How Insurance Rates Are Regulated

Regulation Is at the State Level, Not Federal

California State Capital Building in Saramento
Image courtesy of [Jordan McAliister] / Getty Images.

As a buyer of business insurance, you may have wondered who determines the rates you pay for commercial policies. Can insurers charge whatever rates they choose or are rates set by regulators? Are insurers regulated by the states or the federal government? This article will answer those questions.

Insurance Rates are Regulated by the State  

Insurance companies are regulated by the states. Each state has a regulatory body that oversees insurance matters.

This body is often called the Department of Insurance, but some states use other names. Examples are the Office of the Insurance Commissioner (Washington) and the Division of Financial Regulation (Oregon). The insurance department is headed by a commissioner. Depending on the state, the insurance commissioner may be appointed or elected.

All states regulate the rates used in some types of insurance. The extent of regulation varies widely from state to state. Some states exert very tight control while others impose very little. Most states fall somewhere in the middle.

Why Not Federal Regulation

Many insurance companies conduct business across state lines. A few do business in virtually all states. Why aren't insurers regulated by the federal government? The answer lies in a law passed in 1945 called the McCarran-Ferguson Act. This law gives states the authority to regulate insurers. The law was enacted in response to a decision by the U.S. Supreme Court the previous year.

The court ruled that the business of insurance constituted interstate commerce. This meant that the federal government had the right to regulate insurance.

The Supreme Court decision threatened to upend the insurance industry by eliminating state control. The McCarran-Ferguson Act restores power to the states.

It gives states the right to tax and regulate insurers. However, the law contains three key exceptions:

  • Insurers are subject to federal anti-trust acts to the extent they aren't regulated by state law.
  • The federal government may pass insurance laws that supersede state laws.
  • Insurers are subject to federal laws barring them from engaging in any boycott, coercion or intimidation.

In 2010 Congress passed the Dodd-Frank Act, which imposed many new regulations on financial institutions. The law established the Federal Insurance Office (FIO). This agency is part of the U.S. Department of Treasury. It was created to monitor the insurance industry to ensure it is financially stable. The FIO is an advisory body only. It has no regulatory authority over insurers.

Purpose of Rate Regulation

There are several reasons why states regulate insurance rates. One is to ensure that rates aren't excessive. In the absence of regulation, insurers might charge rates that are too high and that generate too much profit. A second purpose is the opposite, to ensure that rates aren't too low. An insurer that charges excessively low rates might sell many policies, but lack the funds to pay claims. Rates must be adequate so that insurers remain solvent.

A third goal of insurance regulation is to prevent unfair discrimination. Insurance underwriters are permitted to discriminate in favor of some insurance buyers over others, but the reasons must be valid. For instance, underwriters may charge a higher or lower rate based on a policyholder's claims history. A business that has incurred no prior auto claims may pay less for a commercial auto policy than a similar business that has sustained many auto losses. Underwriters may also discriminate based on the nature of the risk. An insurer may charge more to insure a building that has no fire sprinklers than a similar building that is fully sprinklered.

Insurers are barred from discriminating against policyholders based on factors unrelated to the risks insured. Examples are race, religion and national origin.

Certain characteristics may be used to rate some types of insurance but not others. For instance, many states allow insurers to consider age, sex and marital status in the rating of personal auto coverage. These factors are not relevant to commercial auto rating.

Types of Rate Laws

All states exert some control over the rates used by insurers. However, insurance rate laws vary widely from state to state. Some states have strict laws that require pre-approval of all rates. Others have lenient laws that require no pre-approval. Many require prior-approval of some rates.

There are six basic types of insurance rate laws. 

  1. Prior-approval Insurers must submit rates to the state rating authority and wait for approval before using them. In some states, the insurer may assume the rates have been approved if it has not heard otherwise from the insurance department within a specified time period (such as 90 days).
  2.  File and Use Insurers must file their rates with the regulatory agency but may begin using them immediately after filing.
  3. Use and File Insurers may use new rates immediately but must file them with the regulator within a specified time period.
  4. Modified Pre-Approval Insurers must obtain pre-approval only for rate changes that are the result of an improvement or deterioration of the insurer's loss experience.
  5. Flex Rating Insurers must seek approval for rate changes that exceed a specified percentage. For example, insurers may be required to obtain prior approval if they increase or decrease their rates by more than 5%.
  6. No Filing Insurers are not required to file rates or obtain approval from the regulator.

Many states use a combination of these laws. For instance, a state may require insurers to obtain prior-approval of rates used in personal lines, but allow insurers to "file and use" rates used in commercial lines. Most rating laws permit state regulators to disallow rates that have already been filed. For instance, an insurance commissioner may bar an insurer from using rates filed under a "use and file" law on the basis that the rates are inadequate.

The six types rating laws described above are often divided into two categories: prior-approval laws and competitive rating laws. Competitive rating laws is a collective term that includes all rating laws other than those that require rates to be pre-approved.

Currently, only a few states have prior approval laws that apply to all types of insurance. About a third of the states have no prior approval law at all. The remaining states have a mix of prior approval and competitive rating laws. Generally, rates used in business insurance are subject to less regulation than those used in personal insurance.

Problems With Prior Approval

Prior approval laws are based on the concept that government intervention is necessary to ensure that rates are adequate but not excessive. In the past, many state lawmakers have supported this concept. Over the last few decades, however, legislators have discovered that prior approval laws can create serious problems.

For one thing, a rating system based on prior approval is costly. Both insurers and state regulators must employ staff to ensure that rates are submitted and reviewed in accordance with the law. Insurers that operate in multiple states have an added burden, since the filing requirements vary from state to state. The costs incurred by insurers and state agencies are passed onto insurance buyers. Thus, rates are often higher in prior approval states than in those with competitive rating laws.

Secondly, prior approval laws create rates that are artificially low. Regulators often resist rate increases requested by insurers, causing increases to be delayed. When rates are too low, insurers suffer financial losses. When rates finally increase, insurers' financial condition rebounds. The result is seesawing profits and losses.

Prior approval laws can also create a shrinking insurance market. When rates are too low to cover insurers' losses and expenses, some insurers leave the state. Others are reluctant to enter. The result is reduced availability of insurance. Service and product choice may suffer as well. When rates are too low, insurers have little incentive to develop new products or improve service. 

Finally, prior approval laws can lead to an influx of average-risk buyers into assigned risk plans. These plans are supposed to be a market of last resort. They are designed for high-risk buyers that can't obtain a policy from a standard insurer. Yet, when insurance is unavailable from "regular" insurers, average-risk buyers are forced into assigned risk plans.

Benefits of Competitive Rating

Because of the problems associated with pre-approval laws, many states have modernized their regulatory process by instituting competitive rating. Competitive rating laws are based on the idea that competition will produce rates that are neither too high nor too low. These laws have been successful in many states because the insurance industry is highly varied. There are numerous insurance companies, and none is large enough to control the market. According to the Insurance Information Institute, there were over 2500 property/casualty insurers operating in the United States in 2015.

Competitive rating laws provide a number of benefits to insurance buyers. One is lower rates. Insurers are more likely to reduce their rates when they know they can quickly raise them later to compensate for losses. Secondly, insurers' financial performance is more consistent under a competitive rating system. When profits and losses are predictable, other insurers will enter the state. As the number of insurers increases, competition among insurers increases as well. This helps keeps prices low. Competitive pressures also encourage insurers to improve their service and diversify their products to attract customers.

Finally, competitive rating creates less demand for assigned risk plans. When insurers are seeking new customers, most insurance buyers are able to obtain coverage in the standard market. Assigned risk plans can operate as intended, and won't compete with standard insurers.