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The Structure of the Business of Insurance

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The business of insurance differs from most other businesses. Because insurers sell an intangible product—a promise to pay in the event of contingent losses—and because these promises potentially affect so many, the business of insurance is regulated more heavily than most other businesses.

The business of insurance is regulated by the states, not by the federal government (with the exception of certain antitrust laws). As a result, while there is necessarily much uniformity of regulation in the business of insurance from state to state, there are also differences.

he business of insurance is regulated by the states, not by the federal government (with the exception of certain antitrust laws). As a result, while there is necessarily much uniformity of regulation in the business of insurance from state to state, there are also differences.

NOTE:For any state-specific question, contact the department of insurance inyour own state.

The laws regulating the business of insurance in some states differ so greatly from other states that many insurers establish separate companies solely for the purposes of writing policies in a given state. Texas and Illinois are two states where this often occurs because of the difficulties imposed by complying with the laws of those particular states.

Twelve states mandate some form of no-fault auto insurance. As a result of these differences, certain types of policies, particularly auto policies, must be written so that people can travel from state to state in their vehicles, yet not run the risk of uninsured losses due to variations in mandatory insurance requirements by state.

Twelve states mandate some form of no-fault auto insurance. As a result of these differences, certain types of policies, particularly auto policies, must be written so that people can travel from state to state in their vehicles, yet not run the risk of uninsured losses due to variations in mandatory insurance requirements by state.

Because of state regulations and other business concerns, a given insurance organization typically comprises multiple insurers. State Farm advertises nationally on television and through other media, but the organization operating under the State Farm moniker is actually comprised of twelve different insurance companies, each separately organized. Indeed, many of the separate insurance companies operating under a single trademark or service mark, such as State Farm, Farmers, Kemper, or Nationwide, have officers and a board of directors, but no actual employees.

There are a number of practical reasons why many insurance organizations do business in this manner, which vary from organization to organization. Some states’ insurance codes and regulations are such that a given insurance organization will establish an insurance company solely for the purposes of writing all of its policies for insurance within a particular state. Another reason an insurance organization might establish multiple insurance companies to operate within a given state is to help the insurance organization track and assess business results.

These business factors (and more), even before looking at the actual loss experience of an individual insured, can affect whether an insurer will categorize the insured as a preferredrisk, a standardrisk, or a substandardrisk. Depending on how an insurance organization decides it wants to compartmentalize its ability to track its results, it may choose to do so based on a preferred, standard, or substandardrisk basis, regardless of the line of business. It may establish separate companies in which to write policies issued to each of these categories of its business.

KINDS OF INSURERS

The most common form of organization for domestic insurers is the capital stock company (corporation) organized and existing pursuant to the laws of whichever of the fifty states is its corporate domicile. The stock of individual capital stock insurance companies is not always publicly traded. Often, insur- ers are wholly-owned subsidiaries of one or more other insurance companies comprising a given insurance organization. For example, the group of companies known as American International Group, Inc. (AIG) owns, directly or through subsidiary companies, such well-known commercial insurers as National Union Fire Insurance Company, American Home Assurance Company, Lexington Insurance Company, Insurance Company of the State of Pennsylvania, and Birmingham Fire Insurance Company. The parent company of this group is the corporation known as American International Group, Inc. This corporation is not an insurer itself. Rather, it is what is commonly referred to as a holding company. If a person wished to invest in the insurance business of the AIG companies, one would buy stock in American International Group, Inc. One could not purchase stock directly in any of the member companies that comprise AIG.

The corporate domicile of a particular insurer may or may not be the same state where that particular insurer has its principal place of business. Just because an insurer is organized and exists as a legal entity under the laws of a particular state, and may even have its principal place of business in that state, does not mean that the insurer operates as an admitted insurerin that state. Insurers can be organized and exist pursuant to the laws of a particular state, and yet operate within that state on a nonadmitted (excess or surplus lines) basis.

The next most common form of insurance company organization is the mutualinsurance company. Stated generally, a mutual insurer is an insurer corporation without capital stock that is owned by its policyholders collectively, who have the right to vote in the election of its board of directors. The principles governing the duties, powers, and obligations of the board of directors of a mutual insurer are generally the same as those applicable to other private corporations.

Many insurers that retain the word mutualin their names have long-since converted to the capital stock form of doing business. They retain the term mutualin their corporate names not only because of the company’s history, but also because the use of the term mutualhas a feel-good quality that helps support the image of security that insurers like to promote.

The third most common form of insurance company organization is what is called a reciprocal insurer, also called interinsurance exchange. In effect, all policyholders of a reciprocal insurer, who are also called subscribers, insure each other. In order to become an insured of a reciprocal insurer, each person or company executes a subscription agreementas part of the application for the policy. In the subscription agreement, that person or entity appoints an attorney-in-fact, who, pursuant to the terms of the subscription agreement, manages the affairs of the reciprocal insurer. The attorney-in-fact is often a separately constituted corporation. Through the corporation’s employees or through contractual relationships with other entities, the attorney-in-fact arranges for underwriting, actuarial, claims, and other services, and enters into reinsurance contracts.

For example, the insurance offered by the American Automobile Association or its affiliated organizations in different states, such as the Automobile Club of Southern California, is offered through entities that are organized as reciprocal insurers. United Services Automobile Association is another well-known example. Reciprocal insurers are often organized and will insure only those persons who share some qualifying membership criteria, such as a club membership or service in the armed forces.

All three types of insurance companies are regulated in substantially similar fashion by the insurance departments of the fifty states. Mutual and reciprocal insurers give their policyholders the right to appear and vote at the annual meetings of insurers, just as stockholders of a corporation have the right to attend annual meetings and to vote to elect directors and pass resolutions on the agenda. This is a right that relatively few policyholders take advantage of. Both mutual and reciprocal forms of insurance company organizations are, in a certain sense, vestiges of a past world in which a relatively small group of localized individuals came together to create a means of providing insurance to an unserved or underserved group of people or businesses. The voting rights aspect of these insurance company organizational forms reflects the different practicalities confronting those persons that, as a small group of affected policyholders, the acts of the board of directors of the company affects directly.

As a practical matter, the differences between capital stock, mutual, and reciprocal insurance organizations affect the average consumer very little, except in the manner in which insurance is sold.

The following comments are somewhat more true of reciprocal insurers than they are of mutual insurers, but nonetheless may apply. The policies offered by reciprocal and mutual insurers are often less expensive than those offered by stock insurers. That factor has been one of the perceived historical advantages that reciprocal and mutual insurers hold over stock insurers. In the past, their cost advantages had much to do with the fact that the underwriters and actuaries for such insurers had a good understanding of the risks posed by the limited classes of individuals to which policies would be issued and the limited geographical scope of the insurers’ operations.

However, the less expensive nature of the policy sold by reciprocal and mutual insurers can be very deceptive in the modern-day world. Reciprocal and mutual insurers developed at a time when the world was much simpler. When everyone was selling nothing more than a standard fire policy, with the terms and conditions of the policy mandated by state law, all insurers were, in effect, selling the same promises. At that time there was a basis for a localized reciprocal or mutual insurer to offer savings to policyholders that mattered.

As society and insurance markets matured, that was no longer the case. Today, homeowners policies offer coverages that go beyond those of standard fire policies. The insurance purchaser needs to compare coverages offered and included (or not included) to determine whether the lower premiums often offered on policies of reciprocal and mutual insurers can be justified by the sometimes lesser coverages offered compared with those of other companies, including stock companies.

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