holders a bad faith claim could be appropriate in addition to any breach of contract action. Choice of Law / Venue Choice of law and venue, where to bring a suit, have become integrally tied together in coverage cases. There is general agreement that insurance coverage issues are state law questions even though most insurance policies do not contain any choice of law provisions. Courts, however, have also made venue decisions based on issues such as 1) the place where policies were contracted; 2) the location of the damage and/or 3) the principal place of business/residence of the policy holder. Lost Policies Some claims between insureds and insurance companies have developed over the inability of the policy holder to prove coverage by producing an executed insurance policy. If a policy has been lost or destroyed, the policy holder must satisfy two requirements to prove coverage. First, the policy holder must prove that the policy was, in fact, lost or otherwise unavailable by showing that he made a diligent search for the policy in all places where it can likely be found. Second, the policy holder must prove the existence and the contents of the policy by identifying the parties to the contract, the policy period and the subject matter of the policy. Secondary evidence includes any correspondence, certificates of insurance, claim files, management reports, corporate records, ledger entries, receipts, licenses and agent files and agent testimony. Coverage disputes also evolve around the nature of damages or hidden exposures such as: Environmental Litigation There are numerous actions pending in state and federal court concerning the interpretation of commercial liability policies and environmental claims. Much of the confusion was started by the insurance companies themselves when they first marketed the 1966 standard form Comprehensive General Liability (C.G.L.) policy which represented coverage for environmental hazards. Some companies went so far as to refer to environmental problems, in their sales literature and presentations, as a "hidden exposure" that policy holders should consider. Agents were instructed to sell the new policy on the basis of its broadened coverage in the area of pollution which was then only a growing, but minor exposure. Since the 1960s, the Environmental Protection Agency (EPA) has contended with almost 300 million tons of hazardous industrial chemical waste leading to passage of the Superfund legislation which has obtained almost $4 billion in settlements from waste generators, disposers and transporters of hazardous materials. Similar pending litigation involves other forms of mass tort liability, including asbestos, DES and other substances. The generators, disposers and transporters of hazardous waste and product manufacturers, installers and sellers faced with mass tort claims all turned to their insurance companies for coverage, and insurance coverage litigation often followed. 263

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In response to a flood of litigation, the insurance industry began making adjustments. In 1973, certain terms in the C.G.L. policy were revised. For example, the 1973 C.G.L. policy defines "occurrence" as "an accident,, including continuous and repeated exposure to conditions, which results in bodily injury or property damage neither expected or intended from the standpoint of the insured." Obviously, an occurrence under the 1973 definition required exposure to conditions over a period of time. "Property damage" was also changed to read "physical injury to or destruction of tangible property which occurs during the policy period . . . or, the loss of use of tangible property which has not been physically injured or destroyed, provided such loss of use is caused by an occurrence during the policy period." Thus, compared to the pre-1973 contracts, "property damage" now requires physical injury to tangible property. This distinction may be critical in certain hazardous waste cases and in asbestos property damage cases. In fact, courts have held that some insurers are not required to provide a defense in suits where the there was no covered "occurrence" or "property damage" as defined in the C.G.L.. In the late 1970s and early 1980s, a number of carriers made even more dramatic moves by changing the "pollution exclusion" clause in their policies from the "sudden and accidental" variety to what is called the "absolute pollution exclusion". Although there are several versions of this exclusion, the basic thrust of each is to exclude coverage if the omission or discharge was accidental or sudden. Since most hazardous waste problems are sudden and accidental, the absolute exclusion appears to exclude most pollution incidents. A growing number of courts are siding with insurers where the absolute exclusion is in place. In these cases, most environmental exposure falls back to the insured and his own ability to cure the problem. The results can be devastating to a company, its owners and their respective estates. Excess Insurance Claims With the increase in mass tort litigation, environmental litigation and substantial jury awards, excess insurance policies and the role of excess insurance carriers have received increased scrutiny. In general, the fact that a primary carrier owes duty to its insured is well known. With respect to an excess insurer, the courts continue to struggle with the origin of duty. In coverage disputes where the insured is bringing action against BOTH a primary and excess insurer, the excess carriers sometimes moves to dismiss the lawsuit on the basis that the actual exhaustion of the underlying primary liability limits is a prerequisite to a claim under the excess policy. Policy holders, on the other hand, argue that the mere potential that the underlying insurance will be exhausted is enough to justify a coverage dispute against the excess carrier. The courts have sided with each. Another area of dispute is the drop down -- where an excess insurer "drops down" to provide insurance when the primary insurer has become insolvent. Courts are split on this issue, although a majority currently feel that an excess insurer is NOT OBLIGATED to drop down and provide coverage to an insured. The court's determination is usually based upon the language of both the primary and excess insurance policies. In yet another decision, the courts have determined that the "trigger" of excess coverage is the amount "indemnified", not the additional costs involved in defense nor punitive damages. In Harnischfeger v. Harbor, for example, the fact that the insured paid $3 million in defense and indemnity expenses could not yet trigger the $3 million excess policy limits because the legal expenses incurred were not a factor. Business Insurance Disputes In recent years, the number and variety of claims brought against business has increased significantly. In spite of this fact, many businesses have not given adequate consideration to the potential insurance coverage for these claims. As an example, businesses which face claims only against their directors and officers, might tend to ignore the possibility of comprehensive general liability (C.G.L.) insurance coverage. Likewise, when companies face claims of unfair business practices or statutory violations, they consider the bodily injury and property damage portions of their C.G.L. policies only, failing to consider the advertising injury and personal injury provisions, which may provide broader coverage. In one advertising coverage dispute, the court held that the insured was NOT covered by its C.G.L. policy because the insured failed to establish that its advertising activity caused the alleged injuries. The 264

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insured was selling a product that "infringed" on a competitor suggesting that the relationship of selling and advertising were the same thing. Another courts rejection of coverage involved copyright infringement. Here, an insured distributed brochures that merely advertised copyrighted material for sale. Directors and officers liability coverage typically insures the directors and officers directly and provides that the insurer will pay on behalf of or reimburse the directors and officers for "loss" arising from claims alleging "wrongful acts". Coverage is NOT afforded under this insuring agreement if the corporation is required or permitted to indemnify the directors and officers. Coverage has also been denied for claims involving dishonest conduct, claims in connection with the Employee Retirement Income Security Act (ERISA), claims involving bodily injury, personal injury and property damage as well as claims involving seepage, pollution and hazardous waste. In a "wrongful entry" claim, the courts first rejected the insured's coverage under his C.G.L. because the insured trespassed AND committed battery against a tenant. The courts ruled that actual damages resulted from the battery only. Later, on appeal, the court reversed its decision since it was determined that the battery could not have taken place if the insured had not trespassed. The trespass made the battery possible. Other, business insurance coverage exclusions occur under the following conditions: Liability under contract, willful violation of a penal statute, offenses relating to employment, libel and slander made prior to effective date of insurance or with knowledge that it is false.

Defenses of the Insurer

Much attention is devoted to the "rights" of policy holders. Insurance companies, however, have their own safeguards, which help protect their interests, but add to the growing list of things that can go wrong with insurance. Depending on the issue at hand, the result of having these "built-in" protections can completely void a policy or greatly limit its scope of coverage. Defenses consist of legal tools and techniques that help an insurer initially determine pertinent aspects of the insurance risk for purposes of deciding whether to issue the policy and at what premium. After a policy is committed, additional policy conditions help the insurer "contain" the risk within the intended bounds of the contract. Over the years, a series of standard defense devices have evolved. These can be categorized as concealment, representations of the insured, conditions, warranties and limitations to coverage. Concealment The insured has the duty to disclose to the insurer all material facts that might influence a decision to issue a policy of insurance at all, or issue it at a particular level of premium. The holding back of information can, in some cases, constitute fraud by the insured and can render a policy void. In general, the rule on determining when a policy is voided lies in the issue of "bad faith". If the insured withholds information that he knows would be necessary to the insurer in evaluating risk, the insurer has grounds to void the contract. Examples might include an life insurance policy where an insured has agreed to an examination by the insurer's physician but still fails to still to disclose a medical condition that is critical to the insurer's risk decision. The burden of proof as to fraud in concealment falls on the insurance company. In some cases, courts have sided with the insurer in establishing fraud by "inference". An example might be discovered evidence that the insured had made a previous attempt to destroy the covered building. On occasion, the insured has won based on the argument that facts uncovered by the insurer were not material because it was NOT made a subject by the questions asked on the application even though most applications include a provision requiring the insured to represent that he or she has disclosed all material information. Again, the issue of bad faith enters the picture. Only when the insured conceals a fact in bad faith, knowing the fact to be material, will the policy be voidable. An example is a life insurance application which contains a question as to how many times the insured has been hospitalized and for what causes. If the insurer describes one hospitalization but fails to mention a second, the 265

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incomplete answer is considered material and grounds for voidance of the policy. However, if the insured had left the answer blank or merely given a date without specifying the cause, the incompleteness would be obvious and NOT grounds for voidance. The test is whether or not the reasonable insurer would be misled. Once a contract of insurance becomes binding, the insured ceases to be obligated to disclose any material information. In the case of life insurance, for example, where there is an appreciable period of time between the submission of the completed application and the issuance of the policy, the duty of the insured to disclose new or forgotten material information continues. The duty to disclose applies only to facts, and not to mere fears or concerns of the insured about his health or the subject matter of the policy. There is also no requirement that the insured disclose facts that the insurance company already knows, or which the insurer has waivered. Nor, is the insured required to communicate events that are a matter of public record such as earthquakes, forest fires, etc. Misrepresentations A representation by the insured that is untrue or misleading, material to the risk, and is relied upon by the insurer in issuing the policy at a specific premium is considered a misrepresentation and grounds for voidance of the policy, unless the policy is beyond the incontestable period. This is true even if the misrepresentation was made by the insured innocently, with no intent to defraud. A minority of courts, however, take a somewhat less severe position limiting or prohibiting voidance where the insured's misrepresentation was NOT an intent to deceive the insurer. Representations by an insured to an agent bind a contract because they are considered to be made to the insurer itself. However, a policy refusal or voidance could occur when the insured has reason to believe that the agent will not pass information on to the insurance company. The insurer cannot void a policy based on a representation by an insured regarding an intention or future conduct unless it is made a condition of the contract. An example here would be an oral statement by an insured that he will install a fire alarm at the premises. The insurer relies on this representation and reduces the premium but does not include an express term in the contract regarding the alarm. On the other hand, a written commitment by an insured to install an alarm that is not followed can jeopardize the policy. Many insurance conflicts center around materiality. A representation is considered material if it served to induce an insurer to enter into a contract that would otherwise be refused or issued at a different premium. The point where representations by an insured cause coverage problems is where such representations are made with the intent to deceive and defraud. The burden of proving a representation to be material falls on the insurance company. If a material representation is found to be substantially correct, or believed to be correct by the insured, the courts have not permitted a voidance or limitation of coverage. An example might be an insured indicating he has not seen a physician within the past five years when he has been to a doctor for treatment of minor and passing ailments. Warranties & Conditions The terms warranty and condition are generally used to mean the same thing -- a representation or promise by the insured incorporated into the contract. A warranty or condition statement that is untrue and relied upon by the insurer at the inception of the policy can void the contract. A possible exception to this rule occurs in life insurance where an "incontestable clause" prohibits the insurer from voiding a policy after the insured has survived a given period of time -- usually two years. Thus, a valid warranty/condition is a powerful tool for insurers. In recent years, the effectiveness of warranties and conditions have come under fire. In fact, many statutes now place stiff definitions and limitations on warranties. One statute, for example, provides that all statements made by the insured will be considered to be a "representation" rather than a warranty unless fraudulently made. As previously discussed, it is much harder to void a policy for misrepresentation than for a violation of a warranty or condition. Another statute requires that the breach of warranty is a defense for the insurer ONLY if it actually contributed to causing the loss, as opposed to simply increasing the risk. This is the most severe type of statute for the insurer, since even is cases in 266

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which the breach caused the loss, it is frequently impossible to prove the cause, e.g., a fire completely destroys a portion of a building. Limitations on Coverage Insurers over the years have attempted to control their exposure by tightening terms of the insurance contract. Adding personalized warranties and conditions is cumbersome and not always useful as a defense for insurers (see warranties and conditions above). Some courts, however, believe that insurers side-step warranties and conditions by creating numerous clauses that serve, instead, to limit coverage. The reason insurers have do this is because many of the statutes which commonly limit warranty defenses, such as incontestability, "contribute to loss" statutes and "increase the risk" statutes, do not apply to limitations to coverage. There are several types of limitations that insurance companies can and do employ: Limitations of Policy Subject Matter -- A homeowner's policy may cover most household possessions in general, but specifically exclude from coverage particular items like cash or coin collections. Likewise a health policy may exclude or waiver certain illnesses. Limitations by Type of Peril -- A fire policy may except from coverage any loss caused by a fire resulting from lightening or earthquake. Limitations on Proceeds Paid -- Casualty insurance policies frequently specify an upper limit of proceeds payable for any loss, as well as limiting the payment to the value of the insured's interest in the property damaged. Automobile policies generally fix the upper limit of coverage both in terms of maximum proceeds per person and maximum proceeds per accident. Limitations on Period Covered -- Every policy will be specific as to the date of expiration, and in some cases, as with life insurance, will also specify a grace period beyond the date of expiration that insureds may make a premium payment. Also, the date of inception of a policy can be specified on the policy or can be subject to the occurrence of some event such as the payment of the first premium or delivery of the policy to the insured. A limitation on coverage can cause considerable conflict between insurer and insured. One reason is the fact that in some instances, it is nearly impossible to determine from the wording of a clause whether it is a warranty or limitation. In response, the courts have developed two tests to distinguish the two. In one test, if the circumstance which is the subject of the clause is discoverable by the insurer at the time of inception of the policy, the clause will be classified as a warranty rather than a limitation. An example might be a policy condition that obligates the insurer when the policy is delivered to the insured "in good health" when, in fact, the insured is suffering from a discoverable disease. Another test deals with risk. If a clause refers to a fact which potentially affects risk, but necessarily causes the loss, it is considered to be a warranty not a limitation. An example is a life insurance policy with a provision that excludes a death benefit WHILE the insured is flying in a private plane. The insured can bring action to force payment of such a claim, EVEN if the insured died of a heart attack while in a private plane. The flying merely increased the risk, but need not be the actual cause of death. Such a clause is considered a warranty. On the other hand, if flying in the plane was the cause of death, it could be interpreted to be a limitation that is better defended by the insurance company.

Settlement Disputes
Some forms of insurance, like life insurance, are generally settled with ease since the amount paid in the event of loss is fixed by the contract. Similarly, in the case of accident insurance, the proceeds are measured by a specific amount agreed to be paid for loss of a particular limb or faculty, or, as in the case of health insurance, by the medical expenses actually incurred. By far, most settlement disputes occur 267

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over property/casualty policies where the payment in the event of loss is determined by an amount up to the "actual cash value" of the property at the time of loss. There are two basic approaches which insurance companies use in an attempt to arrive at a mutually agreeable value -- reproduction costs less depreciation and market value. Reproduction Cost Less Depreciation This measure is aimed at determining the cost of replacing the exact depreciated property that was lost. If this were the only option for insureds, it would represent an extreme hardship where, for example, the owner of a fifty-year old home that is destroyed would have great difficulty replacing it with a new building on the depreciated settlement, For this reason, replacement cost insurance is offered. Here, depending on the wording of the contract, the insured may be required to actually repair or replace the building in order to collect full payment. The most pressing problem for insureds is to keep policy limits above the 80% of market value requirement. Insurance companies require policy limits above this level to assure adequate coverage and keep premium levels high. Insureds may lose, however, if inflation and rising house prices cause the limit of coverage to wind up below the 80% figure at the time of loss, thereby nullifying the replacement cost provision. Market Value Items of commerce that are readily replaceable in kind, e.g., a warehouse full of books, shipments of grain, etc., have a market value that is relatively easy to establish. In the case of income producing property such as office buildings, apartments or commercial buildings, market value is determined by a more detailed method using the capitalization of earnings. Disputes in this area usually require testimony of an expert witness who determines the rate of return on investment that a reasonable investor would require in investing in this type of property.

Insurer insolvency
An agents or clients greatest fear would be realized when a perfectly good policy fails because the company behind it cannot pay. When a state determines that an insurer is in trouble, the insurance commissioner usually files an application to the court. The court petitions the insurance company to show cause why the company should not be placed in rehabilitation or liquidation. Once a company is placed under supervision, an injunction is issued to restrain the insurer, its officers, agents and others from any disposition of property without court approval. Liquidation is the more severe condition where the insurance commissioner must take title to the insurer's assets and use them to pay creditors and policyowners. Rehabilitation, on the other hand, allows for a restructuring of the insurer under the guidance of the commissioner. Unless the condition is extremely severe, companies are usually started in rehabilitation. If it is later determined that a restructuring will still not revive the insurer, a liquidation is ordered. If an insurer is liquidated, all policy owners and other potential claimants MUST be informed and permitted to file a proof of claim with the insolvent estate. These claims will then be evaluated and a value established. Recent failures have demonstrated that claim values can be less than the amount due the policy holder. Under these conditions, a policy owner can file an appeal and seek a court decision before the actual liquidation of the company occurs. In order to protect the overall insurer estate, there are time limitations for filing these appeals. Once all appropriate values are determined, the assets of the insurer will be distributed under a statutory procedure. This process requires that certain priority lien holders be paid in full, while others may divide what is left. The typical liquidation order of priority is as follows: 1. 2. 3. 4. 5. Liquidation expenses and costs Unpaid wages of employees of the insurer Taxes Policy holders, insureds and guaranty funds Reinsurers and all other claims 268

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If a reinsurer indemnifies a liquidating company, it is only required to pay to the liquidator the actual loss it indemnifies. In other words, the reinsurer can only be called upon to pay deficiencies up to the limit it has agreed, once the ceding company, the liquidating insurer, has made all possible payments. This provision, which appears in most reinsurance contracts, is called an insolvency clause . The disadvantage of an insolvency clause is that policy owners, guaranty funds and other third-party claimants have no additional claim against reinsurance proceeds. An exception to this rule is where a cut through clause exists. A cut through endorsement would require a reinsurer to pay a loss or specified portion of a loss directly to the policy owner or insureds when an insolvency or another specific event occurs. General creditors and other third party claimants could be excluded under a cut through endorsement.

State Guaranty Funds

The liquidation of a troubled insurance company can be extremely involved and lengthy. This is the reason that guaranty funds were established. They are an advance payment system to pay off individuals and groups who would be devastated by the liquidation process. Yet, they may still not fully restore a client or move fast enough to replace lost coverage because they have many exclusions, limits and triggers that are not widely known. Generally speaking, a claim against a state guaranty fund is typically limited to residents of that state. Payments are limited to certain amounts, depending on the type of insurance purchased. Once a claim has been paid, the guaranty association becomes subrogated to the claimant's rights to further payments. Thus, a policy holder who collected from a state fund forfeits his claim rights against the insolvent insurance company. Exclusions In general, guaranty acts exclude from coverage policies issued by entities that are not regulated under the standards applicable to legal reserve carriers. Insurance exchanges, assessment companies, fraternals, HMOs and, in many cases, the Blues (Blue Cross and Blue Shield -- especially where they have not been converted to legal reserve carriers), are commonly excluded. The guaranty laws also commonly exclude from coverage policies or portions of policies under which the risk is borne by the policyholder or which are not guaranteed by the insurer. Variable accounts in some life policies or annuity contracts are examples. Significant variation does exist in the treatment of unallocated funding obligations (UFOs), including GICs, which are commonly purchased as pension plan assets on professional, sophisticated advice by pension plan trustees. Limits of Protection Most guaranty associations limit their protection to policyholders who are residents of their own state. (It does not matter where the policyowner's beneficiaries live.) The trend toward adopting such a residents-only provision follows a major amendment to NAIC's model guaranty act adopted in 1985. Arizona, Virginia, West Virginia, Nevada, North Carolina and Oregon very recently amended their life-health guaranty laws to cover only their own residents. However, if the insolvent insurer's domiciliary state follows the NAIC model, coverage would be extended by the domiciliary state to residents of another state if that state also has a similar guaranty act and the impaired company was not licensed there and the policyholder is not eligible for coverage there. An example of such a situation would be a New York resident who owns a policy of the Executive Life Insurance Company, which is domiciled (chartered) in California. Since New York has a life-health guaranty association but the company was not licensed to do business there, New York residents will be covered by the California Life Insurance Guaranty Association. However, residents of a jurisdiction such as the District of Columbia which does not have a life-health insurance guaranty association would have no guaranty association protection, even though Executive Life was licensed there. Other states, like Alabama, still follow an older model act and guaranty benefits of impaired or insolvent 269

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insurers domiciled in their own state, no matter where the policyholders live, and also cover their own residents who are policyholders of licensed companies domiciled in other states, unless coverage is provided by the state of domicile. Dollar Limits As we have discussed in an earlier section, typical pay outs to policyholders who are victims of failed or financially strapped insurance companies might range from $100, 000 to $300,000 for life and health policies and from $300,000 to $500,000 for casualty failures. Individuals who have several policies may have additional limits. For example, a person who owned a term life insurance for $500,000, a whole life policy with cash values of $150,000 and a single premium annuity with an accumulated value of $200,000, will collect ONLY $300,000 -- the maximum aggregate limit per person regardless of how many policies. The fact that these policies may be spread among three different insurers does not make any difference. There would still be a $300,000 maximum in most states. The same is true for property/casualty claims. Regardless of the number of policies or how they are distributed among different insurance companies, the maximum claim that can be paid by a state guaranty fund is fixed at between $300,000 and $500,000 per individual. Triggers Generally, guaranty associations provide coverage when the company has been declared financially impaired or has been ruled to be insolvent by a court of law. However, there are some situations preceding such a judicial action when many associations may take measures to cover the impaired insurer's policyholder obligations, particularly for health benefits, death benefits, and immediate annuity payments. However, since the primary purpose of the guaranty associations is to protect policyholders, and not to bail out impaired or insolvent insurers, most associations are reluctant to provide coverage before an order of liquidation, unless it is clearly demonstrated that to do so in a particular case will be less costly over time. Coverage Options Guaranty associations may provide coverage directly, or through outside administration or other insurance companies. In many cases, the guaranty association will continue coverage for the full policy period. It may do this directly or it may transfer the policy to another insurer or administrator. In multi-state insolvencies, most guaranty associations work through NOLGHA to secure an assumption reinsurance agreement with another insurer or a claims servicing agreement with a third party administrator on a multi-state basis. If the impaired or insolvent insurer is licensed in more than one state, as most are, NOLHGA's affected member associations try to work closely through our Disposition Committee with domestic receivers to protect policyholders and insure early and equitable access of guaranty associations to the insolvent company's assets. On behalf of its participating member guaranty associations, NOLHGA's Disposition Committee expedites reinsurance assumptions, claims processing and audits.

Asset Protection Planning

Better Client Protection or Lost Insurance Sales
Some may think of asset protection as doomsday planning, but every agent who has spent time in the business has a file on cases where expected coverage was lost or reduced due to limits, exclusions, warranties, preexisting conditions or any one of the reasons presented above. Attorneys who routinely sue agents and insurance companies also have a file. But their cases are different. They feature smart and financially secure people who dutifully purchased insurance yet lost everything over a technicality or unforseen claim beyond the scope of the policy. Seeing problems like this day after day, it is no wonder that some in the legal profession may have a hard 270

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time advising a client to insure up. Rather, they are encouraging their clients to supplement basic insurance coverage with legal entity planning or, more simply put, asset protection. While it doesnt appear to be a watershed, a limited number of insurance sales will likely be lost to asset protection planning. Then again, there is cause to consider that both insurance and asset protection are closely linked in providing a higher level of client protection. Knowing this, it may serve the clients best interest for an agent to associate with a competent asset protection attorney and know when to refer.

Legal Protection Theories

There are as many legal techniques that form the basis of asset protection as there are forms of insurance. The nucleus of these strategies, however, is focused on specific principles of legal theory. Here are a few to consider:

Free Alienability of Property

Our common law system favors the free alienability of property. In essence, this theory concludes that one who is free from creditor concerns is absolutely free to dispose of his property as he sees fit. This may include gifts to children, a spouse or a transfer to a trust. Clearly, asset protection planning is not an excuse to defraud creditors or evade taxes. Furthermore, fraudulent conveyance laws generally protect present and subsequent creditors from transfers of assets made by a person who is or foreseeably will become their debtor. In essence, asset protection should be viewed as a vaccine, not a cure. And, like a vaccine, it should be administered before a problem . . . when the legal waters are calm . . . for best results.

Whole vs Sum of the Parts

One of the basic premises of good asset protection is the legal assumption that "the whole is worth more than the sum of the parts". This issue takes on more meaning with the knowledge that most asset protection planning involves the intentional "breaking up" of large ownership blocks into much smaller blocks, each with its own title and life. The force and effect creates a smaller "target" for a plaintiff or large creditor to pursue. It has long been a fundamental legal tenet that small, individual ownership can lead to better protection of assets because a third party interested in laying claim to a client's assets will consider a fractionalized interest to be worth far less than a whole. The common sense of this issue prevails: A creditor or high ticket insurance claimant, will factor in the cost, time and effort needed to force the sale of a single block of assets, under one ownership, in contrast to the much higher cost, time, effort and delay to retrieve multiple, variously titled assets. Further, in the case of some fractionalized assets that have been planned properly, there is no hope of the third party actually acquiring the asset. Rather, he would have to settle for the right to any income or benefits that might accrue form the fractionalized interest. For most, the thought of being in business with other fractionalized owners who are, for the most part, at "odds with the third party", will be a distressing issue to overcome. In such cases, third parties may be completely discouraged from pursuing such an action. This is an important element of asset protection to keep in mind when studying the forms of ownership that follow.

Choice of Governing Law

In the United States, individuals generally have the freedom to select the law that will govern a business transaction. Examples include the use of Delaware or Nevada corporate law by a company domiciled in California. Choice of law principles likewise allows a grantor of a trust to set up a trust that is governed 271

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by the laws of his or hew home state or any other state. Taken further, there is no reason to limit one's choice of law to a particular state, the fifty states or any one foreign country when a world of governing laws is available. Factors to consider when choosing a governing law include the tax laws of the jurisdiction, whether laws are more favorable and protective, the political and economic climate of the jurisdiction, language barriers, telecommunication facilities, etc.

Free & Clear vs Encumbering

The old school thinking -- owning "free and clear" -- is not always the best way to protect assets. By owning property free and clear, one is exposed to the potential for a large loss. In the case of real estate, a large earthquake can demolish property. Similarly, a sizeable judgment from a lawsuit can take property away. Some asset protection attorneys suggest encumbering or highly leveraging property (loans) to such an extent that a creditor will lose interest in pursuing it.

Conventional Forms of Protection Are Losing Ground

The new school of thinking is that traditional methods are not working like they used to. The corporate veil is seemingly more pierce- able than ever. Further, the concerns with insurance coverage exist on three fronts: insolvency of the carrier, the willingness to continue coverage and exclusions such as punitive damages and gross negligence of associates.

Problems With Legal Entity Protection

Most asset protection programs involve the use of holding entities designed to isolate liability and thus contain exposure. Of course, good attorneys and financial advisors will admit that these measures are not foolproof. And, critics also point to volumes of law known as fraudulent conveyance which can void a transfer of property if it is done without adequate consideration and with intent to avoid creditors.

Fraudulent Transfers
An example is a situation where a person hastily transfers title of a property to another family member to avoid creditors. This is not the ideal form of protecting assets. In fact it is called the "poor man's asset protection". Creditors are usually able to prove that a "fraudulent conveyance" occurred. Or, courts determine that the debtor failed to cut the strings by retaining benefits or control over the property. In either case, the creditor may proceed against the debtor and void the transfer of property. For this method to have a chance, it must be used in the true context of "gifting" and be consistent with goals of the client (planning for college or an estate). The intent should be to have little control over the gifted asset. Broadly speaking, a fraudulent conveyance is defined as a transfer of property without adequate consideration and with the intent that the transferee will hold the property for the benefit of the transferor, returning it when requested, so as to defraud creditors who could otherwise seize the property in payment of their debts. If a transfer is found to be fraudulent, it can be made "null and void" by a court of law. In essence, the law is not so naive that it will allow a person to avoid the payment of legal debts simply by making a "gift" of his property to another family member or a friend. Fraudulent conveyance laws protect present and future creditors against transfers of property made with the intent to hinder, delay or defraud them. Intent In general, if the courts determine that a debtor has a particular creditor or series of creditors in 272

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mind and is trying to remove his assets from their reach, his intent is "fraudulent" and could be grounds to allow a judgment to proceed or discharge a bankruptcy. If the debtor is merely looking to his future well being, the transfer would not be fraudulent.

Fraudulent conveyance rules are directed at individuals who attempt to make themselves appear insolvent by transferring away all or most of their assets at the last minute. Creditors today are not so easily fooled. Planners suggest that advanced planning where assets are transferred for reasonable reasons, such as estate planning, long before a judgment lawsuit is the best remedy. When this cannot be done, asset professionals suggest legal transfers to entities such as family limited partnerships and corporations. Fraudulent conveyance may be avoided here because there is no loss of value. The final entity may not be reachable by creditors. ALWAYS CHECK WITH A PROFESSIONAL BEFORE MAKING OR ADVISING ANY ASSET TRANSFER DECISIONS.

Timing of Claim Specific bankruptcy laws provide that every transfer made and every obligation incurred by a debtor within one year prior to the filing of bankruptcy is fraudulent. Fair Consideration In general, a transfer of property by a debtor is considered fraudulent if the conveyance is made without receiving reasonable consideration in exchange for the property. In essence, the transfer is a sham to avoid creditors. Threat of Claim To constitute a fraudulent conveyance, there must be a creditor in existence or the debtor feels there is a threat of claim from a current or future creditor. However, where the creditor is not in existence at the time of the transfer there must be evidence presented by a damaged creditor that there was still fraudulent intent. An example might be the physician who systematically transferred assets out of his name because he was unable to secure malpractice insurance and, at the same time, restricted his practice to less risky medicine. Courts held that the doctor acted prudently to protect his assets from future, unforeseen adversity where malpractice insurance was not available. Here, future "victims" of the

The Statute of Limitations for fraudulent conveyance in most states range from two to six years. For a bankruptcy, a transfer can be set aside if it is made within one year preceding the filing and it is considered fraudulent.
doctor's medical malpractice were not identifiable or known, individually or as a class. Further, as long as no evidence proved that the doctor intended to commit malpractice, the transfer of assets was NOT legal fraud. Debtor Solvency The solvency of a debtor is another factor used by the courts to determine fraudulent 273

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transfer of property. Cases where legal fraud were proved include situations where debtors were "head over heels" in debt just prior to transferring assets or where the debtor transferred assets knowing that the business venture he was starting or operating was highly speculative or financially hazardous. In other words, the courts will rule fraudulent conveyance where the debtor's objective is "If I succeed in business, I make a fortune . . . If I fail, my creditors will bear the loss". Obviously, there are many facts that can determine the fraudulent nature of transferring assets. As a result, there has been significant federal and state legislation that control this area of law, each with corresponding criminal and civil penalties.

Creditor Access
Besides suspicious transfers, creditors have many opportunities to seize or access property and/or income based on the clients existing holding entity. Following is a short list of their rights by the type of ownership entity: Joint Tenenacy There are many ways that creditors can reach a joint tenancy. In the case of a dwelling, a creditor attempting to reach the interest of a joint tenant can cause ONLY the interest of the debtor to be sold. This compares with community property in that the creditor can force the sale of the entire dwelling to satisfy payment. For most other property, the general rule is that the creditor can acquire the interest of the debtor. However, if the debtor is a joint tenant, the creditor forces an end to the joint tenancy and he or she becomes tenants in common with the remaining joint owners. In essence, holding title as joint tenants carries little creditor protection since creditors can attach a jointly held interest and petition the court to "partition" or divide up the property. If it is property that cannot be divided, creditors can ordered it sold to receive the debtors share. Tenancy in Common In the case of a dwelling, a creditor attempting to reach the interest of a tenant in common can cause ONLY the interest of the debtor to be sold. This compares with community property in that the creditor can force the sale of the entire dwelling to satisfy payment. For most other property, the general rule is that the creditor can acquire the interest of the debtor. And as a tenant in common, the creditor can force a sale of the common asset. For this reason, it is important to select co-tenants who appear to be relatively free from financial problems. Community Property The general rule is that community property is liable for debts of either spouse during the course of the marriage. Obligations incurred prior to the marriage or after a separation or divorce are consistently treated as the separate obligation of the spouse incurring the debt. Whether a spouse contracts for individual benefit or for the benefit of the community property is irrelevant. A creditor's ability to reach marital property is not effected by the purpose for which a spouse contracts. If a debt that is a joint obligation of a husband and wife, the community property together with the separate property of each spouse will be liable for the debt. A spouse who pays a single payment on behalf of the other spouse is said to have granted "apparent authority" to the other spouse to contract joint debts. The spouse who paid the bill may be held liable for subsequent debts incurred by the other spouse. A spouse who wishes to avoid such joint liability should make clear to the other spouse and any creditors that said spouse incurred this debt and acted without 274

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his or her authority or consent, or that the payment being made on behalf of the other spouse does not constitute authority for the other spouse to make future contracts that might obligate the paying spouse. Partnerships In general, the assets of a partnership are not available to a creditor of a partner on a personal debt of the partner. In practical terms, a creditor must only look to the debtors share of partnership proceeds AFTER the partnership has been dissolved and debts of the partnership paid. Alternatively, the creditor can look to attach the debtors profits and surplus from the partnership. This is called a charging order. It does NOT make the creditor a partner. The charging order is intended to protect partners of a partnership that having nothing to do with the claims of creditors of the individual partner.

The transfer of property to a partnership or corporation by a debtor does not in itself prejudice or harm the rights of a creditor. Many courts agree that it is the absolute right of debtors to organize their personal business into corporations or other legal entities. And, as long as these entities continue to be run there is no automatic trigger of creditor fraud C especially where the debt is small in comparison to the value of the property transferred. AGAIN, ALWAYS CONSULT A PROFESSIONAL BEFORE TRANSFERRING ASSETS. ASSETS

A charging order is obtained by the creditor by making application to a court which then charges the interest of the debtor partner with payment of the unsatisfied amount of the judgment. The court may then or later appoint a receiver of the partner's share of the profits, and of any other money due or to be due him from the partnership. If a charging order fails to be an available remedy, the courts have allowed the foreclosure sale of a partner's interest. At a foreclosure sale, only the partner's interest, not specific assets of the partnership, are sold. It is unlikely, however, that a partnership interest will bring a high price from third parties. If the creditor becomes the purchaser, and until the dissolution of the partnership occurs, the creditor will still be entitled to only receive the partner's profits. Corporations In general, creditors of the corporation can proceed only against the assets of the corporation and not ordinarily against the stockholders, officers, directors, agents or employees of the corporation. Exceptions to the above rule include where parties in the corporation have personally guaranteed some form of corporate obligation; where employees of the corporation have been negligent or have committed a wrongful act; where officers have not paid withholding taxes or similar taxes; where specific fiduciary violations can be determined. Legal advisors are split on the issue of creditor rights against an incorporated sole practitioner. Some assess the "key person" rule in support of complete liability. Others argue that many lawsuits are derailed simply by the existence of a corporation. In many instances, the obstacles that must be hurdled to gain access to a debtors partnership interest help shield a partner from all but the most determined creditors. Limited Liability Companies (LLC) In an LLC, no one has personal liability for the debts of the 275

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partnership. All members of the LLC are liable to creditors ONLY to the extent of their investment in the company Trusts In general, unless there are restrictive provisions in the trust spendthrift verbiage, a beneficiary's interest may be attached by his creditors or the beneficiary may sell his interest. Creditors have also gained access to trust assets when the following conditions exist: The trust was funded as a result of a fraudulent conveyance The settlor of the trust retained too much control over trust assets The settlor retained too much of an interest in the trust The trust is illusory (trust is non existent or a sham)

Exemption Planning
Exemption planning takes advantage of known "safety nets" already built into the law to help place certain kinds of assets beyond the reach of creditors. Most exemptions must be filed or claimed. If not, they are considered waived. Civil Codes Certain civil code sections offer exemption protection from creditors. They might include payments made for child support, spousal support and family support. The Homestead Homesteads are claimed on the principal dwelling of the debtor or the debtor's spouse. A declaration of homestead can only be made for a residence that is real property, not a houseboat or mobile home. This exemption may also be carried over where the proceeds from a formerly homesteaded dwelling are used to purchase a new dwelling within six months. The amount of a homestead exemption is a minimum of $50,000. This can be increased to $75,000 for a family dwelling and up to $100,000 for certain elderly, disabled or low income dwellers. An owner or his spouse may declare and record a homestead. Personal Property There are many articles of a personal and business nature that are exempt from creditors. A partial list includes: Personal Possessions Items such as health aids, jewelry ($2,500), household furnishings (appliances, clothing and other items determined to be "ordinarily and reasonably necessary"), cemetery plots and motor vehicles ($1,200). Business Property Tools, equipment and vehicles necessary to earn a living are exempt up to $5,000 ($10,000 for husband and wife). Life Insurance & Annuities Both are exempt without filing. This means a creditor cannot force a policy holder to cash-in his policy. However, a debtor can be forced to borrow against the policy. The first $4,000 in loan value is exempt ($8,000 for a husband and wife). If a policy matures, the proceeds are exempt to the extent that they are reasonably necessary for the support of the debtor. his spouse and dependents. Health Insurance Benefits from a disability or health insurance policy are exempt without filing (does not apply if the creditor is a health services provider). Retirement Plans In general, state laws protect most private or public retirement plans, IRAs and Keoghs from creditor claims unless they have exceeded their contribution limit or are needed for child or spousal support.

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Retirement plans that meet ERISA guidelines (at least 50 employees, etc) that contain approved anti-alienation or spendthrift language are generally safe from creditors. Selfemployed or small business owners, who open their own private ERISA type plans may not have creditor protection. In essence, ERISA plans are intended to cover employees. The owner or partner of a business is not really an employee under strict ERISA guidelines. Thus, non-ERISA plans may provide better creditor protection

Personal Injury or Wrongful Death Damage Awards to support the debtor and his family.

Most are exempt to the extent they are needed

Bankruptcy Filing bankruptcy is another method of exempting assets from creditors when necessary. It is important to note that there are federal AND state bankruptcy codes. A federal filing alone may NOT exempt debtors from state creditors. Well known types of bankruptcy filings include: Chapter 13 allows an individual under court supervision and protection to develop and fulfill a plan to pay his or her debts in whole or in part over a three year period, but it can last another two years. Chapter 11 is a version of Chapter 13 for businesses. Chapter 7 is a complete discharge of debts. Assets are liquidated to satisfy creditor claims. Miscellaneous Exemptions Paid earnings, Veteran's benefits, unemployment benefits, workers compensation payments and college financial aid are exempt. Medicaid / Medi-Cal Planning A huge portion of our senior population has been caught off-guard. Their longevity combined with escalating costs of long term care has created a need to try and capture the benefits of Medicaid through exemption planning. If they dont, a reasonable stay in a nursing home could impoverish their entire estate. It is a small wonder, then, why these people have turned in record numbers to lawyers and financial advisers to find Medicaid loopholes -- ways to divest themselves of income and assets in order to qualify for Medicaid. The process by which medical and nursing home care reduces a persons assets is known as a spendown. In the case of Medicaid, some have referred to it as the path to poverty. In essence, a person cant get assistance from Medicaid until virtually all assets are depleted. Certain assets are considered noncountable or exempt. They include: a house used as a primary residence. a care for transportation to work or medical services a wedding ring a cemetery plot household furniture 277

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cash surrender value of life insurance under $1,500 real property if it is essential for support (land to grow food) or it produces income for ones daily activities. Assets that are countable vary from state to state. California lets the recipient keep about $2,000 in liquid assets. The general rule is, if the prinicipal of the item can be accessed (even if it cost a penalty to get), it counts as an asset for Medicaid purposes. Here is a short list of what counts: cash, CDs and money market accounts stocks, bonds, mutual funds treasury notes and treasury bills vacation homes and second vehicles cash value life insurance and deferred annuities revocable living trusts

Medicaid rules do not also require the immediate impoverishment of a spouse. But, the limits of what can be kept may mean a lower quality of life than what he or she is accustomed to living. In addition to exempt assets like a house, car and burial plot, the amount a spouse can keep varies from state to state. The maximum in California is $80,760. The amount that can be kept is determined by adding ALL available assets of BOTH husband and wife. If one-half of the total does not exceed the amounts above, the spouse can keep them. The rest must be sold and used to pay any medical bills before Medicaid will participate. In addition to asset criteria, there are guidelines for income. Generally speaking, for a person to be eligible for Medicaid he must spend all his income -- Social Security, pensions, interest, dividends, and so on -- on nursing home care before Medicaid helps. In other states, the income restrictions are severe. Income is capped at around $2,000+ per month, even if all assets are spent down and even if this income doesnt cover the cost of the nursing home. All of these guidelines and limits are a clear reminder that Medicaid and Medi-Cal benefits are supposed to be for low income individuals.

Offshore Protection
The most aggressive protection strategies involve the use of foreign trusts, offshore corporations and offshore banking. Certain foreign jurisdictions do not recognize the judgments of US Courts. To reach assets held offshore it may be necessary for the creditor to retry the claim in the foreign jurisdiction. This would require hiring local attorneys and have witnesses, exhibits and other evidence be presented in the foreign court. The costs associated with such an action may deter a creditor from pursuing the debtor further. One method of obtaining this protection is through the use of a foreign trust. Typically, the trust is located in a jurisdiction with laws favorable to judgment debtors. This means that a very short statute of limitations for fraudulent conveyance and a very high burden of proof for creditors to overcome. A duress clause is added to the trust which makes the trust irrevocable in case of a lawsuit or threatened asset seizure. In the event that a creditor attempts to have the foreign court assert jurisdiction over the trust, a clause in the trust agreement provides the power to move the trust to a new jurisdiction. Additional protection can be obtained by creating an offshore corporation. This corporation would achieve greater confidentiality and protection through the use of nominee officers, nominee directors and bearer shares. The corporation would hold title to bank accounts, brokerage accounts and other 278

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investments. The bearer shares would be controlled by the offshore trust. The offshore corporation would typically be formed in a jurisdiction other than the location of the foreign trust. Offshore bank accounts are another method of using offshore protection. Accounts are typically opened in a country with strict bank secrecy laws and with modern communications and financial facilities for quick transferability. Many of these accounts can be linked to time deposits, debit card services and even financially secure mutual funds and other securities. Despite all the advantages that offshore protection appears to offer, it is not cheap. Only the most sophisticated and wealthy can justify these strategies. Properly implemented, however, an offshore structure can result in the most comprehensive and effective asset protection available.

Multi-Entity Protection
Asset protection professionals have discovered that, like insurance, there are many approaches to legally solving a clients exposure. Offshore trusts, the subject of the last section is one option that can represent an extremely strong defense. For most, however, more affordable and manageable stateside techniques, using a multi-entity approach, are gaining favor. The multi-entity planners arsenal may consist of a combination of two, three or four of the entity methods to achieve added wealth protection in conjunction with and beyond insurance. A coordinated approach can have, as a goal and outcome, many advantages: The preservation of assets from liability claims The lowering of the taxable value of an estate Reduction of current income tax liability Facilitate charitable gifting while keeping a legacy intact

Following are the entity structures involved:

The Limited Liability Company

The Limited Liability Company (LLC) is a hybrid business entity which has similar characteristics to both a Corporation and a Limited Partnership. The LLC is formed by at least two partners which can be any combination of one or more individuals and/or one or more legal entities. An LLC is structured much like a Limited Partnership in that the Managing Member controls the financial organization of the company much like the General Partner of a Limited Partnership. The Members are the silent business partners who have no control over the management of financial affairs of the company but have a right to distributions (on an annual or other basis) of any income or loss of the business. The LLC has been an available business entity in the State of California since September, 1994 and is much in demand and is thought to be the most advantageous way to structure and operate a business in America today. From an asset protection standpoint, the LLC is the recommended way to operate a business (Note: Businesses requiring professional licenses cannot use LLCs, but can use a related statue called a Limited Liability Partnership, (LLP). The reason for this is that you, as the business owner, will not be personally liable for any of the debts or obligations of your business. Therefore, a catastrophic lawsuit or IRS tax lien will not necessarily expose any of your personal assets to the liabilities of the business.

Corporations
The most traditional way to operate a business in America is to structure your business as a Corporation. 279

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Essentially, the Corporation is a business entity which is formed by filing Articles of Incorporation with the State in which your business is operating. The Corporation is formed by the Incorporator who files your Articles of Incorporation. Thereafter, an original Shareholder Meeting is held and a Board of Directors is selected. Thereafter, the Board of Directors selects the Officers who will actually operate the day-today operations of the company. In California, for example, one person may be the sole Shareholder, sole Director and sole Officer of the company. The downfall of the corporate format in some states is that the courts have indicated that if it is inequitable for the business creditor, they will not allow the corporate veil to protect your business or personal assets for your creditors. In essence, then, if your Corporation is sued or has an IRS problem, not only are all of your business assets completely exposed to the business liability, but your personal assets could also be completely exposed through the business liability.

The Family Limited Partnership

Asset protection planners say that the most preferred way to own personal after-tax assets is through a Family Limited Partnership (FLP). The FLP is a partnership format which requires at least two partners, like the LLC. The FLP generally will own all personal assets such as the family residence, stocks and bonds, mutual funds and other types of investments. The general purpose of the FLP is to protect your personal assets from creditors. The FLP operates by virtue of the Uniform Limited Partnership Act which states that no creditor of yours can pierce your FLP and obtain assets held by your FLP. The only remedy that a creditor of the FLP has is to either receive an assignment or foreclose upon the individual/debtors Limited Partnership share utilizing a court procedure known as a charging order. The charging order entitles the creditor to become an assignee of the Limited Partnership share held by the debtor/partner. However, the great benefit of the Limited Partnership is that the General Partner (the client) does not have to make any distributions of income or other assets to any Limited Partner(s) through the course of the year. In spite of the fact that the General Partner never has to make distributions, the Limited Partners are responsible for paying all the taxes of the partnership. Therefore, if a creditor obtains a charging order or forecloses upon a Limited Partnership interest, that creditor will have to pay their proportionate share of the taxes that they have foreclosed upon or have received via a charging order. In view of this unique capability, the FLP is the best asset protection tool that can be utilized to protect your assets. An additional benefit of the FLP is that from an estate tax perspective, the IRS will allow discounts of between 15%-40% of the value of assets held in the FLP. This is the equivalent to reducing your estate tax exposure by that percentage upon your death. One of the most frequent questions about establishing family limited partnerships is how to unwind them. There are four basic ways to get assets out of the Family Limited Partnership: First, you may make pro-rata distributions from your Family Limited Partnership to the partners. Distributions will flow from the assets of the Family Limited Partnership to you or to your Revocable Living Trust, which would be recommended. Second, your Family Limited Partnership may pay a management fee to your Corporation. The amount of the management fee is determined by you and the terms of this fee can be very flexible. Income from that fee can be used to pay a variety of corporate expenses such as salaries, employee benefits, retirement plans, etc. Third, your Family Limited Partnership can loan money to you, your spouse, or other family members. Repayment of the loan is effectively repayment to yourself. Fourth, the Family Limited Partnership is totally revocable by you, your fellow shareholders and Limited Partners at any time. In the unlikely event that you would ever need to dismantle and revoke the Family Limited Partnership, the Corporation or the Trust, it simply takes unanimous vote by you and your spouse to do so. If this happens, title of your assets can be transferred back to your direct 280

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The Revocable Living Trust

One of the most underrated legal documents which should be prepared for almost every family or individual is the Revocable Living Trust. Most people are not aware of the fact that if they have only a Will, or if they have no planning documents in place, that upon their death the probate court obtains jurisdiction of all their assets. Therefore, upon your death, your heirs would have to hire an attorney and file a petition in probate court to transfer your assets if you do not have a trust. The major problem with the probate process is that it takes anywhere from twelve (12) months to twenty-four (24) months to probate even a $200,000 estate. In addition, there are probate fees which can range anywhere from 3% - 10% of the gross value of your estate. Accordingly, your heirs may end up paying hundreds of thousands of dollars to acquire title to assets which are legally theirs to begin with! In view of the above, the implementation of a Revocable Living Trust is an essential to any estate protection plan.

Multiple Entity Structuring In Action

A possible structure for both business and personal affairs might utilize a Limited Liability Company to operate an existing or new business. The LLC is for the most part a marketing company. It enters into contracts, employs individuals, and generally absorbs all of the liability of the business. The LLC is operated as a shell; it owns no assets. The purpose for utilizing the LLC as a shell company is that if the LLC has creditor problems or is sued then it can file for bankruptcy protection and a new LLC can be put in its place very quickly and efficiently. A corporation might be utilized in the business context to handle all of the advanced tax planning for the business. The Corporation is usually filed in Nevada to take advantage of the fact that Nevada does not have state income or corporate taxes. A Nevada corporation can be set up to be either one of the partners of the LLC or can be utilized to own the equipment of the business and lease the equipment back to the LLC. The advantage of owning the equipment through the Nevada Corporation and leasing it to the LLC is that if the LLC ever has creditor problems it can file bankruptcy and the Nevada Corporation can reclaim the equipment and re-lease it to a new LLC. With respect to personal assets, it might be recommended that they be held by a Family Limited Partnership or Limited Liability Company as represented in the illustration.

What Does Multi-Entity Structuring Accomplish

Taxes With respect to the Limited Liability Company from which the business is operated, a possible illustration might be a $60,000 per-year net income being paid to the LLC from the operation of the business. From the $60,000 net income, $25,000 per year would be paid to the client in the form of a salary. The remaining $35,000 would be payable to the client through a beneficial distribution of income from operations on either a monthly, quarterly or annual basis. Without a Limited Liability Company, you would pay approximately $9,180 in self-employment taxes based upon a $60,000 per year business income at the current 15.3% self-employment tax rate as seen in the Figure. With the implementation of the LLC and a beneficial distribution of $35,000 per year, you would save $5,355.00.

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Utilizing a Corporation in the business plan allows the business owner to receive a variety of benefits through the Corporation. The expenses involved in providing such benefits may be deductible to the Corporation and not includable in the taxable income of the client. These benefits include health, accident insurance, payment of unreimbursed medical and dental expenses, disability insurance and group term life insurance. In addition, automobile expenses can be reimbursed and/or paid through the Corporation. The Corporation can also reimburse and/or pay the entertainment expenses made on behalf of the client or the clients family. Pension Planning Utilizing the corporate format, business owners can set up their own corporate pension plan which they can control as both the administrator and trustee. Therefore, the business owner or individual can contribute up to 15% of their net taxable income in said plan in any given year. Once the money is contributed to the plan, it grows tax-deferred but is completely taxable upon retirement. The significant advantage of the Corporate Pension Plan is that the Internal Revenue Code allows for business owners to borrow from their own corporate pension plan of up to 50% of the pension plan assets not to exceed $50,000. This benefit allows business owners to contribute 15% of their gross salary every year to a corporate pension plan and still allows said business owner to obtain a certain amount of liquidity with respect to pension plan contributions. As you may be aware, there are certainly some problems with Qualified Pension Plans which include but are not limited to the following: PENALTIES FOR EARLY WITHDRAWAL DISTRIBUTIONS MUST BE TAKEN AT AGE 70 DISTRIBUTIONS ARE FULLY TAXABLE WHEN THEY ARE WITHDRAWN ANNUAL REPORTING AND ADMINISTRATIVE COSTS QUALIFIED PENSION PLANS ARE ACCESSIBLE TO LAWSUITS AND TAX LIENS Alternative Pension Planning Because of the problems above, Multi-Entity Planners offer alternative methods to better facilitate retirement planning. A highly recommended method utilizes various sections of the Internal Revenue Code . . . specifically Sections 79,162, 419A(f)(6), 501(c)(9) and ERISA . . . a specific insurance product and trust to overcome the problem areas indicated above. Alternative pension planning utilizes the concept of an Irrevocable Trust which receives all of the clients contributions. An employers contributions are made to the Irrevocable Trust which is managed by a multi-billion dollar financial institution. The clients business has no control over the Trust nor does the owner have any control over assets until such time as the business owner decides to terminate his plan contributions and obtain it back on a tax-free withdrawal basis!

All agents should recognize the need to clarify any situation where an insurance product is being used as an alternative to a pension plan. Full disclosure here can avoid a replay of recent industry troubles where clients were told they were getting a pension plan, when, in fact, they were sold a life insurance policy.
These pension plan alternatives allow business owners or other professionals to deduct 100% of their 282

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contribution as a business fringe benefit (expense) and receive 100% tax-free withdrawals (income)! This method also enables clients to enjoy the flexibility of early retirement as well as the comfort of knowing: THE FUNDS CAN BE USED FOR OFFSETTING ESTATE TAXES Since the method of vesting is through an Irrevocable Life insurance Trust or Family Limited Partnership, the client does not personally own the contribution funds. As a result, upon the clients death, all contributions would be payable to the Trust or FLP and not the clients estate. THE FUNDS ARE COMPLETELY ACCUMULATION PERIOD PROTECTED FROM CREDITORS DURING THE

Statutory and case law protect the clients contributions. In addition, the Irrevocable Trust structure is considered virtually impenetrable. THERE IS LITTLE OR NO ANNUAL REPORTING THERE ARE NO MANDATORY DISTRIBUTIONS Another area of concern that can be solved by using the alternative pensions is that of converting distributions from EXISTING qualified pension plans into totally tax-free withdrawals in your retirement years. Consult a professional in this area before making any decisions. Estate Planning Advanced Multi-Entity Structuring can provide the following estate planning advantages: The market value of your estate is lowered due to well-established principles granting discounts for lack of marketability and fractional ownership of an asset. You save up to fifty-five percent (55%) in estate taxes for every dollar your taxable estate is lowered through the implementation of a Family Limited Partnership. The Internal Revenue Service allows a minimum of a twenty-five to forty percent (25%-40%) discount on all the assets placed in a Family Limited Partnership. In a typical illustration, a $2,000,000 estate could receive a 40% discount thereby excluding $800,000 of assets from estate valuation. This $800,000 exclusion would represent an approximate $400,000 in estate tax savings to the heirs of the client.

In one form or another, the trust arrangements described above are also known as VEBAs (Voluntary Employees Beneficiary Association), section A(f)(6) or Section 79. Major corporations, labor organizations and governmental units have used VEBAs and these code sections to provide benefits to members from contributions made by employers and members.

The estate plan allows for lifetime gifts of Limited Partnership interests to your children, grandchildren, other loved ones or charities while you maintain control over the assets. You can begin to reduce your estate by making gifts of fractional interests in your Family Limited Partnership which will further reduce the estate taxes due upon your death. 283

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This estate plan creates a way for you to manage your family assets. This is accomplished by setting up your Corporation as the General Partner of your Family Limited Partnership which will continue to manage your Family Limited Partnership despite the death or disability of any of the shareholders. This estate plan eliminates the need for probating your estate since a trust will transfer all assets to your children or grandchildren without court intervention even beyond the death of you or your spouse. This estate plan will clarify, prioritize and systemize your entire estate by (1) compiling all the essential information regarding your estate into one complete source; (2) reorganizing your financial paperwork into a single comprehensive file; and (3) transferring your diversified investment portfolio into a single, easier-to-manage asset -- your Family Limited Partnership.

Asset Protection Plans

What happens today if a third party gets a judgment against you, your spouse or your business? Without implementing an asset protection plan, the majority of your assets are subject to seizure by third party creditors. Your creditors can pick and choose whatever they please in order to execute upon a judgment taken against either you or your business. Without an asset protection plan, almost all of your personal and business assets will be exposed to execution by a potential creditor. After implementing an asset protection plan, the majority of your assets are owned by a Family Limited Partnership and are safe from seizure by creditors. Once your assets are transferred to a Limited Partnership format or a series of Limited Partnerships, the third party creditor cannot seize or obtain any portion of your estate. The creditors only recourse is to obtain a charging order against your interest in your Family Limited Partnership or Business Limited Partnership. A charging order is similar to a garnishment of wages and requires that all distributions from your Family Limited Partnership which would have gone to you must now be paid to the third party creditor. THE CHARGING ORDER CANNOT FORCE ANY DISTRIBUTIONS TO BE MADE FROM THE LIMITED PARTNERSHIP! If you or your Corporation, as General Partner, decides not to distribute any income to the limited partners, then the creditor does not receive any money. At the same time, the creditor is responsible for all of the income tax responsibility or liability from the Limited Partnership. Assuming your Limited Partnership has taxable income and no pro rata distributions are made to the partners, the creditor becomes liable for phantom income. In other words, the creditor must pay income tax on money earned by the Partnership but for which it did not receive any distribution. This unfavorable result dramatically improves your negotiating position against any creditors and helps to level the playing field. An asset protection plan developed by a professional provides the following asset protection advantages for your business and family: It shields your assets from the ever-expanding damage awards for personal injury and professional liability and it protects your assets from unfair or outrageous financial claims of judgment creditors. It insulates your assets from the effects of death or bankruptcy of your co-guarantors, co-makers of debts and fellow General Partners. With the asset protection plan, the problems of your partners do not become your problems. It provides an entity you control to be the beneficiary of the estate from which you anticipate an inheritance. Parents redraw their Wills or Trusts to leave their estate not to their children directly, but to their childrens Family Limited Partnership so that the childrens inheritance is protected from creditors. It provides protection for your legacy. If a son or daughter is in a high-risk occupation, you can 284

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implement an asset protection plan and thereby leave your children a Limited Partnership interest as their inheritance. This protects the assets of the parents while they are alive and passes on the same protection to their children.

Charitable Remainder Trust Planning

Although most people do not think of gifting assets to charities, the gifting of assets to a Charitable Remainder Trust is oftentimes an effective tax avoidance and asset protection. An advanced protection program designed by a multi-entity planner provides the following charitable advantages for your family: By transferring the family business, ranch, farm or other family asset into a Family Limited Partnership, a gift of a Limited Partnership interest to a charitable organization can be made while the family business, ranch, farm or other family asset remains intact to produce income for the benefits of all partners. As a Limited Partner, a Charitable Remainder Trust or organization has no control over the daily management of the Family Limited Partnership so that the family business, ranch, farm or other family asset may be operated essentially the same as before the transfer of Limited Partnership interest. The value of the Limited Partnership interest that is given to the Charitable Remainder Trust or organization can be taken as an immediate tax deduction on your current years income taxes. In some cases, this may provide you liquidity that you previously did not have. By requiring the vote of all Limited Partners of the Family Limited Partnership and all the shareholders of the corporate General Partners, including the charitable organization, to liquidate the entities, you have optimized your potential to obtain a reduction in the valuation of your taxable estate.

In a typical case, a client could contribute $1,000,000 in appreciated real estate to a Limited Partnership and thereafter gift Limited Partnership interests to a Charitable Remainder Trust. By doing so, the client can take an immediate $1,000,000 charitable deduction which he or she can use over six years to reduce his or her taxable income. An even greater benefit is the fact that that $1,000,000 piece of property can now be sold and the $1,000,000 in proceeds can be reinvested in the Limited Partnership for the entire term of the partnership (usually 25 to 55 years). Accordingly, some clients can buy and sell real estate as well as other capital appreciated assets such as stocks and bonds, etc. during their entire lifetime and never pay any tax on the income received from said sales. Upon death, all of the Limited Partnership assets could be transferred to a Charitable Remainder Trust which could have as its beneficiary a Family Foundation thereby allowing your children or designated beneficiaries to continue to operate the Limited Partnership for their lifetime and the lifetime of all generations in perpetuity. As you can imagine, the tremendous tax and asset protection benefits of the program cannot be overstated. The bottom line is that you can own and control your assets in perpetuity without ever paying any taxes on them or losing them to the Internal Revenue Service or other creditors.

Implementing a Multi-Entity Asset Protection Plan

Implementation of an Advanced Tax Planning and Asset Protection Program involves the transferring of title of your assets to various entities which include: Family Limited Partnerships, Business Limited Partnerships, Corporations and certain types of Trusts as well as Limited Liability Companies. The only limitations to the asset protection plan espoused by asset protection professionals is that the person implementing the plan must be financially solvent in accordance with general accepted accounting principles both before and after implementation, and the purpose of the transfer must not be to hinder, delay of defraud creditors. 285

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Your net worth after implementing this program will remain substantially the same. The percentage of ownership in the Limited Partnership will not change the total amount of your net worth despite the fact that you now do not own any assets directly in your own name. However, you still control them through the connection of your Family Limited Partnership and your Revocable Living Trust.

Maintaining Control of a Multi-Entity Program

To maintain effective lifetime control over the any multi-entity program, you, your family members and other shareholders enter into carefully drafted agreements. These agreements include a Family Limited Partnership as well as various other contracts which bind all members and entities to vote for you as the person in charge. With respect to the Limited Partnership Agreement, since you act as General Partner, you control each and every movement of cash and other assets in and out of the Limited Partnership. You have total lifetime control over all of your assets utilizing these entities which cannot be disrupted even by death. As a result, the plan works much more favorably than the implementation of just one Trust Agreement or just one Corporation.

Is A Multi-Entity Asset Protection Plan Right For Your Client?

Do they want to reduce the amount of income taxes they are paying? Do they want to leave the majority of taxable estate to your family rather than to the IRS? Do they want your assets to be preserved from expanding liability judgments? Do they want to make a charitable gift while keeping assets intact? If they answered Ayes to any of these questions you should consult with a multi-entity planner.

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CHAPTER 5 NEW FRONTIERS OF INSURANCE MARKETING

We start the final chapter of this book asking the same question we posed in the beginning of our course How will you sell insurance in 10 years? The issues we have presented under these covers should provide you some major clues about where to look for the answer, or at least how to recognize the problems you will face. Coming from a decade of mergers, insolvency threats, and major misconduct claims, is it possible that future marketing conditions can get worse before they get better? Well, on the legal front, when courts and juries are involved, it can always get worse and it can always fail to improve. However, there is little to gain by wholesale pessimism. We prefer to say that the insurance business will put problems of the past aside and forge ahead . . . actually there is little choice, and our Country is based on this kind of self-healing. For example, when rising property taxes threatened homeowners in the late 1970's they pushed back with an initiative to limit taxes. When doctors were threatened by record-setting malpractice claims they pushed-back by placing limits on the claims, and when insurance companies got tired of settling every frivolous claim that came along they pushed back by taking them to trial. When potential Y2K litigation threatened the very basis of doing business, our government passed laws to limit the exposure. Of course, it will take time for these push-back efforts by industry and government to build a defense against the tide of litigation. Along the way, new legal challenges will also need to be swatted down. The purpose of this chapter is suggest possible areas of legal and sales issues that agents may face in the future. Some may seem too large to have an effect on an individual agent, but that is probably what all of the agents in our agent blunders thought also. The fact is, you can be affected by many different events and changes in the insurance industry. Your best defense, is to know about the triggers or issues that create problems, i.e., stay on top of trends and manage potential conflicts using techniques similar to those we discussed earlier.

LIFE & HEALTH CHALLENGES

Sales Conduct
It will take years for the current wave of market misconduct lawsuits to settle down. Before it is all over, however, there will probably be a few more companies and agents fall. The claims will probably be similar to those we are now experiencing: insurance sold as an investment, non-performing vanishing premium policies, churning policies, misrepresentation for life insurance sold as a pension plan, interest rate and investment performance falling short of projections and more. Currently, insurance companies are settling these suits even though claims are wildly exaggerated or untrue. As of the printing of this book, for example, major settlements are in the works for Crown Life, Equitable Life, Metropolitan Life, National Benefit Life, New York Life, Phoenix Home Life and Prudential . Pending cases are ongoing with Allianz Life, Cigna, Jackson National Life, Manufactuers Life, Northwestern Mutual Life and Paine Webber . Agents by the hundreds, who were involved with specific offerings of these companies, are being investigated. Already, more than 100 Met Life representatives (the first misconduct case filed in 1994) are charged with deceptive sales practice and at least one has been asked to leave the insurance business. 287

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One of the most important lessons to be learned from these sales misconduct lawsuits is the need to conduct personal due diligence. Dont always assume that sales literature from your insurer is without fault. The consumer protection issues presented in Chapter 4 discuss this as well as other matters critical to sales conduct.

American Disabilities Act

Insurance companies and their agents may see increased activity in the area of civil rights claims, particularly those dealing with the American Disabilities Act (ADA). In Parker vs. Metropolitan Life (1995) a client alleged unlawful ADA discrimination because the disability plan, administered by Metropolitan Life, distinguished between benefits for mental and physical disabilities. The client had already received the maximum two years of benefit for a mental disorder although the plan provided for payments to age sixty-five for individuals with physical disorders. Although the client did not prevail, the courts would have allowed these benefits for someone else who was ADA eligible.

AIDs / HIV
Cases are surfacing that challenge the AIDs/HIV policy exclusions and limitations. In one case, the limitation was outlined in the policy and listed in the data page entitled Schedule of Benefits. The courts held that although the line pertaining to the limitation was clearly eligible, it was not highlighted, set apart, or emphasized in any way. Therefore, the limitation was not enforceable. (Gonzales vs American Life - 1994).

Defining Occupation
In Oglesby vs Penn Mutual Life (1995) the insurer denied a disability claim to a client radiologist (vascular interventional radiologist) since a spine and neck problem still allowed him to practice within the same specialty but still permitted him to work as a radiologist. The courts disagreed because the insurance company initially listed his occupation as radiologist then later narrowed it to vascular interventional radiologist. In essence, they could not deny benefits. Look for more of these narrow definition conflicts which may involve agents.

Psychologically Induced Illness

In Rizk vs Dun & Bradstreet / Met Life (1994) the client claimed he was unable to perform certain work tasks due to back injuries. The insurer denied claims because they felt that clients injuries were at least partially psychologically induced. The courts, ruled in favor of the client because his disability was total as defined by the policy regardless of whether the illness was psychologically stimulated.

Experimental Treatment
There will undoubtedly be many cases defining what is experimental treatment under health policies in the years ahead. Recent cases have tested policy meaning regarding alleged experimental breast cancer treatment, AIDs-related liver transplants, bone marrow transplants, etc. Clients have lost their claim for coverage on the basis of a legitimate denial based on policy terms (Wolf vs. Prudential Insurance - 1995) and Hendricks vs Central Reserve Life Insurance - 1994) and (Barnett vs Kaiser Foundation Health Plan - 1994). Insurance companies have lost their cases where an exclusion about experimental treatment was NOT highlighted in a conspicuous manner (Gonzales vs Associates Life Insurance - 1994) or where policy language was considered ambiguous (Fredericks vs Blue Cross of Michigan - 1995) and (Bailey vs Blue Cross of Virginia - 1994).

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Language Barriers
There are new cases developing in the area of language misunderstandings where clients have pursued claims on the basis they did not fully comprehend the matters at hand. In Parsaie vs United Olympic Life Insurance (1994) a client prevailed in her action against a health insurer because she understood little English and could not read the application. She relied on the advice of the agent but failed to disclose a preexisting condition. The courts determined that the insurance company could only deny coverage where an intent to deceive was found. In this case, they said there was no intent to deceive.

Defining Accidental
Policy language often limits coverage for accidentally sustained injuries. Thus, cases have and are developing where attempted suicides have left clients permanently or severely injured. Since the injuries were self-inflicted, insurance companies have refused to pay. In one case, the insurer lost to a client who attempted suicide because accidental was NOT defined in the plan documents (Casey vs Uddeholm Corp - 1994). In another example, the client also prevailed because the courts decided her treatment for an attempted drug overdose suicide was really treatment for her underlying depression. Further, the insurer was found to have misled her by not informing that mental and nervous disorders would not be covered if followed by an attempted suicide (Lutheran Medical Center vs Contractors Health Plan 1994). Finally an insurer was prohibited from withholding a claim because the client had a subjective expectation of survival, thus even though his injuries were self-inflicted it was still deemed an accident (Todd vs AIF Life Insurance - 1995).

CASUALTY CHALLENGES
Some of the agent challenges above also have application to the casualty agent. There will also be new legal conduct issues related to fiduciary duties of agents as well as some unusual problems in the areas listed below:

Tenants As Implied Beneficiaries

The courts are leaning more and more to the proposition that tenants are implied beneficiaries under a landlords policy. In Bannock vs Sahlberry - 1994 the tenant and landlord had only an oral lease agreement. Even though the tenant was responsible for the fire, the landlords insurer could not recover from the tenant since he was an implied additional insured. However, in the reverse situation, a landlord could not be construed to be an implied beneficiary of the tenants policy (American National Fire Insurance vs A. Secondino - 1995). More bizarre is the case of Cigna Fire vs Leonard (1994). Here, the tenant was required to obtain fire insurance naming the landlord and mortgagee as additional insureds. However, he only purchased insurance on himself and then proceeded to intentionally burn his business to the ground along with the landlords building. The courts denied the landlord and mortgagees claim against the tenants insurer because there was no clear intention to cover the lessor or the mortgagee. Only the tenant was named in the policy but his claim was denied under the policys arson provision.

EIL vs CGL
Within the last 20 years the insurance industry introduced environmental impairment liability insurance (EIL) in an effort to provide pollution coverage for events the industry deemed not to be covered by the more well-known comprehensive general liability policy (CGL). A very important distinction between these coverages is that EIL policies are claims-made policies, while CGL policies are occurrence-based. The introduction of EIL insurance provided clients an alternative that was broader than CGL coverage in some respects, while narrower in others. For example, the insurance industrys position is that EIL insurance 289

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affords coverage for the gradual release of contaminants that, according to the carriers, would no be covered under typical CGL policies. On the other hand, as discussed above, claims under an EIL policy must be made during the policy period. One issue that continues to surface is the relationship of EIL coverage to other insurance purchased. For example, assume a company purchases both primary CGL insurance and EIL insurance. The question then arises whether the EIL insurance is primary coinsurance or excess to the CGL. In Rhone-Poulenc vs International Insurance (1994), the client owned both EIL and CGL policies. However, the EIL policy contained a provision that loss or damage could not be recoverable as long as other insurance was in force. The courts ruled that the EIL was indeed excess coverage, however, there could be cases where EIL, if purchased alone, could be the primary insurer for environmental liabilities.

Contamination
Despite the fact that policies have been written as All Risk insurers continue to deny contamination claims based on policy exclusions. In W.H. Breshears vs Federated Mutual Insurance (1994), the court rejected a clients claim for coverage on the basis that an oil spill on his property was not covered property because it was land and pavement only, not considered property. In Conde vs State Farm Fire & Casualty (1994), a client was denied coverage, which was upheld by the court, for contamination caused to his home by an exterminators negligence because contamination was not defined in the policy. The court also rejected the clients argument that the exterminators negligence (a covered peril) was the actual cause of loss.

Sick Building Syndrome

People have an unusual ability to acquire the problems and illnesses of others. Most sick building illnesses are found to be psychologically based rather than rooted in fact. In Sternmann vs May Department Stores (1994), an employee claimed a long-term disability from toxic exposure at her place of work. The company refused full disability coverage since tests showed that toxic levels did not exist in the building. The courts ruled against the client even though her physicians diagnosis was total disability due to toxic exposure and chemical sensitivity.

Asbestos
The removal of asbestos continues to be a major source of conflict between clients and insurance companies. In University of Cincinnati vs Arkwright Insurance - 1995 asbestos was found in a dormitory that suffered a partial loss due to fire. The clients all risk policy did not cover the removal of asbestos since it was not considered an unexpected event

Lead
New standards introduced in September 1996 require property owners who are selling or renting real estate built prior to 1977 to disclose any known lead-based paint or lead hazards. Experts believe that the next wave of lawsuits will result from these disclosures and potential client illnesses, real or not.

Business Interruption
On the heels of major hurricanes and earthquake, claims are surfacing concerning business interruption where clients have been forced to close stores and businesses incurring major damages. A major issue that occurs in these cases is the determination of income. Most policies include a clause similar to this: In calculating your lost income we will consider your situation before the loss and what your situation would probably have been if the loss had not occurred. In American Auto Insurance vs Fishermans Paradise (1994), the client lost his argument that his store would have made huge profits in the aftermath 290

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of Hurricane Andrew if it were left undamaged. The courts disagreed indicating that hypothetical profits would have created a windfall not contemplated by the policy.

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