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Framework of Regulation

Given the central role the insurance industry plays in millions of American lives and businesses, it is subject to a number of regulators — the federal government, state governments, and industry watchdogs. The primary purpose of this regulation is to promote the public welfare by maintaining the solvency of insurance companies. Policyholders depend on a company’s financial stability to pay benefits well into the future — one insolvent company can jeopardize thousands of insureds. In addition to ensuring the financial strength of individual insurers, regulators also provide consumer protection, enforce fair trade practices, and take care that insurance contracts are offered to the public at fair prices. It is very important that insurance agents be aware of and comply with all insurance laws and regulations.

History of Regulation

The history of insurance regulation in the United States reveals a tug-of-war between the authority of the states and the federal government. Though a balance between these two bodies has been reached and maintained for many years, arguments favoring control by one governing authority over another are still being waged.

Paul v. Virginia (1868) The U.S. Supreme Court ruled that the sale and issuance of insurance is not interstate commerce, upholding the right of each state to regulate insurance within its borders.
The Armstrong Commission (1905) The New York state legislature appointed a commission, named for the New York state insurance commissioner, to respond to public outcry over abuses by insurers. The result was the New York Insurance Code, which set a precedent and pattern for insurance regulation by other states throughout the country.
United States v. Southeastern Underwriters Association (SEUA, 1944) The Supreme Court overturned Paul v. Virginia, ruling instead that insurance is a form of interstate commerce to be regulated by the federal government. This subjected insurance companies to a series of federal laws — many in conflict with existing state laws — and resulted in a radical shift in regulatory control to the federal government.
The McCarran-Ferguson Act (1945) Congress responded to SEUA by making clear that continued regulation of insurance by the states was in the public’s best interest. However, it also made possible the application of federal antitrust laws “to the extent that [the insurance business] is not regulated by state law.” As a result, each state enacted an Unfair Trade Practices Act to conform to the federal law. Today, the insurance industry is considered to be state regulated.
Variable Annuities (mid-1950s) New insurance products called variable annuities appeared in the marketplace, raising the question: insurance products regulated by the states, or securities regulated by the SEC? The Supreme Court answered “Yes” to both — federal securities laws applied to the underlying product, while the insurers issuing variable annuities remained subject to state insurance regulators. As a result, “variable” insurance products must conform to both SEC and state regulation.
Financial Services Modernization Act (1999) Congress repealed the Glass-Steagall Act of 1933 (which had barred common ownership of banks, insurance companies, and securities firms). Under the new legislation, commercial banks, investment banks, retail brokerages, and insurance companies can now enter each other’s lines of business.

The ongoing story of insurance regulation reflects the roles the courts and the federal government have played in regulating the industry. As a rule, insurance companies have tended to side with the regulators they deemed weakest. In the early years of this country, the federal government was seen as the less stringent regulator. Now states are seen in that light — and by and large, the insurance industry has been content to keep primary regulation in the states’ hands.

Federal Regulation of the Insurance Industry

Although the primary regulation of insurance is left to the states (under the McCarran-Ferguson Act of 1945), the federal government influences the annuity industry in three ways:

Internal Revenue Code Insurance companies are taxed differently than most other corporations. Policyowners pay premiums, which insurance companies invest. Generally speaking, interest earned by insurance companies is not taxed — Uncle Sam is willing to defer taxation on that income until the policyowner withdraws it from the policy. In the case of life insurance (but not annuities) benefits paid from an insurance policy are free of income taxation.
Retirement Plans (ERISA) The Employee Retirement Income and Security Act of 1974 (ERISA) regulates pension plans, other retirement accounts, and employee benefit plans. This law overrides any state laws governing retirement plans and investments within those plans. Plans that meet ERISA requirements are said to be “qualified” — they qualify for special tax treatment that allows their values to grow faster. ERISA also governs “employee benefit” plans such as employer-provided health care coverage.
Variable Contracts As noted above, the Supreme Court ruled that variable annuities and variable life policies are considered securities under federal law. Investments within a variable annuity contract or insurance policy fall under the jurisdiction of the SEC, while the companies issuing these contracts are subject to regulation by the states. Likewise, agents selling variable products must be dually licensed: a state license as an insurance agent and a federal license as a securities representative.

Federal Securities Laws

Securities Act of 1933 Requires companies issuing securities (stocks, bonds, etc.) to register those securities with the SEC. It also requires all sales of “new issues” to be accompanied by a prospectus. Most variable annuities must be registered under this Act (some group variable annuities sold to qualified retirement plans need not register). Some equity indexed annuities are registered, but most remain unregistered.
Securities Exchange Act of 1934 Regulates the trading of securities once they have been issued. It also requires registration of broker-dealers and their sales representatives. The Financial Industry Regulatory Authority (FINRA) currently administers registration of broker-dealers and sales personnel — resulting from the merger of the regulatory powers of the New York Stock Exchange and the National Association of Securities Dealers (NASD). FINRA’s jurisdiction covers securities registered under the ’33 Act. As such, FINRA rules apply to variable annuities (and a few equity indexed annuities), but do not extend to fixed annuities (including most indexed annuities) or other insurance products.
Investment Company Act of 1940 Imposes requirements on professionally managed investment portfolios such as mutual funds — these portfolios must be registered with the SEC. The Supreme Court ruled that “separate accounts” of variable life insurance and variable annuities are also subject to this Act. This law treats sales of these types of investment companies as “new issues,” making them subject to the prospectus requirement of the Securities Act of 1933.
FINRA suitability regulations apply only to the sale of “registered” products: namely individual variable annuity contracts (and a few equity indexed annuities). We will explore FINRA regulations governing suitability of annuities in Chapter 6. In addition, many other federal laws have an impact on the operations of insurance companies and their agents — including disclosures under the Fair Credit Reporting Act and privacy guidelines imposed under the Financial Services Modernization Act.

Florida’s Department of Financial Services and Office of Insurance Regulation

The Department of Financial Services, headed by Florida’s Chief Financial Officer, and the Commissioner of the Office of Insurance Regulation oversee the insurance industry in accordance with the provisions of the Florida Insurance Code. They each have administrative (enforcement), quasi-legislative (rule-making), and quasi-judicial (hearing and penalty) powers in order to carry out their responsibilities.

The Florida Legislature adopted a Policyholder Bill of Rights to protect the insurance-buying public. This Bill of Rights sets forth a series of aspirational goals to guide the Department and Office in their day-to-day operations (Florida Statutes, Chapter 626.9641).

Florida Policyholders’ Bill of Rights The following principles shall serve as standards to be followed by the Department, Commission, and Office:
  • Policyholders shall have the right to competitive pricing practices and marketing methods that enable them to determine the best value among comparable policies
  • Policyholders shall have the right to obtain comprehensive coverage
  • Policyholders shall have the right to accurate and balanced advertising and other selling approaches that provide accurate and balanced information on the benefits and limitations of a policy
  • Policyholders shall have the right to an insurance company that is financially stable
  • Policyholders shall have the right to be serviced by a competent, honest insurance agent or broker
  • Policyholders shall have the right to a readable policy
  • Policyholders shall have the right to an insurance company that provides an economic delivery of coverage and that tries to prevent losses
  • Policyholders shall have the right to balanced and positive regulation by the Department, Commission, and Office
Note: This section shall not be construed as creating a civil cause of action by any individual policyholder against any individual insurer.

The Florida Insurance Code is a broad set of regulatory principles. It sets general policy, but leaves the details of regulation to the Department and Office. For example, the Insurance Code states that advertising of insurance products should be balanced and not misleading — how that general principle is interpreted in day-to-day operations is spelled out in rules promulgated by the Department or Office (e.g., when are testimonials permitted? how are statistics to be used? must agents obtain insurer permission prior to placing an advertisement?).

The Department of Financial Services focuses its regulations and authority on consumer and agent issues, such as agent licensing and anti-fraud efforts; while the Office of Insurance Regulation concentrates on regulation of insurance companies and contract terms. Both are empowered to investigate complaints, audit industry participants, and, if need be, rehabilitate insolvent insurers.

Florida Regulation of Insurers

Certificates of Authority (Authorized vs. Nonadmitted Insurers)

An admitted insurance company is one that the Office of Insurance Regulation has licensed to transact business in Florida under the provisions of state law — in other words, an “admitted” company has a certificate of authority to operate in Florida. Admitted companies are also called “authorized” companies.

Insurance companies that have not been authorized by the Office are said to be “nonadmitted.” A nonadmitted insurance company does not come under the jurisdiction of the Florida Office of Insurance Regulation with regard to examination of its financial soundness, approval of types of coverages offered, or its advertising. Florida’s Life and Health Guaranty Fund (described below) only covers the liabilities of authorized insurers — anyone purchasing policies from unauthorized or unlicensed companies would be at risk if those insurers could not meet their claims. Florida will hold the agent personally liable for any insurance contract placed with an unauthorized insurer.

The Department of Financial Services imposes severe penalties on agents who aid and abet illegal operations involving unauthorized insurers:

  • Conviction of a third-degree felony
  • Liability for all unpaid claims
  • Suspension or revocation of all insurance licenses

The Office of Insurance Regulation imposes similar penalties for acting as an insurer without proper licensure:

  • Conviction on charges of up to a first-degree felony
  • Liability for all unpaid claims
  • Suspension or revocation of all insurance licenses
WARNING — Unauthorized Entities:

The State of Florida has taken a very strong position on the issue of authorized entities. An unauthorized entity is an insurance company that is not licensed with the Florida Department of Financial Services. Agents and brokers have responsibility for conducting reasonable research to ensure that they are not writing policies or placing business with unauthorized entities. Lack of careful screening can result in significant financial loss to Florida residents due to unpaid claims and/or theft of premiums. Agents may be held liable when representing these unauthorized entities. It is the agent’s and broker’s responsibility to give fair and accurate information regarding the companies they represent.

Any question about the authorized status of a company can be checked by calling the Florida Department of Financial Services at 1-877-693-5236 (inside Florida) or 850-413-3089 (outside Florida).

Solvency & the Florida Life and Health Guaranty Association

The public relies on insurance policies to address the financial uncertainties of life — policies are only of value if there is a high probability that the company will be able to fulfill its promises far into the future. One of the primary reasons for state regulation is to ensure the financial integrity of insurance companies operating in the state. The Office of Insurance Regulation monitors the continued solvency of insurance companies, requiring companies to file annual reports and auditing a domestic insurance company’s complete financial and operating situation at least every three years.

Occasionally, an insurance company will fail (be declared insolvent). When this happens, the Office of Insurance Regulation will appoint a receiver to handle the liquidation or reorganization of the insurer in a process similar to bankruptcy. Upon liquidation, the Florida Life and Health Guaranty Association — an organization comprised of all authorized life and health insurers in Florida — will take over the duties of the failed insurer: collecting premiums, servicing the policy, and paying claims. The Association assesses its member firms to fund those payouts.

The Association will pay claims against the failed company’s traditional life insurance products (but not variable policies or contracts). Coverage limits:

  • Up to $300,000 in death benefits for life insurance ($100,000 in cash value)
  • Up to $250,000 in cash surrender and withdrawal values for deferred annuity contracts
  • Up to $300,000 for all other benefits, including long-term care policies
  • These limits represent the total amount payable per owner, per member company, not per policy
Important: While the Guaranty Association exists to provide an extra level of protection for policyholders, Florida law prohibits agents from referring to this protection as part of their sales presentations.

Investments

Insurance companies collect premiums from contract owners and invest those funds. These investments, which make up part of the “general assets” of the insurance company, back the company’s promises to its fixed annuity contractholders. Income from investments offsets the total cost of future claims. The Office of Insurance Regulation imposes investment guidelines on insurance companies to safeguard those assets and income — and mandates methods for valuing those assets for financial statement purposes.

The general account of life insurance companies may be invested in obligations of the federal, state or local governments, corporate bonds, real estate mortgages, real estate, corporate stocks, and policy loans. These long-term investments balance the long-term commitments insurance companies make to their policyholders and provide the degree of safety, yield, and liquidity desired. The Office imposes minimum ratings for corporate bonds held by insurers and severely limits so-called “junk bonds” in the portfolio. Companies issuing equity indexed annuities will also invest in equity indexed options to hedge their liability under these contracts — these options are held in the company’s general assets.

Variable annuities are backed by investments in “separate accounts.” The investment guidelines described above apply to the general assets of the company — not those held in the separate account. The only requirement for assets held in separate accounts is that they have a “readily determined” market value — that is, the investment must be publicly traded (such as stocks on a stock exchange).

Legal Reserve System

Florida’s Insurance Code requires insurers to charge themselves a minimum liability on their financial statements — known as the legal reserve — for all policies and contracts currently in force. This liability amount represents future claims by policyowners. The Code has a standard valuation provision that dictates the assumptions and procedures insurance companies must use in calculating the size of their legal reserve.

The legal reserves appear as a liability on the company’s balance sheet. The legal reserve is a measure of the insurance company’s future liability under the contract. To remain solvent, insurers must maintain assets (investments) equal to — and hopefully greater than — the legal reserve.

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