Dependable Insurance

Most businesses are lightly regulated by the government. That’s because local, state, and federal governments have only three concerns about how most businesses operate: Are they paying their taxes, including payroll taxes? Are they treating employees fairly? Are they keeping customers safe? If a business is doing these things, it can expect to hear little from any government.

There are exceptions, however. Among them are businesses that have significant negative externalities, which is an academic term for making messes for others to clean up. The classic one is pollution. So, if your business causes significant water or air pollution or has the potential of creating a public health threat, you should expect to see government inspectors from time to time.

Another exception: If your business operates under a government franchise. This would include electric and natural gas utilities. In most places, customers cannot choose their electric or gas suppliers; they are chosen by governments. In return for the franchises, these companies see some form of regulation, principally, rate regulation.

Another example of regulated businesses are financial institutions, including banks and investment firms. That’s because we’ve learned from experience that if major financial institutions fail, they can drag down the entire economy. (If we need a reminder, the financial meltdown of 2008 and resulting Great Recession showed us again the damage Wall Street could do if unconstrained.) So, the federal government has learned to regulate banks and investment firms to minimize the risk that, should they falter, they will wreak havoc.

Finally, there are insurance companies, which are generally regulated at the state level and make up a special category. They share some aspects with other regulated companies, but have a characteristic that’s the primary reason they are regulated—and have been for nearly 200 years.

First, here’s what insurance companies share with other regulated companies. Insurance companies are financial institutions, and like banks and investment firms, if they stumble, they could plunge the economy into chaos. (In the 2008 financial crisis, a huge insurance company, AIG, nearly did fail and the federal government pumped $150 million into it to keep it afloat. AIG paid back the government’s investment with interest five years later.)

Second, insurance has become almost mandatory for certain activities. Drive a car? It’s likely your state requires that you show proof of auto insurance to renew your license plate. Have a home mortgage? The lender will almost certainly require that you buy homeowner’s insurance. Renting space for your business in an office building? The landlord will likely require that your business have liability protection in case a customer slips and falls. And, if your business has 50 or more employees, the federal government requires that you provide them health insurance. (It has less stringent requirements for businesses with fewer than 50 workers.)

Because insurance is so woven into our lives—and required in some instances—it’s not surprising how big the industry is or that it’s regulated. Property, casualty, auto, life and health insurance combined took in $4.6 trillion in insurance premiums worldwide in 2013. The United States alone accounted for 27 percent, or $1.3 billion, of those premiums. (By way of contrast, $1.3 billion is only a little less than what Americans spend annually on food cooked in homes or served in restaurants.)

But their size, pervasiveness, or role as financial institutions aren’t the reasons states began regulating insurance companies, starting in 1837.

The reason: Insurers sell promises of protection. And early on state governments realized that if they didn’t make sure those promises were kept, insurance—and all the things it supports—could not be sustained.

What is the promise? That if you pay a little in monthly or annual premiums, you will be covered if something terrible befalls you. It’s easy to see this in homeowner’s insurance. The average homeowner pays $136 a month for protection against everything from fire and wind damage to a neighbor tripping on your front steps and suing you for injuries. (Most home policies don’t cover flood or earthquake damages. If you need protection from those disasters, you buy the coverage separately.)

But what would happen if a series of tornadoes raked across your state and insurers were hit with thousands of claims? These things do happen. Texas had 188 tornadoes in 2019. The average tornado causes $2.5 million in property damage. That is approaching $500 million in claims in a single state for a single year. Are the insurance companies that have taken your money month after month capable of paying off such losses?

This is the reason state governments got involved in insurance regulation, beginning with a Massachusetts law in 1837 requiring insurance companies to maintain reserves large enough to pay off catastrophic claims. In 1851, New Hampshire created the country’s first office of state insurance commissioner. (The job: inspect the companies’ books to be sure they had the reserves and were paying out claims as required.)

Today, every state has an insurance commissioner of some sort, elected in 11 states and appointed in others. Their main tasks, as they were in the 19th century, are to be sure insurance companies can keep the promises they make and are treating customers fairly.

Still, insurance companies are businesses. And, like any business, notwithstanding the regulation and reserve requirements, they can run short of cash or even fail—and sometimes do.

What happens then? Basically, insurance laws provide that states step in to help protect the policyholder and, in some instances, society at large. When losses are temporary, states can dip into insurance guaranty funds to bail out companies. When the company’s problems are long-term, they can find other insurance companies to take over the insolvent firm’s policies and other assets.

If you’ve read other entries in this series, this will seem like an old story. Some businesses need government to set the rules, enforce the rules, require disclosure of risks, protect consumers from dishonest business practices, and take action if all else fails. We’ve seen these things in the creation of the 30-year mortgage, nuclear safety and waste disposal, honest markets and sound banks, appliance energy standards, professional licenses, and food and drug safety. In an even larger sense, the courts are vital to businesses. If state and federal courts did not enforce contracts and resolve disputes, businesses could not function.

And, we see it again with insurance. Without government oversight, requirements and, sometimes, guarantees, there would be far less insurance purchased than there is. We could survive in such a world, but it would be one in which everyone lived in fear of illnesses we could not afford to treat, fires that left us homeless, lawsuits that bankrupted us, or a parent or spouse’s death that ruined a family financially.

Insurance reduces these risks by making a promise. And, behind that promise is a government’s effort to ensure that the promise will be kept.

Footnote: Earlier, we mentioned that governments regulate businesses that create negative externalities. People, too, can make messes. Insurance—and government requirements that you purchase coverage—make sure that, if a mess is made, it’s managed. Take auto insurance. If you caused a wreck, you might need medical attention; so might others. And cars and other property will almost certainly need fixing. Insurance—and the requirement that all drivers be covered—are a way government can be sure somebody will clean up the mess.

More information:

https://en.wikipedia.org/wiki/Insurance_in_the_United_States

https://en.wikipedia.org/wiki/Insurance_regulatory_law

https://en.wikipedia.org/wiki/Insurance_regulatory_law

Give the credit to: federal government 15%, state governments 85%

Photo by Thomas Hawk licensed under Creative Commons.