Definitions of Insurance and Related Information (23-FEB-06,	 
GAO-06-424R).							 
                                                                 
This letter concerns a variety of issues related to identifying a
universal definition of insurance and the challenges associated  
with doing so. We briefed congressional staff on the preliminary 
results of our work on June 24, 2005, and on our final results on
November 29, 2005. Specifically, we provided information on (1)  
the elements that are commonly part of definitions of insurance, 
(2) a few products not universally defined as insurance or	 
regulated across the states by their insurance departments, (3)  
possible regulatory implications of developing separate 	 
definitions for insurance products covering insurance risks in	 
more than one category, (4) current developments in statutory and
financial accounting communities in re-evaluating their 	 
guidelines for measuring risk transfer in reinsurance contracts, 
and (5) certain circumstances when finite risk contracts are	 
used.								 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-06-424R					        
    ACCNO:   A47617						        
  TITLE:     Definitions of Insurance and Related Information	      
     DATE:   02/23/2006 
  SUBJECT:   Insurance						 
	     Insurance regulation				 
	     Private sector					 
	     Federal regulations				 
	     Product safety					 
	     Insurance losses					 
	     Risk assessment					 
	     Reinsurance					 

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GAO-06-424R

     

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February 23, 2006Letter

The Honorable Michael G. Oxley Chairman Committee on Financial Services
House of Representatives

Subject: Definitions of Insurance and Related Information

Dear Mr. Chairman:

This letter transmits to you our briefing slides concerning a variety of
issues related to identifying a universal definition of insurance and the
challenges associated with doing so. We briefed your committee staff on
the preliminary results of our work on June 24, 2005, and on our final
results on November 29, 2005. Specifically, we provided information on (1)
the elements that are commonly part of definitions of insurance, (2) a few
products not universally defined as insurance or regulated across the
states by their insurance departments, (3) possible regulatory
implications of developing separate definitions for insurance products
covering insurance risks in more than one category, (4) current
developments in statutory and financial accounting communities in
re-evaluating their guidelines for measuring risk transfer in reinsurance
contracts, and (5) certain circumstances when finite risk contracts are
used.

We focused on insurance and reinsurance in the private sector and excluded
federal insurance programs. We identified elements crucial to defining or
developing a definition of insurance, but we did not attempt to compile an
exhaustive list of all private sector products that might be considered
insurance. We reviewed relevant documents from the National Association of
Insurance Commissioners (NAIC), academic sources, accounting boards,
insurance companies, professional and industry associations, state
insurance regulators, federal securities regulators, court cases, and
general media. We also met with knowledgeable staff at NAIC and other
professional and industry associations. We conducted our work from
December 2004 through December 2005 in accordance with generally accepted
government auditing standards.

Definitions of Insurance

We looked at a variety of sources to identify a definition of insurance
and found that, while most definitions differed because they were
developed for specific purposes or had changed over time, the definitions
shared key elements of risk transfer and risk spreading. Definitions of
insurance are developed for various purposes such as different fields of
study, categories of insurance, and state or federal statutes.1

While risk transfer and risk spreading are key elements, these definitions
often include other elements, or parameters, commonly found in the
definitions. These include

o indemnification, which is the payment for losses actually incurred;

o the ability to make reasonable estimates of future losses;

o the ability to express losses in definite monetary amounts; and

o the possibility of adverse, random events occurring outside the control
of the insured.

Further, while products may transfer various types of risks, a product
must transfer insurance risk to qualify as an insurance product. Insurance
risk is coverage for exposures that have the potential for financial loss.
It is defined by NAIC as equivalent to underwriting risk. That is, for
property-casualty insurers, it is the risk of mispricing new business or
the risk of underestimating needed reserves for business already written.
The accounting industry defines insurance risk as those risks related to
uncertainties resulting from both the amount and timing of losses paid and
other expenses.

Even when some losses lack certain elements of insurance, insurers have
sometimes found ways that allow coverage for such losses. For example,
nonpecuniary or noneconomic losses (e.g., the loss of well-being or
happiness) lack certain elements of insurance-there is no commonly
accepted method of expressing a definite monetary amount for nonpecuniary
losses and no measurable means to indemnify the insured. For example, the
loss of happiness upon the death of a loved one would be difficult if not
impossible to quantify in monetary terms; instead of attempting to
quantify such a loss, life insurers agree to pay a predetermined amount of
monetary benefits upon the death of the insured, and they charge a premium
based on both the amount of insurance and the expected mortality risk of
the insured.

In reviewing the various definitions of insurance, we also found that
court interpretations and state regulatory practices change definitions
over time. For example, courts have emphasized different elements of an
insurance contract such as its principal object and purpose as in Jordan
v. Group Health or have focused on the legal elements necessary for an
enforceable contract as in Griffin Systems v. Washburn.2 (See slides 5-8
and 13-15 for further discussion of various definitions of insurance.)

How States Define and Regulate Insurance

Generally, states define and regulate the same products as insurance.
While states rely on a variety of sources to provide a legal and
regulatory definition of insurance, these sources sometimes lead to
differences in how certain products are categorized-whether as insurance
or not. In an effort to reduce confusion, NAIC has attempted to catalog
products regulated by each of the state insurance regulators in
standardized lists known as Uniform Product Coding Matrices (UPCM)-one for
property casualty products and another for life/accident/health products.
Insurers are to use the UPCM as a guide for filings of insurance rates and
policy forms. Most of the products in the UPCM are recognized and
regulated across all states as insurance. However, some differences still
exist. For example, prepaid legal service plans are defined and regulated
as insurance in Texas but not in South Carolina.

Many states have a statutory definition that is stated generally and may
explicitly include and/or exclude specific insurance products.3 A few
states do not have a general definition. For example, Illinois' statute
lists classes of products subject to or excluded from regulation. When a
product is not listed in the statute, Illinois regulators apply a
functional definition consisting of the elements articulated in Griffin
Systems v. Washburn.

We identified some products either not included in the UPCM or subject to
differences in statutory or regulatory approaches among various state
insurance regulators. These include

o products created and offered by noninsurers as substitutes for other
products underwritten by insurers (e.g., debt cancellation contracts
created by lenders as substitutes for credit insurance; see slide 18);

o products that are viewed sometimes as insurance and other times as
prepayment or discount payment plans for services (e.g., legal and medical
services plans; see slides 21-22);

o various annuity products sold by insurers because whether a particular
annuity product is insurance hinged on the level of insurance risk and/or
investment risk assumed by the insurer (e.g., variable annuities in which
the insurer assumes no investment risk and period certain annuities in
which the insurer assumes no mortality risk; see slides 27-28); and

o insurance products regulated by state departments other than state
insurance departments because of their historical association with
particular industries or economic activities (e.g., title insurance that,
according to a state insurance department official, is historically
associated with the real estate market; see slide 31).

Products we identified with differences in regulatory approaches among
some state insurance regulators are listed and discussed on slides 18-31.

Regulation of Products That Cover Insurance Risks in More Than One
Category

Products that cover insurance risks in more than one category (life,
accident, health, property casualty) could face uncertain regulation if
separate insurance definitions were developed and used for each category. 
Currently, insurance products are classified by regulators as life,
accident,4 health, or property casualty insurance, even though some
products cover insurance risks in more than one of these categories.

Based on the product descriptions in NAIC's UPCM, we list and describe
eight insurance products we found that cover risks in more than one of the
categories (slides 33-34). Our list was not intended to be exhaustive but
to illustrate that some products could actually fit in two or more
categories even though each product is historically associated with one
particular category of insurance. The historical associations have not
affected insurance regulation because insurance definitions generally
apply across categories. However, if separate statutory definitions of
insurance were developed for each category, it is unclear how products
characterized by features from multiple categories would be classified for
regulatory purposes. As a result, products that cover insurance risks in
more than one category might be regulated differently or might be
regulated under multiple regimes. For example, it is unclear whether
accident insurance that also provides death and health care benefits would
be regulated solely as accident insurance or also as both life and health
insurance, and whether regulation would differ across the three types of
insurance. (See slides 32-34 for additional information on this issue.)

Reinsurance

Reinsurance is insurance for insurers. In contrast to insurance,
reinsurance is not sold as a standard product. Each contract is separately
negotiated. Two basic types of reinsurance contracts exist-treaty and
facultative. The key difference between treaty and facultative reinsurance
contracts is how insurers select risks for transfer. In a treaty
reinsurance contract, the reinsurer and insurer agree on which select
class(es) of underlying policies of the insurer's to underwrite. In a
facultative reinsurance contract, the reinsurer and insurer agree on
individual underlying policies. In addition to the method of selecting
underlying policies, reinsurance contracts usually contain features such
as floors and caps that limit the amount of risks underwritten.

The transfer of risk is the key element to defining reinsurance. While
reinsurance contracts can also transfer noninsurance risks, it is the
transfer of insurance risk that is the focus when evaluating the validity
of a reinsurance contract. Further, if sufficient insurance risk is
transferred, the entire contract can be defined as reinsurance and qualify
for reinsurance accounting-a type of accounting treatment sought when
beneficial to the insured's financial statements.5 Currently, the
statutory and financial accounting communities are re-evaluating methods
used in determining whether a reinsurer's contract covering property
casualty insurance risks actually transfers insurance risk. Both statutory
and financial accounting standards establish the necessary conditions of
risk transfer for reinsurance contracts including that the reinsurer
assume significant insurance risk and face a reasonable possibility of
significant loss.6 Statutory and financial accounting guidelines also
clarify that while reinsurance contracts may transfer other types of
risks, such as investment risk, only insurance risk is subject to the
conditions for determining risk transfer. Also, the guidelines require
that determinations of risk transfer should consider all features in a
contract such as cancellation provisions or payment schedules that delay
the reinsurer's timely reimbursement of claims; features like these may
limit the transfer of insurance risk. In addition, financial accounting
guidelines explain that determining the extent of risk transferred in one
reinsurance contract should be done in the context of all other related
contracts or agreements because they may potentially limit the transfer of
insurance risk. However, once the determination is made that the contract
transfers sufficient insurance risk, reinsurance accounting can be applied
to the entire contract, including any noninsurance risks being
transferred. (See slides 35-42 for further information on reinsurance.)

Finite Risk Contracts

No widely accepted definition exists for finite risk contracts. Finite
risk contracts can be used by both insurers (finite risk reinsurance) and
noninsurers (finite risk insurance). In general, such contracts transfer
less insurance risk than traditional reinsurance or insurance. Instead,
finite risk contracts tend to emphasize financing and accounting benefits.
Specifically, the contracts allow the insured to transfer to a reinsurer
or insurer both insurance risk and uncertainties about the timing of
certain cash flows and recognition of certain income and expenses. Thus,
an insured could use these contracts to both reduce insurance risk and
control or smooth the timing of cash flows and the recognition of certain
expenses and income. This could favorably affect earnings, capital, and
certain ratios that regulators, rating agencies, and investment analysts
might use to measure and monitor a company's financial health.

Finite risk contracts must transfer sufficient insurance risk to
legitimately qualify for these financing and accounting benefits. Although
finite risk contracts can be legitimately structured to meet these
requirements, some companies that originally presented their finite risk
contracts as transferring sufficient insurance risk, and thus qualifying
for the financing and accounting benefits, were discovered to have used
mechanisms such as undisclosed side agreements that resulted in little or
no insurance risk actually being transferred. Disguising such contracts to
look like "real reinsurance" or insurance can mislead regulators,
policyholders, and investors about the actual financial condition of the
company. (See slides 43-47 for further discussion of finite risk
contracts.)

In summary, we found that there is no single, universal definition of
insurance. However, we identified certain key elements of risk transfer or
risk spreading that were common among the varying definitions. Moreover,
while statutory definitions of insurance sometimes differed between states
leading to differences in the regulation of certain products, states
generally define and regulate the same products as insurance. Insurance
products also are categorized by type of insurance risk such as life,
accident, health, and property casualty. However, some products, while
designated as belonging to one of the major categories, have
characteristics that fall into more than one category. Therefore, if
separate statutory definitions of insurance were developed for products in
each category of insurance risk, products that transfer insurance risks in
more than one category could face uncertain regulation.

Concerning reinsurance and its accounting treatment, the amount of
insurance risk actually transferred is important because of the benefits
of reinsurance accounting to the ceding company. Specifically, if
insurance risk is transferred at sufficient levels, the entire contract
would qualify for reinsurance accounting, with resulting positive effects
on the ceding company's reserves and surplus. Another type of contract-the
finite risk contract-can receive reinsurance accounting or other preferred
accounting treatment but transfers less risk at a lower premium than
traditional insurance. Recently some companies that had these contracts
and used reinsurance accounting treatment were found to have transferred
insufficient insurance risk to qualify for such treatment.

As agreed with your office, unless you publicly announce the contents of
this report earlier, we plan no further distribution until 30 days from
the date of this report. At that time, we will send copies of this report
to the Chairman and Ranking Minority Member of the Senate Committee on
Banking, Housing, and Urban Affairs and the Ranking Minority Member of the
House Committee on Financial Services. We also will make copies available
to others upon request. In addition, the report will be available at no
charge on GAO's Web site at http://www.gao.gov .

If you or your staff have questions regarding this report, please contact
me at (202) 512-5837 or [email protected] . Contact points for our Offices
of Congressional Relations and Public Affairs may be found on the last
page of this report. Lawrence D. Cluff, Angela Pun, Mel Thomas, Christine
J. Kuduk, Nancy S. Barry, and Tania L. Calhoun made key contributions to
this report.

Sincerely yours,

Orice M. Williams Director, Financial Markets and Community Investment

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