specifically named in the policy, whereas open-peril policies insure against all per-
ils except those specifically excluded by the policy. For example, many homeown-
ers in low-lying areas are required to buy flood insurance. This insurance covers only
losses due to flooding, so it is a named-peril policy. A homeowner’s insurance policy,
Chapter 21 Insurance Companies and Pension Funds
525
Casualty or liability insurance protects against financial losses because of a
claim of negligence. Liability insurance is bought not only by manufacturers who
might be sued because of product defects but also by many types of profession-
als, including physicians, lawyers, and building contractors. Whereas the risk expo-
sure in property insurance policies is relatively easy to predict, since it is usually
limited to the value of the property, liability risk exposure is much more difficult
to determine.
Liability risk exposure can have long lag times (often referred to as “tails”).
This means that a liability claim may be filed long after the policy expires. Consider
liability claims filed against the manufacturers of light airplanes. In the 1950s, 1960s,
and 1970s, Cessna and Piper produced airplanes that are still being used today. The
companies often get sued when one of these 30- or 40-year-old planes crashes.
Insurance premiums grew so large in the 1980s due to the extensive lag time that
both Cessna and Piper had to stop producing private airplanes. The cost of the lia-
bility insurance put the price of the planes out of reach of most private pilots.
There has been extensive publicity about high liability awards given by juries.
These awards have often been well above what the insurance companies could have
predicted. Liability insurance premiums continue to rise as a result. Some states have
attempted to limit liability awards in an effort to contain these insurance costs.
Reinsurance
One way that insurance companies may reduce their risk exposure is
to obtain reinsurance. Reinsurance allocates a portion of the risk to another company
in exchange for a portion of the premium. Reinsurance allows insurance companies
to write larger policies because a portion of the policy is actually held by another firm.
About 10% of all property and casualty insurance is reinsured. Smaller insurance
firms obtain reinsurance more frequently than large firms. You can think of it as insur-
ance for the insurance company.
Since the originator of the policy usually has more to lose than the reinsurer,
the moral hazard and adverse selection problems are small. This means that little spe-
cific information about the risk being reinsured is required. As a result of the sim-
plified information requirements, the reinsurance market consists of relatively
standardized contracts.
Terrorism Risk Insurance Act of 2002
The September 11, 2001, terrorist attacks
led the insurance industry to rethink its exposure to losses that could potentially
destroy even the best-capitalized insurance company. Following an intensive lob-
bying effort by the insurance industry, new legislation was passed on November 26,
2002, limiting the amount insurance firms would be required to pay out in the event
of future attacks. The Terrorism Risk Insurance Act of 2002 is limited to acts of inter-
national terrorism in which losses exceed $5 million. Should an act of terrorism occur,
as defined in the legislation, the government will pay 90% of the losses. Losses in
excess of $100 billion are not covered.
Insurance Regulation
Insurance companies are subject to less federal regulation than many other finan-
cial institutions. In fact, the McCarran-Ferguson Act of 1945 explicitly exempts insur-
ance from federal regulation. The primary federal regulator is the Internal Revenue
Service, which administers special taxation rules.
Most insurance regulation occurs at the state level. Not only must an insurance com-
pany follow the standards set by the state in which it is chartered, but it must also com-
ply with the regulations set in any state in which it does business. New York requires
that any insurance company doing business in the state comply with its investment
526
Part 6 The Financial Institutions Industry
standards. Because New York is such a big market, virtually every company complies.
This makes the New York State regulations almost the same as national regulations.
The purpose of most regulations is to protect policyholders from losses due to
the insolvency of the company. To accomplish this, insurance companies are
restricted as to their asset composition and minimum capital ratio. All states also
require that insurance agents and brokers obtain state licenses to sell each kind of
insurance: life, property and casualty, and health. These licenses are to ensure that
all agents have a minimum level of knowledge about the products they sell.
See the Conflicts of Interest box above for a discussion of recent scandals affect-
ing a major insurance broker. Such scandals could result in increased insurance
industry regulation.
C O N F L I C T S O F I N T E R E S T
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