text:
State of Arizona
of the
Auditor General
Report to the Arizona Legislature
By Douglas R. Norton
Auditor General
November 1998
Report Number 98-21
2910 NORTH 44th STREET • SUITE 410 • PHOENIX, ARIZONA 85018 • (602) 553-0333 • FAX (602) 553-0051
November 20, 1998
Members of the Arizona Legislature
The Honorable Jane Dee Hull, Governor
Mr. Charles Cohen, Director
Arizona Department of Insurance
Transmitted herewith is a report of the Auditor General, A Performance Audit of the
Arizona Department of Insurance. This report is in response to a May 27, 1997,
resolution of the Joint Legislative Audit Committee. The performance audit was
conducted as part of the Sunset review set forth in A.R.S. §41-2951 through 41-2959.
We found the Department generally functions effectively. However, the Department
can improve the manner in which it reviews insurance rates and investigates insurance
fraud. Arizona adopted an open competition approach to regulating most property and
casualty rates in 1980. Nevertheless, the Department continues to review all rate filings
for adequacy. Since market forces serve as the primary regulator of rates in an open
competition environment, such detailed and comprehensive reviews are generally
unnecessary. Instead, the Department should target its rate reviews to those companies
which may be at the greatest risk from charging inadequate rates, or companies which
may be engaging in predatory pricing. Further, the Department should expand its
market monitoring activities to ensure that all insurance markets remain competitive.
We also found that the Department's Fraud Unit has recently demonstrated a stronger
impact in the fight against insurance fraud. For example, between fiscal years 1995 and
1997, the rate of indictments and convictions increased from 48 percent to 73 percent.
Despite this improvement, the Unit's overall impact may still be limited because it does
not adequately track whether insurance companies comply with fraud reporting
November 20, 1998
Page -2-
As outlined in its response, the Department of Insurance agrees with the findings and
recommendations, although it does not agree with all of the report's underlying
analysis regarding rate review. Because the Department's disagreement with the
analysis is largely philosophical, we have enclosed an Auditor's Note immediately
following the response summarizing our position on the issues raised by the
My staff and I will be pleased to discuss or clarify items in the report.
This report will be released to the public on November 23, 1998.
Douglas R. Norton
Auditor General
The Office of the Auditor General has conducted a performance audit of the Arizona
Department of Insurance (Department), pursuant to a May 27, 1997, resolution of the
Joint Legislative Audit Committee. This audit was conducted as part of the Sunset re-view
set forth in Arizona Revised Statutes (A.R.S.) §§41-2951 through 41-2957.
The Department was established in 1913 to regulate the insurance industry in Arizona.
As provided in the Arizona State Constitution, all companies selling insurance within
the State shall be subject to licensing, control, and supervision by a department of in-surance.
Further, Title 20 authorizes the Arizona Department of Insurance to license
insurance companies and agents, provide consumer assistance, investigate complaints
from the public, review insurance forms and rate filings, monitor the financial status of
insurers, oversee guaranty funds, and collect premium taxes and other fees.
Rates and Regulations Division
Uses Ineffective Rate
Review Process
(See pages 9 through 16)
Although Arizona adopted an open competition approach to regulating rates in 1980, the
Rates and Regulations Division (the Division) within the Department uses an ineffective rate
review process. State law requires that insurance rates not be excessive, inadequate, or un-fairly
discriminatory. Typically, state insurance departments regulate rates for these stan-dards
using two primary approaches:
n Prior Approval—which requires that no insurer use an insurance rate without first filing
and receiving the state insurance department's approval; or
n Open Competition—which relies on competition as the primary regulator of rates.
However, insurance departments may still review rates to ensure they are not inade-quate
or unfairly discriminatory.
While prior approval and open competition are equally effective in ensuring fair insurance
prices, there is typically less cost associated with an open competition approach. Although
insurance companies no longer need approval before using open competition rates in Ari-zona,
the Division continues to subject the approximately 3,000 rate filings it receives each
year to the same scrutiny as those under a prior approval approach. Consequently, the Divi-sion
has not taken advantage of the potential cost savings associated with an open competi-tion
While the Division continues to review all rate filings, these reviews offer minimal consumer
protection. First, the Division cannot disapprove a rate filing even if it appears excessive be-cause,
under the State's open competition rating law, rates are presumed not to be excessive
if a reasonable degree of competition exists. Second, the Division's current process for re-viewing
rates for adequacy is not sufficient to identify insurers at risk of future insolvency.
By focusing on only one rate of many that a company may have in effect, the Division can-not
determine possible future solvency problems. Further, the Division does not disapprove
rates when they appear to be inadequate, and has a 15-month backlog of rates to be re-viewed.
Therefore, the Division can more effectively use its resources by targeting its rate
reviews to those companies most in danger of future insolvency should they charge inade-quate
In addition to targeting its rate review activities, the Division should also expand its moni-toring
of the State's insurance markets to ensure a competitive environment. This expanded
market monitoring should consider at least the following four statutorily required "tests of
competition" for all markets, where feasible:
1) The number of insurers actively engaged in the business;
2) The market share and changes in market share of insurers;
3) The existence of price differentials; and
4) The ease with which new insurers can enter the market.
Fraud Unit Can Further
Enhance Its Performance
(See pages 17 through 22)
While the Department's Fraud Unit has improved since its inception in fiscal year 1995, it
can take additional steps to further enhance its effectiveness. Although the Fraud Unit pro-duced
a minimal number of cases for prosecution in its first 2 to 3 years, it has recently dem-onstrated
a stronger impact in the fight against insurance fraud. For example, between fiscal
years 1995 and 1998, the number of insurance company fraud referrals increased from 620 to
1,355, while the number of fraud referrals submitted for prosecution increased from 23 to
147. Additionally, between fiscal years 1995 and 1997 the rate of indictments and convictions
obtained from those cases submitted for prosecution increased from 48 percent to 73 per-cent.
Despite this improvement, the Unit's inadequate tracking and analysis of fraud referrals
may ultimately limit its impact. Although statute requires insurance companies to report
suspected fraud cases to the Department, some insurers may not report suspected fraud.
However, due to limitations in its fraud referral database, the Department cannot determine
which insurance companies have reported suspected fraud and which have not. The Fraud
Unit should revise its referral form to capture an insurance company's unique identifier and
enter this number in the fraud referral database. This will allow the Unit to identify those
companies that have not reported suspected fraud. In addition, the Fraud Unit should enact
procedures to inform and educate insurance companies regarding case referrals.
Other Pertinent Information
(See pages 23 through 26)
During the audit, other pertinent information was collected regarding the Department's
regulatory oversight of public risk pools. A public risk pool is a cooperative group of
government entities that join together to finance self-insurance expenses and share
losses. Three public risk pools have become insolvent in recent years, leaving some
public entities liable for their own claims. Because these pools are considered a form of
self-insurance, they are regulated at a much lower level than traditional insurers. For
example, public risk pools do not have to meet as strict financial requirements as do
traditional insurers and the Department has no authority to intervene in the operations
of public risk pools to avoid insolvencies. Instead, the Department's role is primarily
limited to providing recommendations to abate an insolvency should one occur.
1 Indictment and conviction rate is based upon fiscal year 1995 through 1997 data because a large
number of referrals are pending review by prosecutors in fiscal year 1998. The number of indictments
and convictions reported for fiscal year 1998 may change significantly due to the high number of
pending referrals.
(This Page Intentionally Left Blank)
Table of Contents
Introduction and Background ................................................. 1
Finding I: Rates and Regulations Division
Uses Ineffective Rate Review Process............................... 9
Background........................................................................................................ 9
Arizona Does Not Take Full Advantage
of Open Competition Environment ............................................................... 10
Inefficient Rate Review
Process Provides Minimal
Consumer Protection........................................................................................ 11
Division Could Better Use Resources
by Targeting Reviews and Monitoring Markets .......................................... 13
Recommendations............................................................................................. 16
Finding II: Fraud Unit Can Further
Enhance Its Performance.................................................... 17
Insurance Fraud
a Costly Crime................................................................................................... 17
Fraud Unit Performance
Steadily Improving........................................................................................... 18
Inadequate Tracking and
Analysis of Referrals May Limit
Fraud Unit's Impact.......................................................................................... 20
Recommendations............................................................................................. 22
Other Pertinent Information..................................................... 23
Table of Contents (concl'd)
Sunset Factors ......................................................................... 27
Agency Response
Auditor's Note
(to Agency Response)
Table 1 Department of Insurance
Statement of Revenues, Expenditures, and
Other Changes in Fund Balance
Years Ended June 30, 1996, 1997, and 1998
(Unaudited).......................................................................... 3
Table 2 Department of Insurance
Fraud Unit Annual Output Statistics
Years Ended June 30, 1995 through 1998
(Unaudited).......................................................................... 19
Table 3 Public Risk Pools That Have Become Insolvent
Years Ended June 30 or December 31, 1992
through 1997 (Unaudited) ................................................. 25
The Office of the Auditor General has conducted a performance audit of the Arizona
Department of Insurance (Department), pursuant to a May 27, 1997, resolution of the
Joint Legislative Audit Committee. This audit was conducted as part of the Sunset re-view
set forth in Arizona Revised Statutes (A.R.S.) §§41-2951 through 41-2957.
The Department of Insurance was created and placed under the direction of the Arizona
Corporation Commission in 1913. In 1968, Arizona voters approved a constitutional
amendment creating an independent Department of Insurance. The amendment estab-lished
that all insurers operating within the State shall be subject to the licensing, con-trol,
and supervision of a department of insurance. As such, the Department's mission
is to:
"… promote a favorable insurance marketplace for the benefit of Arizona residents and
to foster a financially and legally sound insurance environment that enhances Arizona's
economic development and protects insurance consumers."
In fulfilling its mission, the Department licenses or otherwise approves the transaction
of insurance business by companies, agencies, brokers, and other insurance-related en-tities;
monitors the financial health of insurers; protects insurance consumers against
illegal business practices; and collects more than $144 million in insurance premium
taxes and other revenue for the State.
Organization and Staffing
As of July 1, 1998, the Department is authorized 138 full-time equivalent employees (FTE) to
fulfill its various responsibilities. Aside from the 7 executive staff within the Director's Of-fice,
the Department's remaining personnel are divided among 10 divisions:
n Consumer Services and Investigations (27 FTEs)—This Division provides a variety
of consumer services, including responding to inquiries; distributing information; inves-tigating
complaints; and monitoring the activities of insurers, agents, brokers, adjusters,
and bail bondsmen. The Division also assists consumers having difficulty in obtaining
insurance coverage.
n Corporate and Financial Affairs (24 FTEs)—This Division monitors solvency of the
more than 2,000 active insurance companies conducting business in Arizona through ex-amination
and analysis of insurers' financial information. In addition to staff, the Divi-sion
also has 54 private contractors available to conduct financial examinations.1
n Administrative Services (20 FTEs)—This Division handles the Department's business
and licensing functions, including accounting, budgeting, revenue forecasting, and pay-roll;
and licensing agents, brokers, adjusters, and others who qualify for licensure under
Arizona insurance law.
n Fraud (16 FTEs)—This Unit investigates complaints involving fraud committed against
n Life and Health (15 FTEs)—This Division reviews life and health insurance forms,
rates, and advertising material for compliance with Arizona insurance laws.
n Rates and Regulations (11 FTEs)—This Division's primary responsibilities include
reviewing property and casualty rates and forms for compliance with Arizona insurance
laws; and licensing and registering various insurance-related entities, such as life and
health insurance administrators.
n Market Conduct Examination (7 FTEs)—This Division monitors insurers to ensure
they do not engage in any unfair trade or claims settlement practices. In addition to staff,
the Division has between 25 to 30 private contractors in the field at any given time ex-amining
insurers' marketing, rating, underwriting, and claims practices.
n Guaranty Funds (5 FTEs)—This entity administers Arizona's two guaranty funds,
which were established to pay claimants when insurers become insolvent and are unable
to meet their obligations.
n Receivership (3 FTEs)—This division supervises and coordinates all domestic insur-ance
companies (those incorporated in Arizona) that become insolvent.
n Information Services (3 FTEs)—This Division manages the Department's computer
resources and maintains the Department's Internet Website.
1 Contract examiners' costs are covered by those insurers examined, as required by A.R.S. §20-156.
Table 1
Department of Insurance
Statement of Revenues, Expenditures, and Other Changes in Fund Balance1
Years Ended June 30, 1996, 1997, and 1998
1996 1997 1998
State General Fund appropriations $ 4,640,200 $ 4,388,500 $ 4,780,500
Insurance premium taxes 114,146,310 120,515,441 124,636,458
Licenses and fees2 11,992,819 12,027,697 13,569,099
Sales and charges for services 126,022 109,443 117,562
Fines and forfeits 1,029,373 1,527,470 810,287
Interest on investments 17,812 16,058 15,307
Other 48,445 111,811 801,468 6
Total revenues 132,000,981 138,696,420 144,730,681
Personal services3 2,719,330 3,025,798 3,616,194
Employee related 653,228 676,798 765,892
Professional and outside services4 7,332,214 7,313,488 7,801,199
Travel, in-state 22,387 25,191 28,617
Travel, out-of-state 17,338 18,573 21,940
Other operating 1,307,758 1,026,158 1,153,358
Capital outlay 222,861 7,161 82,668
Total expenditures 12,275,116 12,093,167 13,469,868
Excess of revenues over expenditures 119,725,865 126,603,253 131,260,813
Other financing uses:
Remittances to the State General Fund5 119,853,354 126,693,733 130,575,128
Reversions to the State General Fund 81,722 110,549 135,428
Total other financing uses 119,935,076 126,804,282 130,710,556
Excess of revenues under expenditures and other
financing uses (209,211) (201,029) 550,257
Fund balance, beginning of year 852,102 642,891 441,862
Fund balance, end of year $ 642,891 $ 441,862 $ 992,119
1 The table excludes financial activity of the Arizona Property and Casualty Guaranty Fund and the Arizona Life and Disability
Insurance Guaranty Fund since assets for these funds are held by the State on behalf of others. As of the end of fiscal year 1998,
these funds had unaudited ending fund balances of $328,926 and $11,981,344, respectively.
2 Primarily includes fees charged to insurers for examinations performed in accordance with A.R.S. §20-156. The Department
examines the affairs, transactions, accounts, records, and assets of insurers who have the authority to do business in the State.
3 From fiscal year 1996 through fiscal year 1998, the Department converted independent contractor positions to full-time equiva-lent
positions within the Department. Thus, the Department's FTE count grew from 121 FTE in fiscal year 1996 to 134 in fiscal
year 1998. Associated personal services and employee-related expenditures also increased.
4 Primarily includes compensation to independent contractors and reimbursement for expenditures related to examination serv-ices
performed in accordance with A.R.S. §20-156.
5 Excludes amounts received from the Arizona Life and Disability Insurance Guaranty Fund, which are liquidated assets of insol-vent
insurers and are ultimately deposited in the State General Fund.
6 Primarily includes reimbursements for the administrative costs of operating the Guaranty Funds and Receivership Division. The
Guaranty Funds were previously administered externally; therefore, there were no reimbursements for the Guaranty Funds in
prior years. Additionally, reimbursements for administrative costs of the Receivership Division vary significantly depending on
receivership collections.
Source: The Arizona Financial Information System (AFIS) Accounting Event Extract File for years ended June 30, 1996 and 1997, and
the AFIS Revenue and Expenditure by Fund Program, Organization, and Object report, the AFIS Trial Balance by Fund report,
AFIS Status of Appropriations and Expenditures report, and the State of Arizona Appropriations Report for the years ended June
30, 1996, 1997, and 1998.
The Department's operations are funded through a General Fund appropriation and
fees that are assessed to insurers. The majority of revenue the Department collects is
remitted to the State General Fund. As illustrated in Table 1 (see page 3), fiscal year 1998
premium tax revenues totaled $124.6 million, while licenses, fees, and other revenues
amounted to $15.3 million. For its operations, the Department spent $13.4 million dur-ing
fiscal year 1998. Table 1 also summarizes the Department's revenues, expenditures,
and other changes in fund balance for fiscal years 1996 through 1998.
Follow-up on Prior Audits
As part of the current audit, concerns identified in the Auditor General's 1995 special inves-tigation
of the Insurance Examiners' Revolving Fund and the performance audit of the De-partment
(Auditor General Report No. 89-8) were reviewed. The primary recommendations
presented in the 1995 report and subsequent actions taken are described below:
n Independent contractors still receive significant employee benefits—While the De-partment
has taken some action to reduce the benefits provided to independent con-tractors,
they still receive significant employee benefits. The 1995 special investigation
found that the "independent contractors" hired by the Department to perform financial
and market conduct examinations and analysis may meet the common law definition of
"employee" and therefore, the Department may be liable for applicable employment-related
taxes and withholdings. As such, the report recommended that the Department
exercise considerably less control over its independent contractors by maintaining a true
independent, arm's-length relationship with them.
Although the Department discontinued the policy of paying its contractors holiday pay,
the Department continues to provide some of its contractors with office space, clerical
assistance, computer equipment, office supplies, and reimbursement for travel expenses.
Therefore, the Department should take additional steps to ensure it maintains an appro-priate
relationship with its independent contractors.
n Oversight of contractor billings has improved—The 1995 report also found that the
Department did not adequately monitor the billings of contractors; however, the De-partment
has since improved its oversight in this area. Specifically, the 1995 special in-vestigation
report recommended that the Department monitor and verify contractor
billings, ensure that contract examiners do not process their employer's billings, and en-sure
that reimbursements are not made for unallowed expenses. This would help ensure
that contract examiners are compensated for only those services actually provided and
reimbursed only for allowable expenditures actually incurred. To improve contract en-
forcement and oversight, Department employees now review contractor billings and
contractors must submit receipts for all expenses incurred (except meals).
Recommendations presented in the 1989 performance audit report and subsequent actions
taken are described below:
n Other reforms considered to control increasing automobile insurance rates—The
1989 audit found that although statutes use rate regulation to control affordability of in-surance,
rates are not significantly affected by the type of rate regulation system. There-fore,
the 1989 report recommended that the Legislature consider other types of reforms
to reduce automobile rates including no-fault insurance, limitations on noneconomic
damage awards, joint and several liability, and automobile theft and fraud initiatives.
In the early 1990's, reforms were implemented to control increasing automobile insur-ance
rates. Specifically, the Legislature established the Automobile Theft Authority in
1992 to assist law enforcement with funding and programs for reducing the State's auto
theft rate. Legislation was also approved in 1994 to annually assess insurers a fixed
amount to fund a fraud unit within the Department of Insurance. Finally, two referen-dums
were initiated to pass no-fault insurance laws in 1990; however, Arizona citizens
rejected them.
n Delays in processing complaint cases referred to the Attorney General's Office
have increased—Although the Department has attempted to address lags in the
processing of complaints referred to the Attorney General's Office, delays have not
only continued, but have increased. According to the 1989 audit, it took an average
of 72 days from referral of the complaint to issuance of a hearing notice or consent
order. The Department now reports averages of 140 and 169 days for 1996 and 1997,
respectively. The Department is attempting to address some of the continuing delay
by reassigning a Department staff member to draft hearing notices and consent or-ders
to submit to the Attorney General's Office with the complaint case files, thus
relieving Attorney General staff from having to perform this activity.
n Department's timeliness in resolving routine complaints continues to exceed de-sired
time frame—The 1989 audit found that the Department failed to resolve nearly
half of all consumer complaints within its established standard of 30 working days, due
primarily to a manual system of tracking complaints and inadequate staffing.
The Department has attempted to address the issue of untimely complaint resolution by
implementing an automated complaint tracking database, increasing its investigative
staff by 50 percent, and upgrading the position classification for investigators. In addi-tion,
the Department has also revised its internal goal from 30 working to 60 calendar
days to more realistically reflect the time needed to resolve complaints. The Department
now reports that in fiscal year 1997, it took an average of 71 calendar days to resolve a
complaint. Department personnel point out that although 71 days exceeds the Depart-ment's
goal, it compares favorably to the number of days required by other state regu-latory
agencies to resolve complaints, especially given the Department's complaint-to-staff
Notable Accomplishments
Similar to the 1989 audit, work performed for this audit indicates that the Department func-tions
effectively in several areas. For example, the Department expedited its licensing proc-ess
through implementation of the "On-the-Spot" licensing program, whereby an individual
can bring in a completed license application and have it reviewed by a licensing specialist. If
the application is in order, a license will be issued on-the-spot (i.e., within an average of 20
In addition, in 1993 and 1998 the Department received accreditation from the National As-sociation
of Insurance Commissioners (NAIC) Financial Regulation Standards and Ac-creditation
Committee.1 In order to receive such accreditation, the Department must have
the laws, resources, and operating procedures necessary to meet NAIC standards. Such
standards ensure state insurance departments analyze the financial condition of their do-mestic
insurers in a consistent and thorough manner. Consequently, accredited states may
rely on the financial analyses of other accredited states so that multi-state insurers do not
have to submit to costly and duplicative examinations in each state in which they transact
In conjunction with accreditation, the Department has enhanced its financial surveillance
program, increasing its staff from 4 analysts in fiscal year 1992 to 11 analysts in fiscal year
1997. Additionally, the analysts now perform most of their analyses on computerized finan-cial
data, making their reviews more timely.
Audit Scope and Methodology
The audit focused on the Department's ability to efficiently and effectively fulfill its role
to regulate the conduct of insurance business in this State. Specifically, audit work as-
1 The NAIC is an organization of insurance regulators from the 50 states, the District of Columbia, and
the 4 U.S. territories. It was created in 1871 to provide a forum for the development of uniform policy
when uniformity among states is appropriate.
sessed the impact of performing detailed reviews of property and casualty rates regu-lated
under open competition law and the effectiveness of the Department's Fraud Unit.
To assess the value of the Department's current property and casualty rate review process, a
review was conducted of state legislation pertaining to rate regulation, interviews were con-ducted
with the Department's rate analysts, and analyst productivity statistics were exam-ined.
Additionally, articles and studies on the benefits and costs of rate regulation were re-viewed.
Various organizations and individuals were also contacted, including Property and
Casualty Rate and Regulation Divisions in 13 other states with open competition rating
laws, industry trade organizations, insurance research organizations, and a rate service or-ganization.
1 Written communications from the Department's rate regulatory division to its
financial regulatory division pertaining to potentially troubled insurers identified during
rate reviews were also reviewed. Finally, documentation pertaining to prior reviews of Ari-zona's
regulation of property and casualty rates was obtained and reviewed.
To evaluate the effectiveness of the Department's Fraud Unit, interviews were conducted
with fraud investigation personnel from eight other states, industry fraud investigators, and
state and county prosecutors responsible for prosecuting fraud cases.2 Additionally, reviews
and analyses were conducted of the Fraud Unit's database, investigation files, and perform-ance
data. Documentation from the National Insurance Crime Bureau and the Coalition
Against Insurance Fraud was also obtained and reviewed. Further, two meetings of the Ari-zona
International Association of Special Investigation Units were also attended. Finally, an
auditor accompanied Fraud Unit investigators on an actual investigation.
This report presents findings and recommendations in two areas:
n The Department's Rates and Regulations Division needs to target its rate review activi-ties
and expand its current monitoring of insurance markets.
n The Department's Fraud Unit needs to improve its case referral tracking and formalize
procedures for corresponding with and educating insurers about fraud referrals and in-vestigations.
1 Organizations contacted included the National Association of Insurance Commissioners, American
Insurance Association, Alliance of American Insurers, Insurance Information Institute, Center for
Risk Management and Insurance Research, Insurance Institute of America, American Academy of
Actuaries, and Insurance Services Office, Inc. States contacted included Colorado, Florida, Idaho, Illi-nois,
Iowa, Kansas, Kentucky, Missouri, Tennessee, Utah, Vermont, Wisconsin, and Wyoming.
2 States contacted were those with established insurance fraud units, the majority of which are located
on the East Coast, and included California, Connecticut, Florida, Maryland, Massachusetts, New Jer-sey,
North Carolina, and Pennsylvania.
In addition, the report contains an Other Pertinent Information section on the Department's
current regulatory responsibility over public risk pools.
The audit was conducted in accordance with government auditing standards.
The Auditor General and staff express appreciation to the Director and staff of the Arizona
Department of Insurance for their cooperation and assistance during the course of the audit.
Although Arizona adopted an open competition approach to regulating most property and
casualty rates in 1980, the Rates and Regulations Division uses an ineffective process to re-view
these rates. Further, the Division's current labor-intensive, time-consuming rate review
process has a limited impact on consumer welfare. Therefore, the Division should revise its
approach to regulating rates in an open competition environment by adopting a targeted
approach to reviewing rates for inadequacy and expanding its market monitoring program.
State law requires that insurance rates not be excessive, inadequate, or unfairly
discriminatory. As such, Arizona, like most other states, has established a process to review
insurance rates to ensure compliance with these three standards, thereby protecting
consumers' interests. Typically, insurance departments regulate rates using two primary
n Prior approval—which requires that no insurer use an insurance rate without first filing
and receiving approval by the state insurance department; or
n Open competition—which relies on competition as the primary regulator of rates.
However, even under the open competition approach, insurance departments may still
review rates to ensure they are not inadequate or unfairly discriminatory. According to the
NAIC, as of July 1998, about 80 percent of the states regulate some of their property and
casualty lines of insurance through some variation of open competition.
Arizona Does Not Take Full
Advantage of Open Competition
Although an open competition approach to regulating rates is equally effective and less
costly than a prior approval method, the Division has not realized the potential benefits
available under open competition. In 1980, Arizona moved from a prior approval rating law
to an open competition regulatory approach.1 Evidence suggests it is equally effective at
protecting consumers but less costly to administer. However, the Division has not taken
advantage of these cost savings because it continues to subject all rate filings to a detailed
Open competition equally effective and less costly—Most of the empirical work on various
regulatory approaches indicates prior approval and open competition are equally effective
in ensuring fair insurance prices, but there is typically less cost associated with an open
competition approach.2 First, regulators incur fewer administrative costs because they do
not have to subject each filing to a detailed review in order to determine if it meets statutory
standards, since market forces serve as the primary regulator of rates. Second, insurers incur
less cost because they can quickly adjust their rates in response to changing costs or
competitive pressures without the delays associated with obtaining approval. Finally,
consumers incur fewer costs because insurers can introduce new products in response to
consumer needs without passing on the costs associated with prior approval regulation.
Division does not take advantage of cost savings—The Division has not taken advantage of
these cost savings because although insurance companies no longer need prior approval to
use open competition rates, the Division continues to subject all rate filings to the same
scrutiny as it would under a prior approval approach. Specifically, the Division continues to
review in detail each of the approximately 3,000 rate filings it receives each year, taking an
average of two hours to complete each filing. Under a prior approval approach, analysts
must review each rate filing, including examining supporting documentation, actuarial
methodology, and rate calculations, to determine if a rate is excessive, inadequate, or
unfairly discriminatory. However, under open competition, market forces are the primary
regulator of rates. Consequently, the Division should not have to review or analyze every
open competition rate filing to the same degree as a prior approval filing.
While Division officials contend that reviewing every rate filing in detail provides
maximum consumer protection, studies suggest that applying a prior approval approach in
1 In Arizona, only workers' compensation and title insurance are still subject to prior approval regulation
in the property and casualty market.
2 Ettlinger, Hamilton & Krohm. "State Insurance Regulation," 1995, pgs. 72-76.
an open competition environment is not only unnecessary but costly to taxpayers.
Specifically, one study states, "…certainly regulatory agencies in prior approval environments
may appear to be more accountable to the consumers (voters); nevertheless, after the smoke clears…the
taxpayers have expended a lot of money while receiving very little, if any, measurable benefit."1
Furthermore, as a study by the National Association of Insurance Commissioners (NAIC)
points out, "…if an insurance department attempts to evaluate each and every price of an individual
insurer, little benefit would be obtained from the enactment of an open competition rating law."2
In addition, other states that have enacted open competition laws do not review every
rate filing in detail. Auditors contacted 13 states that have an open competition law and
found that, in practice, 10 limit their detailed reviews to those rates that are of unique
concern to that particular state.
Inefficient Rate Review
Process Provides Minimal
Consumer Protection
Even though the Division continues to review all rates, these reviews offer minimal con-sumer
protection. Specifically, the Division's rate reviews are unnecessary to protect con-sumers
against excessive rates. Additionally, the Division currently employs an ineffective
process to ensure the adequacy of rates submitted by insurers.
Reviews unnecessary to protect against excessive rates—While the Division continues to
review all filings for the purpose of protecting the consumer, reviewing filings for excessive
rates is unnecessary. Under the State's open competition rating law, rates are presumed not
to be excessive if a reasonable degree of competition exists. In fact, the Director cannot
declare a rate excessive unless he has determined that a market is uncompetitive, a situation
that has never occurred in the 18 years the open competition law has been in existence.
Consequently, the Division does not need to review individual filings for excessive rates
because the Director does not have the authority to disapprove a rate filing even if it appears
to be excessive. Instead, the Division should monitor markets for excessive rates as
discussed on page 14.
Reviews ineffective in ensuring adequacy of rates—The Division's current rate review
process also does not effectively protect consumers against the effects of inadequate rates.
One reason often given for reviewing filings for inadequate rates is to identify companies
1 Morrow, J. Glenn. "Regulatory Environments: Do They Matter?" Journal of Insurance Regulation, Fall
1992, p. 52.
2 Hanson, Dineen & Johnson. "Monitoring Competition: A Means of Regulating the Property and Liability
Insurance Business," 1974, p. 640.
that may be at risk for future insolvency. Theoretically, if insurance companies charge rates
that generate insufficient revenue (premiums) to cover operating costs, insolvency can result
and leave an insurer unable to pay the claims of policyholders. While statute prohibits
insurers from charging inadequate rates to consumers, statute does not specify the process
the Department should use to protect consumers from inadequate rates. Currently, the
Division enforces this provision through individual rate reviews. However, individual rate
reviews, as currently conducted, cannot necessarily determine whether a company may be
at risk for future insolvency. Specifically, the Division would have difficulty in identifying
and correcting future insolvency problems for the following reasons:
n Scope of review limited—The Division needs more information than just one rate filing
to determine the potential for future insolvency. Currently, insurers are only required to
submit new rates and rate changes and as such, the Division typically reviews only a
segment of a company's possible rates at any one time. However, identifying one inade-quate
rate filing does not necessarily indicate solvency problems because an insurance
company could have several other insurance products, which may be more profitable.
Unless the Division reviews all of an insurer's rates at the same time, it cannot determine
the company's overall profitability.
n Division does not disapprove rates for inadequacy—Although the Division has the
authority to disapprove rates for inadequacy through an order issued by the Depart-ment's
Director, it does not use this authority. Under the State's open competition rating
law, insurers consider many factors besides losses and expenses when establishing their
rates. Such factors include the company's overall profit, the types of investments, divi-dends,
and savings; and "judgment factors," such as potential changes in the economy
and demographic changes, when determining how much they need to charge for a par-ticular
insurance product. Knowing this, even when a rate request appears insufficient to
cover a company's losses and expenses, the Division does not disapprove it. In fact, the
Division has never formally disapproved a rate for inadequacy since the inception of the
open competition law. Instead, the Division relies on insurers to provide additional sup-port,
withdraw or amend an inappropriate rate filing when questioned by Division
analysts. However, because the Division does not track withdrawal information, it was
not possible to determine the effectiveness of this approach.
n Backlog impedes timeliness—The Division currently has not reviewed approximately
2,000 rate filings, representing a 15-month backlog. Therefore, even if the reviews were
effective in identifying potential insolvencies, they are not timely enough to impact the
effects of inadequate rates.
Division Could Better Use
Resources by Targeting Reviews
and Monitoring Markets
Given the limited benefit offered by the current rate review process, the Division could better
use its resources by targeting its rate reviews and increasing market monitoring efforts. Since
inadequate rates do not always indicate future insolvency, the Division should target its rate
reviews to identify those companies most in danger of future insolvency should they charge
inadequate rates. In addition, because open competition depends on competitive markets,
the Division should expand its market monitoring efforts to ensure that all markets remain
Future solvency better monitored through targeted reviews—Rather than review every rate
filing, the Division should target its rate reviews to those companies most in danger of future
insolvency should they charge inadequate rates. The Division can accomplish this, in part, by
obtaining information from the financial surveillance program within the Corporate and Fi-nancial
Affairs Division. This program monitors insurers' current financial condition using
sources such as the NAIC's Insurance Regulatory Information System (IRIS) and annual fi-nancial
statements. Through an automated analysis of such factors as profitability, quality of
assets, liquidity, and risk exposure, staff can promptly detect companies that are undergoing
significant financial changes. By targeting those companies already in a precarious financial
condition, the Division can review those rates more likely to result in future insolvency.
In addition to obtaining financial information from the financial surveillance program, the
Division could use additional methods to target filings at risk for inadequate rates. Some
possible methods described in industry literature and/or discussed with Division staff in-clude:
n Targeting filings of companies showing significant increases in market
share—If a company has secured significantly more business in a relatively short
time period, it might be an indication that it is charging inadequate rates in order to
lure customers away from competitors. As such, identifying those companies with
significant increases in market share can serve as a red flag that a company's rates
might be inadequate.
n Targeting filings of certain lines of insurance—Some insurance products are
more closely associated with greater financial risk than others. For example, non-standard
auto insurance serves higher risk consumers not eligible for standard auto
insurance, and therefore, may involve more frequent losses. In addition, many in-surers
that offer this product do not offer other types of insurance to help compen-sate
for these losses. As such, the Division may want to target those lines associated
with greater financial risks.
n Targeting small and/or new companies—According to Division staff, newer and
smaller insurers may charge lower rates as a way of luring customers away from the
larger, more established insurers. These lower rates may be inadequate. As such, the
rates submitted by small or new companies might warrant review.
To successfully implement a targeted approach to review rates for inadequacy, the De-partment
will require additional resources. According to Division staff, the Department
will have the computer resources necessary to implement targeted rate reviews by Feb-ruary
1999. However, the Division will need additional time to make the required pro-gramming
changes and to train staff on the new targeted rate review approach.
Monitoring markets critical to open competition approach—In addition to targeting rate
reviews, monitoring markets can also ensure a successful open competition environment.
According to an NAIC study, "monitoring competition involves a continuing study of market (ag-gregate
industry) performance as distinguished from a study of an individual company's perform-ance."
1 Under an open competition environment, market monitoring offers the only mecha-nism
to protect consumers from excessive rates. As indicated earlier, no rate can be deemed
excessive unless it is determined that a market is uncompetitive. Under Arizona law, the
Department's Director has the authority to make such a determination after considering at
least the following four specific "tests of competition": 1) the number of insurers actively
engaged in the business, 2) the market share and changes in market share of insurers, 3) the
existence of price differentials, and 4) the ease with which new insurers can enter the mar-ket.
If, through monitoring, the Director determines that a market has failed to remain com-petitive,
statutes authorize the Director to re-impose prior approval regulation until the
market failure has been addressed.
Tests of competition, such as those listed above, can determine certain anti-competitive
practices, including whether an insurer has sufficient market power to influence prices. Spe-cifically,
if the market has many insurers and each insurer has a relatively small market
share, it is assumed that insurers are unable to control the price of the product that they sell.
According to an NAIC report, when the combined market share of a national industry's four
largest companies reaches 75 percent or greater, the market is considered highly concen-trated
(i.e. potentially uncompetitive).2 As such, it may be possible for the leading compa-
1 Hanson, Dineen & Johnson, "Monitoring Competition: A Means of Regulating the Property and Liability
Insurance Business," 1974, p. 693.
2 NAIC Insurance Availability and Affordability Task Force, "Improving Urban Insurance Markets: A
Handbook of Available Options," (draft, June 4, 1996), pgs. 28-29.
nies to control prices.1 Such behavior is particularly important for state insurance depart-ments
to monitor since the insurance industry is exempt from most federal anti-trust laws
that would otherwise address such practices.
Tests of competition can also be used to identify the effects of inadequate rates. For example,
some insurers charge destructively low prices in order to gain a larger market share. In ex-treme
cases, such practices can drive insurers out of the marketplace, resulting in little or no
choice for consumers seeking those insurance products. Monitoring for large changes in
market share could help identify destructively low prices and alert the Division to potential
availability problems.
Division does some monitoring but should expand its program—Because of the importance
of market monitoring under a competitive environment, the Division should take steps to
expand its current efforts in this area. Currently, the Division collects information on all of
the statutorily required tests of competition for the personal automobile market except for
information on the ease of market entry. In addition, it collects price differential information
for personal homeowners and mobile home insurance markets. While valuable, these efforts
do not adequately identify anti-competitive behavior in the homeowner's insurance and
mobile home markets. Furthermore, the Division currently does not collect any information
on commercial markets. While some commercial markets do not lend themselves to
monitoring because they are highly customized, others, such as commercial auto, and
general and professional liability, are conducive to such monitoring. Therefore, the Division
should expand its monitoring efforts to compile information on all four statutorily required
tests of competition for all personal and some commercial markets, where feasible.
Once compiled, the Division should analyze this information over time to track patterns
specific to Arizona insurance markets. In fact, the Department already maintains most of the
information needed to monitor markets. Specifically, it maintains the number and size of
insurers, changes in market share, and information on those firms that have entered or ex-ited
the market. However, the Division does not compile or sort this data in a manner that
enables it to identify emerging market problems. As such, the Division will need to develop
a database to store the data in a manner that is conducive to tracking market behavior.
1 Although precise standards for evaluating market concentration do not exist, economic and anti-trust
literature provides various criteria for use in making preliminary judgments.
1. The Division should obtain information from its Corporate and Financial Affairs Divi-sion
to assist it in targeting those companies that are at the greatest risk for insolvency
should they charge inadequate rates. In addition to using this information, the Division
should identify and use other factors to target filings for inadequate rate review, such as:
n Targeting filings of companies showing significant increases in market share;
n Targeting filings of certain lines of insurance; and
n Targeting filings submitted by new and/or small companies.
2. The Division should expand its current market monitoring program by:
a. Compiling and analyzing, at a minimum, data on the four economic indicators listed
in statutes for all personal lines of insurance. The Division should also compile and
analyze data for those commercial lines of insurance that are conducive to market
monitoring such as commercial auto and general and professional liability; and
b. Developing a database on which it can maintain the economic indicator data and
track trends for determining shifts in market behavior.
While the Department's Fraud Unit has shown some improvement from its early years,
it can take steps to further enhance its effectiveness. Although in its first two to three
years, the Fraud Unit produced a minimal number of cases for prosecution, it has more
recently begun to demonstrate a stronger impact in the fight against insurance fraud.
However, the Unit's inadequate tracking and analysis of referrals may ultimately limit
its impact.
Insurance Fraud
a Costly Crime
Insurance fraud is defined as untrue statements of material fact or the failure to state
material facts to an insurance company or agent with respect to an insurance policy or
claim. It occurs during the process of buying, using, selling, and underwriting insur-ance.
Although the extent of insurance fraud is difficult to quantify, experts within the
industry and among agencies that regulate insurance estimate that, nationally, fraud
occurs in 16 percent of all personal auto insurance claims and in 10 percent of all home-owners',
business, commercial, and health insurance claims. In June 1997, the Coalition
Against Insurance Fraud estimated that the annual cost of insurance fraud to Arizona
consumers in 1995 was $2.2 billion, or $1,616 per family. This cost to Arizona families is
estimated to be 57 percent higher than the national average.
Once approved by the Legislature, the Department established the Fraud Unit in 1994
to combat fraud specifically committed against insurance companies.1 The Unit receives
referrals from insurance companies and determines which cases are potentially
fraudulent and which can be criminally prosecuted. Using documentation provided by
the referring insurance company, the Fraud Unit will investigate the case and, if inves-tigators
believe the case can be successfully prosecuted, submit it to the Attorney Gen-
1 The Department also investigates complaints filed against insurance companies and agents through
its Consumer Services and Investigations Division.
eral's Office or the Maricopa County Attorney's Office for criminal prosecution.1 Suc-cessfully
investigated and prosecuted insurance fraud cases may result in a felony con-viction
and an order to pay a fine and/or restitution to the insurance company for the
loss incurred.
Fraud Unit Performance
Steadily Improving
In its first four years, the Fraud Unit has improved its efforts and ability to successfully
pursue insurance fraud. Despite a slow start, the Fraud Unit has increased the total
number of referrals received and its rate of indictments and convictions. While several
factors contributed to a slow start, the Unit has made significant strides in an effort to
enhance its ability to investigate and ultimately prosecute insurance fraud cases.
Fraud Unit's impact increasing—Although the Fraud Unit's impact was initially limited, it
has steadily increased in recent years. Table 2 (see page 19), illustrates various output statis-tics
indicating the Unit's increasing impact. For example, between fiscal years 1995 and 1998,
the number of referrals from insurance companies increased from 620 to 1,355, while the
number of referrals submitted for prosecution increased from 23 to 147. Additionally, be-tween
fiscal years 1995 and 1997, the rate of indictments and convictions obtained from
those referrals submitted for prosecution increased from 48 percent to 73 percent.2
Also, in comparison to other states, Arizona's Fraud Unit appears to be progressing at a
normal rate given the Unit's relative newness. According to the Coalition Against Insurance
Fraud, based on a review of fraud units across the country, there appears to be a direct cor-relation
between the number of years a fraud unit has been in existence and its caseload and
conviction rate. This suggests that fraud bureaus need a few years of experience to reach
optimum effectiveness.
1 While the Maricopa County Attorney's Office handles only cases in Maricopa County, the Attorney
General's Office handles referrals from all counties.
2 Indictment and conviction rate is based upon fiscal year 1995 through 1997 data because of the large
number of referrals pending review by prosecutors in fiscal year 1998. The number of indictments
and convictions reported for fiscal year 1998 may change significantly due to the high number of
pending referrals.
Table 2
Department of Insurance
Fraud Unit Annual Output Statistics
Years Ended June 30, 1995 through 1998
1995 1996 1997 1998
Referrals 620 595 827 1,355
Referrals submitted for prosecution 23 44 70 147
Outcome of referrals submitted for
Pending review by prosecutors
Closed as unprosecutable
Pending prosecution (indictments)
Rate of indictments and convictions 48% 66% 73% -
1 Outcome of referrals submitted for prosecution will change over time as pending referrals are resolved.
Source: Auditor General staff analysis of Fraud Unit output statistics for years ended June 30, 1995 through
Several efforts made to improve performance—The Fraud Unit's enhanced performance has
resulted from efforts in several areas:
n Criminal Justice Focus—In its first two years, the Unit lacked its current criminal jus-tice
focus. Specifically, disagreement among previous Fraud Unit administration and
staff over whether the Unit would pursue criminal or civil prosecution in insurance
fraud cases contributed to this lack of focus.
In 1996, the Fraud Unit initiated several policies that emphasized the Unit's criminal jus-tice
nature. Specifically, the Unit began to primarily investigate and prosecute insurance
fraud cases under the criminal legal code, aiming for the indictment and conviction of of-fenders.
To complement this focus, the Fraud Unit hired investigators with appropriate
criminal justice experience. Currently, most of the Unit's investigators each have 20 or
more years of prior experience in law enforcement.
n Dedicated Prosecuting Positions—When initially established, the Fraud Unit referred
insurance fraud cases to the Attorney General's Office, where they were assigned to at-
torneys who also worked on a wide variety of criminal cases in addition to insurance
fraud. When compared to prosecuting violent crimes and drug cases, insurance fraud
cases often merited a lower priority. In mid-1997, the Department entered into an inter-governmental
agreement with both the Attorney General and Maricopa County Attor-ney
to provide funding for prosecutor positions, thus ensuring the availability of re-sources
to prosecute insurance fraud cases. This arrangement has contributed to a recent
increase in prosecutable cases pursued by these justice agencies.
n Management Stability—Initially, the Fraud Unit experienced a high level of turnover
among its management and investigative staff. Specifically, three different fraud bureau
chiefs led the Unit in its first two fiscal years. However, leadership of the Unit appears to
be much more stable, as the current bureau chief has been overseeing the Unit since
September 1996. Additionally, even though only one of the ten original investigators re-mains
with the Unit, only two investigators have left the Unit since July of 1996.
Inadequate Tracking and
Analysis of Referrals May Limit
Fraud Unit's Impact
While the Fraud Unit has improved its operational effectiveness, its overall impact may still
be limited because the Unit does not adequately track and analyze fraud referrals. Specifi-cally,
the Unit cannot determine the extent to which insurance companies comply with
fraud reporting requirements. In addition, the Fraud Unit lacks formal procedures to com-municate
its case investigation efforts and ensure these companies appropriately refer fraud
Some insurers may not be reporting suspected fraud—Although statute requires insurance
companies to report suspected fraud cases to the Department, some insurers may not be
reporting suspected fraud. Specifically, A.R.S. §20-466(F) requires that:
"An insurer that believes a fraudulent claim has been or is being made shall send to the direc-tor
. . . information relative to the claim . . ."
Referrals are critical to the overall process, since the Fraud Unit cannot pursue potential
fraud cases without a referral. However, a comparison between the number of referrals
submitted to the Fraud Unit and the total number of insurers operating within the State
suggests numerous insurers do not submit referrals to the Unit. Because companies may not
make referrals for various reasons, such as they have no fraudulent claims or they are un-aware
of the statute that requires them to report suspected fraud, the Department should
contact these companies to ensure that they are aware of the Unit's existence and the process
for making referrals. However, due to limitations in its fraud referral database, the Depart-ment
cannot determine which insurance companies report suspected fraud to the Unit. This
results primarily from the inconsistent data entry of insurance company names. Each time
an insurance company submits a referral, Fraud Unit staff often enter the company name
into the database differently. Given the large number of insurance companies and subsidi-aries
with similar names and abbreviations, it is difficult to identify which company actually
made the referral. For example, a referral may come from State Farm Insurance Company,
State Farm Fire and Casualty, or State Farm Mutual Automobile Insurance Company.
In order for the Fraud Unit to better determine which insurance companies are reporting
fraud and which are not, it needs to track additional information on its database. Specifi-cally,
the Unit needs to revise its referral form to include a unique company identification
code, known as the NAIC number, which should be entered in the fraud referral database.
By capturing this information, the Unit can use the database to determine which companies
are referring cases to the Unit. Moreover, the Unit can then identify companies that have not
reported cases to determine if they need additional assistance in making referrals.
Fraud Unit lacks formal mechanism to correspond with and educate insurance companies—
Even though the Fraud Unit's work depends on insurance company referrals, it has not es-tablished
a formal mechanism to correspond with insurers regarding the status or adequacy
of cases submitted. To a large extent, the Fraud Unit's success depends on the complete and
thorough documentation collected by the insurance company making the referral. However,
insurance company special investigation unit personnel interviewed by auditors indicated
that the Fraud Unit did not consistently inform them of the status of their referrals. In addi-tion,
although the Unit closes many cases because it lacks the necessary information to
prove fraud, the Unit has no formalized policy to educate insurers on what information is
needed to successfully investigate and criminally prosecute insurance fraud.
Other states and the Department's own Consumer Services and Investigations Division
have developed formal procedures for corresponding with insurance companies and
complainants about referrals and also for educating them on information needed to
successfully investigate and prosecute insurance fraud. For example, the Massachusetts
Fraud Bureau reviews all referrals within 20 days of receipt and sends declination let-ters
to companies whose cases are rejected. Additionally, the Bureau provides guide-lines
in conjunction with its training and education program that explain the types of
evidence needed for each type of fraud to lead to a prosecutable case. For example, for a
property loss referral, the guidelines indicate the Bureau needs such documents as po-lice
reports and proof-of-loss invoices submitted by the insured to effectively investi-gate
the referral.
Similarly, the Department's own Consumer Services and Investigations Division, which
investigates consumer complaints against insurance companies, sends form letters to
complainants indicating whether it will investigate the complaint. If the Division does
not address the complaint, it explains the reason it was declined along with other op-tions
the complainant might pursue, such as civil court.
1. The Department should revise the Fraud Unit's referral form to capture an insurance
company's unique identifier (i.e., NAIC number) and enter this number in the fraud
referral database. This will allow the Unit to identify those companies that have not
made reports of suspected fraud.
2. The Fraud Unit should enact formal procedures to inform and educate insurance com-panies
regarding case referrals.
During the audit, other pertinent information was collected regarding the Department's
regulatory oversight over public entity risk pools.
A public entity risk pool (public risk pool) is a cooperative group of government entities
that join together to finance self-insurance expenses and share losses. Coverage pro-vided
by these pools includes property and liability, workers' compensation, and em-ployee
health care. Pooling resources to address insurance needs provides an attractive
insurance alternative for some entities that are too small to legally or feasibly self-insure,
but seek reduced costs and greater control over their loss exposure than tradi-tional
insurers can offer. Government entities involved in these pools range from cities,
counties, and school districts to hospitals and libraries. Public risk pools can either
transfer risk or retain it if they believe it is beneficial to keep the premiums rather than
pay an outside party. Most public risk pools in Arizona do both, accepting some liabil-ity
and transferring the remainder by purchasing a traditional insurance policy.
Regulatory Oversight Over
Risk Pools Is Limited
Because public risk pools are not considered "insurers" but rather a form of self-insurance,
they are regulated at a much lower level than traditional insurers. Specifically, public risk
pools have minimum financial requirements and the Department's jurisdiction over these
entities is limited.
Pools have minimum financial requirements—As compared to traditional insurers, public
risks pools have minimal financial requirements. For example, traditional insurers must
maintain minimum levels of capital and surplus at all times. That is, they must have ade-quate
capital to pay "expected losses" as calculated by an actuary, as well as an additional
"surplus" to cover unexpected losses.1 While strong capitalization is important to the finan-cial
strength of any business, it is particularly important in insurance as it provides a finan-
1 Expected losses are calculated based on a company's historical net reported incurred losses. For new
companies that do not have a history of losses, expected losses are based on industry statistics.
cial buffer against losses that are not anticipated by the actuary. However, public risk pools
are not required to maintain a surplus; only reserves equal to expected losses as calculated
by an actuary.
According to some pool representatives, if minimum financial requirements similar to those
imposed on traditional insurers were imposed on public risk pools, the increased costs
would eliminate the option for some public entities to pool.
Department has limited authority—In addition to the minimal financial requirements asso-ciated
with public risk pools, the Department has limited jurisdiction over public risk pools.
Under the State's hazardous financial condition rule, the Department can place controls on
traditional insurers that are acting in a financially unsound manner. Such action is taken in
an effort to avoid insolvencies. In contrast, the Department can only intervene in public risk
pools when an insolvency has already occurred. Even then, the Department's role is limited
to confirming the insolvency through an examination, providing recommendations to abate
it and, if necessary, reporting the insolvency to the State's legislative and executive leader-ship.
Some Public Risk
Pools Insolvent
There have been three public risk pools that have become insolvent in recent years,
leaving some pool members liable for outstanding claims. Unlike traditional insurance
companies, members of public risk pools remain responsible for the liabilities of their
pool even in the event of an insolvency.
Three public risk pools have experienced financial trouble—Three public risk pools have
become insolvent in recent years, leaving some pool members liable for their own
claims. From fiscal years 1992 through 1997, 3 out of the 13 public risk pools that existed
during this time period have become insolvent. Table 3 (see page 25), provides specific
information on each insolvency. One pool had to cease operations because it did not
have sufficient assets to satisfy outstanding claims, leaving participating public entities
responsible for their own claims. Specifically, the Arizona Public Agency Employee
Benefit Trust, comprised of 13 various public entities and providing health coverage to
approximately 1,250 employees, became insolvent in 1992 and ceased operations in 1994
with a deficit of over $830,000. Due to the closure, pool members were left to pay their
own claims.
As Table 3 indicates, the other two insolvent pools continue to operate. With the De-partment's
assistance, both pools devised "workout plans" to assist them in addressing
their insolvency. The Arizona Municipal Risk Retention Pool was able to maintain suffi-cient
cash flow to pay existing claims while it recovered from its insolvency and has
been solvent since November 1994. The Arizona School Alliance for Workers' Compen-sation
Pool is in the process of obtaining sufficient assets to address the insolvency and,
to date, has had sufficient cash flow to pay existing claims.
Table 3
Public Risk Pools That Have Become Insolvent
Years Ended June 30 or December 31, 1992 through 19971
Arizona Municipal
Risk Retention
Arizona Public
Agency Employee
Benefit Trust
Arizona School
Alliance for Workers'
Type of coverage Property and
Life and Health Workers'
Policyholders 57 municipalities 13 public entities2 15 school districts
Employees covered N/A3 Approximately 1,250 Approximately 2,000
Insolvency date Calendar year 1992 Fiscal year 1992 Fiscal year 1997
Insolvency amount $2,273,8014 $834,140 $778,3784
Current status Operating and now
Ceased operations Operating but remains
1 Insolvency dates were reported by either fiscal or calendar year.
2 This pool had varied types of members such as public hospitals, cities, and school districts.
3 Because the pool provides property and liability insurance coverage for municipalities, it does not
apply to individual employees.
4 These amounts are based on Arizona Department of Insurance examinations as of December 31, 1992,
and December 31, 1997, respectively.
Source: Auditor General staff analysis of correspondence and financial documents maintained by the Arizona
Department of Insurance financial documents.
Pool members/taxpayers are ultimately responsible for claims—Members of public risk
pools remain liable for their claims even in the event a pool ceases to exist. In contrast to
traditional insurance companies, public risk pools require their members to take an
ownership interest in the program. This "ownership interest" results from an "assess-able
policy," meaning pools can assess their members an additional premium not to
exceed the amount of each member's annual contribution to the pool in the event costs
exceed premiums charged during a covered period of time. This provision provides a
source of additional monies for pools should they experience financial trouble and also
distributes any financial hardship among all members. However, assessable policies do
not always provide a mechanism to cure insolvencies. For example, if the insolvency is
larger than the allowable aggregate assessment charged and the pool has insufficient
assets to pay existing claims, the pool may be forced to close its doors, leaving its mem-bers
responsible for the liabilities. If these public entities lack adequate resources to pay
the assessment or cover claims, the liabilities ultimately become the taxpayers' respon-sibility.
In contrast, the State's guaranty funds protect traditional insurance policyholders in the
event an insurance company becomes insolvent.1 These funds exist to pay outstanding
claims of insolvent insurers. However, these guaranty funds do not protect public risk pool
1 Guaranty fund coverage does not exceed $100,000 for property and casualty claims; $100,000 for cash
value or annuity claims; or $300,000 for all life and disability benefits, including cash values and an-nuity
claims as well as death benefits, with respect to any one life.
In accordance with A.R.S. §41-2954, the Legislature should consider the following 12
factors in determining whether the Department of Insurance should be continued or
1. The objective and purpose in establishing the Department.
The Department was established in 1913 to regulate the insurance industry in Ari-zona.
As provided in the Arizona State Constitution, all companies selling insurance
within the State shall be subject to licensing, control, and supervision by a depart-ment
of insurance. Further, Title 20 authorizes the Arizona Department of Insurance
to license insurance companies and agents, provide consumer assistance, investigate
complaints from the public, review insurance forms and rate filings, monitor the fi-nancial
status of insurers, oversee guaranty funds, and collect premium taxes and
other fees. Laws 1980, Chapter 230, §1 and Laws 1990, Chapter 38, §1, define the De-partment's
objectives as:
n To administer state insurance laws
n To protect the citizens of this State who purchase insurance
n To provide a better response to the needs of persons who purchase insurance
n To stimulate the insurance market by encouraging competition
n To protect the public from unregulated insurers and to represent insurance con-sumers'
2. The effectiveness with which the Department has met its objective and pur-pose
and the efficiency with which it has operated.
The Department has been generally successful in meeting its objectives as stated
above. For example, during fiscal year 1997, the Department issued 12,173 new
and 19,888 renewal licenses and monitored over 2,000 insurers. In addition, the
Department initiated 41 market conduct exams to identify any unfair trade or
claim settlement practices in which insurers may be engaging, and completed
116 financial examinations. However, auditors' review revealed that the De-
partment's Rates and Regulation Division could improve its efficiency and in-crease
the consumer protection it provides. Specifically, the Department should
revise its current approach of regulating insurance rates by limiting review ac-tivities
to identifying unfairly discriminatory rates and monitoring competition
within various insurance markets (see Finding I, pages 9 through 16).
3. The extent to which the Department has operated within the public interest.
The Department has operated within the public interest in a variety of ways. For ex-ample,
the Department conducts and publishes automobile and homeowners' pre-mium
comparisons to assist consumers in obtaining coverage for the best price. In
addition, the Department helps protect the public by imposing financial require-ments
and monitoring those requirements. Examples of this include verifying that
insurers maintain the required capital and surplus, routinely examining insurer fi-nancial
information to identify potential solvency problems, conducting market con-duct
examinations of insurers, and requiring insurers to disclose certain material in-formation
to prospective policyholders prior to selling policies.
4. The extent to which rules and regulations promulgated by the Department are
consistent with the legislative mandate.
According to the Governor's Regulatory Review Council (GRRC), the Depart-ment
has complied with A.R.S. §20-143, which authorizes the Director to adopt
rules and is on schedule in repealing and amending its rules according to the
five-year review approved by GRRC on February 3, 1998. In addition, GRRC in-dicated
that the Department provides an outstanding example of timeliness and
quality of rulemaking in its interaction with GRRC and its staff.
5. The extent to which the Department has encouraged input from the public be-fore
promulgating its rules and regulations and the extent to which it has in-formed
the public as to its actions and their expected impact on the public.
The Department ensures adequate public input on proposed rules and regula-tions.
The Department publishes a notice of proposed rulemaking activities in
the Arizona Administrative Register, as required by law. Furthermore, when the
Department anticipates taking action on a proposed rule, it first solicits input
from members of the industry who have an insurance background or who are
likely to be affected by the proposed rule. The Department also publishes press
releases and circular letters to announce important actions, changes to insurance-related
laws, and rules and procedures, as well as its interpretation of insurance-
related laws. With regard to the operations of its boards, the Department con-ducts
public meetings and posts notices for the Guaranty Fund board meetings.
These boards oversee the operations of the Arizona Life and Disability Guaranty
Fund and the Arizona Property and Casualty Guaranty Fund.
Auditors did find that the Secretary of State's Office does not have the Depart-ment's
meeting locations on file. While the Department provided documentation
indicating it filed this information in 1992, the Department should update its fil-ing
with the Secretary of State's Office to ensure compliance with open meeting
law requirements.
6. The extent to which the Department has been able to investigate and re-solve
complaints that are within its jurisdiction.
The Department has been able to investigate and resolve most consumer com-plaints
it receives in a timely manner. However, it takes the Department slightly
longer than its internal goal of 60 calendar days to resolve complaints. According
to the Department's complaint database, it took the Department an average of 71
days to resolve complaints in fiscal year 1997.1 The Department acknowledges
that it has difficulties responding to all complaints within its internal goal of 60
days and it is currently taking steps to reduce its workload by disseminating in-formation
to consumers to enable certain complaints to be resolved without sub-stantial
Department involvement.
7. The extent to which the Attorney General or any other applicable agency of
state government has the authority to prosecute actions under enabling
The Attorney General has the authority to prosecute actions on behalf of the De-partment.
Specifically, A.R.S §20-152 authorizes the Attorney General to prose-cute
Title 20 violations and prosecute or defend all actions resulting from en-forcement
of Title 20 provisions. Furthermore, A.R.S. §20-401.04 provides that the
Attorney General may enforce the order of the director in any court proceeding.
The Department entered into a Collection Enforcement Revolving Fund agree-ment
with the Attorney General's Office. Under this agreement, the Attorney
General's Office provides the legal services necessary to collect outstanding civil
1 This figure is based on complaints that were opened and closed within fiscal year 1997.
penalties and other debts owed to the Department. Lastly, under A.R.S. §20-
466(F), the Attorney General's Office and the appropriate County Attorney have
the authority to prosecute insurance fraud.
8. The extent to which the Department has addressed deficiencies in the ena-bling
statutes which prevent it from fulfilling its statutory mandate.
The Department has actively addressed deficiencies in the insurance statutes
over the years. From fiscal years 1992 through 1997, the Department proposed 25
laws affecting the Department and the insurance industry. Many of the changes
specifically updated the enabling statutes to allow the Department to adequately
regulate the continually changing insurance field. For example, in fiscal year
1996, the Department proposed insurance solvency regulation, which updated
the laws to correspond with the requirements of the National Association of In-surance
Commissioners (NAIC), allowing the Department to maintain its official
NAIC accreditation.
In addition, in fiscal year 1997, the Department proposed legislation to clarify
various aspects of its authority to take over and administer the affairs of insol-vent
insurers. Finally, for the last two legislative sessions, the Department sought
legislation that would grant peace officer status to investigators. According to
Department officials, peace officer status would allow the Fraud Unit, among
other things, to serve search warrants and make arrests, without the assistance of
other law enforcement agencies, thus allowing it to take more swift action in
suspected fraud cases.
9. The extent to which changes are necessary in the laws of the Department to
adequately comply with the factors listed in the sunset laws.
This review did not reveal any changes needed in the laws for the Department to
adequately comply with the factors listed in the sunset laws.
10. The extent to which the termination of the Department would significantly
harm the public health, safety, or welfare.
Regulating the insurance industry is necessary to protect the public in transac-tions
that can significantly affect their financial welfare. Pursuant to federal law,
regulation of the insurance business rests exclusively with the states. Accord-ingly,
all 50 states regulate the insurance industry to varying degrees. If the De-partment
were terminated, another state agency would be needed to regulate the
insurance industry for consumer protection purposes. Should the Legislature de-cide
to terminate the Department, a constitutional amendment will be necessary.
11. The extent to which the level of regulation exercised by the Department is ap-propriate
and whether less or more stringent levels of regulation would be ap-propriate.
Auditors' work suggests that the current level of regulation is generally appro-priate.
12. The extent to which the Department has used private contractors in the per-formance
of duties and how effective use of private contractors could be ac-complished.
Arizona Revised Statute §20-148(B) provides the Department authority to utilize
contractor services. As such, the Department uses private contractors to perform
several functions. For example, the Department uses private contractors for pre-license
testing and to conduct financial and market conduct examinations of in-surers.
Although the use of private contractors in these areas appears appropri-ate,
a 1995 special investigation of the Insurance Examiners' Revolving Fund
(IERF) by our Office found that the billings of these contractors were not ade-quately
monitored by the Department. Since that report was issued, the Depart-ment
has converted 21 supervisory, administrative, and clerical IERF contractor
positions to Departmental positions to improve contract enforcement and over-sight.
According to the Department, it continually reviews its programs to pri-vatize
when it is cost-effective and appropriate, and to eliminate the use of con-tractor
services if this is not the case.
(This Page Intentionally Left Blank)
Agency Response
(This Page Intentionally Left Blank)
Department of Insurance
State of Arizona
Telephone: (602) 912-8400
Telecopier: (602) 912-8453
JANE DEE HULL 2910 North 44th Street, Suite 210 CHARLES R. COHEN
Governor Phoenix, Arizona 85018-7256 Acting Director of Insurance
November 2, 1998
Mr. Douglas R. Norton
Auditor General
2910 North 44th Street, Suite 410
Phoenix, Arizona 85018
Dear Mr. Norton:
The Arizona Department of Insurance ("Department") appreciates the opportunity to
respond to the report of the performance audit conducted by the Office of the Auditor General.
Recommendation 1: The Division should obtain information from its Corporate
and Financial Affairs Division to assist it in targeting those companies which are at
greatest risk for insolvency should they charge inadequate rates. In addition to using
this information, the Division should identify and use other factors to target filings for
inadequate rate review, such as:
· Targeting filings of companies showing significant increases in market share;
· Targeting filings of certain lines of insurance; and
· Targeting filings submitted by new and/or small companies.
The finding of the Auditor General is agreed to, and a different method of dealing with
the finding will be implemented.
The Department agrees that its process for detecting inadequate and unfairly
discriminatory rates should be improved, and we will endeavor to convert from a review of
each rate filing to a targeted approach. However, we do not agree with all of the report's
underlying analysis of the issue, and we believe the report's specific recommendations must
be refined to be practical and effective.
The Department disagrees that "market forces are the primary regulator of rates under
Arizona's 'open competition law'," as stated repeatedly in the report. We agree that under an
open competition system the marketplace is intended to be the primary regulator against
Mr. Douglas R. Norton
November 2, 1998
Page 2
excessive rates, and the Department's role, with respect to regulation of excessive rates, is to
monitor whether a reasonable degree of price competition does not exist in the marketplace
based on the relevant tests of competition pertaining to market structure, market performance,
and market conduct set forth in A.R.S. § 20-383(B)(1) through (4). However, even under an
open competition system, the Department is the primary regulator against inadequate and
unfairly discriminatory rates. This role is crucial to the protection of consumer interests, and
crucial to the success of an open competition system because inadequate and unfairly
discriminatory rates are the insidious by-products of a highly competitive marketplace for
insurance. If unchecked, they ultimately threaten continued competitiveness. Competition
itself naturally prevents excessive rates, but may lead to predatory pricing and other forms of
unfair competition which may cause some competitors to withdraw from the market, and may
cause others to falter or fail financially. As competition breaks down, certain classes of
insurance products may become unaffordable or even unavailable. Thus, the Department's
role in regulating against inadequate and unfairly discriminatory rates is as integral to the
ultimate success of an open competition rate regulatory system as a competitive marketplace.
The Department acknowledges that it has not "formally disapproved" Article 4.1 rate
filings based on grounds of inadequacy. However, the Department is not unable or unwilling
to find rates inadequate. Both the Department and insurers appreciate the considerable
difficulty, expense, and inconvenience attendant to a contested rate disapproval proceeding.
The Department must also consider the practical difficulties associated with initiating
contested proceedings concerning complex, technical rate-making issues wherein the State
will be matched against an insurer's considerable technical, legal, and expert witness
resources. Insurers on the other hand, must consider the adverse publicity that can result
from such proceedings. Consequently, the Department and the affected insurer have
generally negotiated a mutually satisfactory resolution when a rate is found to be inadequate.
On many occasions, insurers have voluntarily amended their rates to avoid the possibility of a
formal rate disapproval proceeding.
The report suggests that the Department has continued to review Article 4.1 rate filings
for excessiveness, notwithstanding the legal presumption that the market is competitive and
therefore rates are not excessive. We wish to make it clear that the Department does not
review Article 4.1 rate filings for excessiveness; our review is limited to seeking evidence of
inadequate and unfairly discriminatory rates. The report also omits any discussion of the
importance of detecting unfairly discriminatory rates, and omits any recommendation to
enforce this standard by targeted rate filing review or any other method. Unfairly
discriminatory rates are potentially disastrous to consumers. The Department is required to
enforce this important standard as well, and any consideration of the feasibility of targeted
review and the appropriate targeting criteria must take this into account.
The Department respectfully submits that the report's analysis and recommendations
are heavily reliant on the misconception that rate regulation is mostly a tool to detect evidence
of specific insurers' future insolvency. The prohibition against inadequate rates is intended to
Mr. Douglas R. Norton
November 2, 1998
Page 3
generally deter insurer insolvency, among other things. However, the regulation of inadequate
rates and the regulation of insurer solvency, while related, are different programs with different
The objective of the Department's solvency regulation programs is to monitor insurers'
financial condition to identify present or potential insolvency or financial weakness and to take
appropriate corrective actions. An insurer's insolvency may result from various causes,
including inadequate rates relative to past policy periods. The objective of the prohibition
against inadequate rates is not to monitor insurer solvency or correct insolvency, but to
generally deter future insolvency, unfair competition, and the ultimate unavailability and
unaffordability of insurance.
The requirement of adequate rates ensures that at the time an insurer issues a
particular insurance product it receives income (i.e., the amount of premium produced by the
rate) sufficient to cover the projected losses and expenses attributable to that particular class
of product. A.R.S. § 20-383(C). In this way, the issuance of that product does not pose a
threat to the insurer's future solvency, nor to the continued existence of fair competition for
products of that class. Article 4.1 does not permit insurers to adopt "loss leader" marketing
strategies whereby insurers intentionally accept excessive losses on one class of product in
order to more aggressively compete in the marketplace for that product. Nor are they
permitted to underprice one class of product based on speculation that exceptional profits will
be realized from another class of product. Therefore, the report's conclusion that review of
rates for inadequacy is ineffective to regulate insurer solvency because all an insurer's rates
must be considered together to determine impact on solvency erroneously confuses rate and
solvency regulation.
The Department believes that making rate filing review dependent on evidence of an
insurer's financial weakness will be of limited effectiveness. For example, each state is the
primary regulator of its domestic insurers' financial condition. However, each state is the sole
regulator of the rates of all insurers, domestic and foreign, doing business in that state.
Therefore, this Department will be intimately familiar with the financial condition of only a
fraction of the insurers whose rates it regulates. As of September, 1998, there were 38
domestic and 749 foreign property and casualty insurers authorized to transact insurance in
Arizona. This Department has little control over the quality of financial regulation exercised by
other states. Additionally, if evidence of financial weakness is present, it is more likely
indicative of past inadequate rates than present inadequate rates because income adequacy
has a prospective effect on financial condition. An insurer which is already manifesting signs
of financial weakness may actually increase its rates in an attempt to increase long term
income. An insurer that decreases rates as a result of financial weakness is one that is
looking for a short term infusion of cash at the expense of long term financial health. In that
scenario, it is more likely that rate levels will be evidence of financial problems rather than the
other way around.
Mr. Douglas R. Norton
November 2, 1998
Page 4
For the above reasons, the provisions of Article 4.1 establish the sound legislative
policy of this state that each rate filed under the open competition system is prohibited from
being inadequate or unfairly discriminatory, not just those filed by insurers which present
detectable evidence of current or future solvency problems. See A.R.S. § § 20-383, 20-385,
and 20-388. The report fails to give due consideration to the ongoing marketplace dynamics
that justify the general proscription against any inadequate or unfairly discriminatory rates,
even when filed by unquestionably financially sound insurers. The Department accepts the
recommendation to adopt a targeted approach to enforcement of Article 4.1. However, we
differ from the report in that we believe the point of targeting must be to identify insurers that
are more likely to have inadequate or unfairly discriminatory rates, not those more likely to be
or become insolvent. The latter, while obviously of critical importance, is the function of the
Department's separate solvency regulation program.
The Report (page 11) states "other states that have enacted open competition laws do
not review every rate filing in detail. Auditors contacted 13 states that have an open
competition law and found that, in practice, 10 limit their detailed reviews to those rates that
are of unique concern to that particular state." The 13 states are identified in the report. The
Department respectfully suggests that a more in-depth review of this comparison is useful.
Notwithstanding that the report characterizes all 13 states as having "open competition" laws,
some of the identified states have different rate laws than Arizona's "use and file" law. For
example, three of the states have laws which do not require rate filings at all. Comparison to
the practices of those states is unavailing. Of the remaining ten states, only five have "use
and file" laws similar to Arizona's. Of those five, one state "targets" filings for review by
exercising its legal authority to exempt certain lines of insurance from any filing requirement.
This Department does not have that power. Of the other four, only two target rate filings for in-depth
review based on discretionary criteria. It does not appear that any of the five "use and
file" law states target rate filings for review by using solvency information in the manner
suggested by the report.1
We disagree that the point of Article 4.1 is to achieve administrative cost savings at the
Department by reducing the amount of analyst time spent reviewing rate filings. The cost of
analyst review by the Department is nominal considering the volume of insurance premium
affected by Article 4.1. We believe the true cost saving element of Article 4.1 is the inherent
cost savings available to insurers and consumers under an open competition system (i.e.,
insurers' ability to quickly adjust rates or offer new products and consumers' rapid access to
new prices and products). The Department's review of rate filings to detect inadequate or
unfairly discriminatory rates does not defeat these inherent cost savings, and we believe
Article 4.1 plainly contemplates that the Department will perform that function. Further,
1 The report states that there are two primary approaches to rate regulation, "prior approval" and "open competition", and that
workers' compensation and title insurance rates are subject to prior approval in Arizona. This is technically incorrect.
Workers' compensation and title insurance rates are subject to A.R.S. § 20-341, et seq. (Article 4) which provides a "file and
use" system wherein the rates must be filed at least fifteen days before they take effect, and may be summarily disapproved by
the Department before they take effect. Article 4 rate filings do not require the Department's prior approval to take effect,
which distinguishes Article 4 from a true "prior approval" system.
Mr. Douglas R. Norton
November 2, 1998
Page 5
implementing a targeted approach to rate filing review will require unique resources, such as
computer hardware and software, computer programmer time, and insurance analyst time to
oversee the continuing compilation, input and analysis of data. Therefore, we disagree that
failure to realize administrative cost savings is a significant deficiency of our current process,
or that significant administrative cost savings will be achieved through a shift to targeting. We
believe the issue is whether the change would enable the Department to be more effective at
enforcing the rate making standards. We agree to make the change because we agree that
the backlog of Article 4.1 rate filings and resulting lack of timely review impairs the
effectiveness of the review.
The Department has implemented a pre-review/prioritization procedure to attempt to
more timely review those rate filings which contain a "program" rate change and/or obvious
unfairly discriminatory rates/rating rules. However, we agree that with current levels of rate
analyst staffing, a targeted approach to rate filing review based on criteria that identifies those
rate filings more likely to present inadequate or unfairly discriminatory rates and more likely to
have significant market impact would be more effective than untimely review of most rate
filings. We note that there is no statutory guidance as to appropriate criteria for targeting
inadequate and unfairly discriminatory rate review, and the Department must therefore
exercise discretion to develop such criteria.
Recommendation 2: The Division should expand its current market
monitoring program by:
a. Compiling and analyzing, at a minimum, data on the four economic
indicators listed in statutes for all personal lines of insurance. The Division should also
compile and analyze data for those commercial lines of insurance that are conducive to
market monitoring such as commercial auto and general and professional liability.
b. Developing a database on which it can maintain the economic indicator
data and track trends for determining shifts in market behavior.
The finding of the Auditor General is agreed to and the recommendations will be
The Department accepts the recommendation that we should expand our market
monitoring program by assuring that we compile data on the economic indicators identified by
statute, by identifying and compiling additional information that is necessary or useful to the
monitoring, and by developing a database and programs to meaningfully analyze that data to
identify trends bearing upon market competitiveness. We agree that this market monitoring
Mr. Douglas R. Norton
November 2, 1998
Page 6
activity will be useful in targeting rate filings for review for inadequate or unfairly discriminatory
rates. We also agree that implementing these recommendations will require additional
resources. The Department was appropriated the resources for Fiscal Year 1998-99 to obtain
and install the necessary computer hardware and the basic operating system and office
software. We will determine what additional resources, such as programming and analyst
personnel and specialized software, are needed to fully implement the recommendations.
The Department questions whether it is practical, reasonable, or cost effective to
expand its monitoring activities to the commercial lines marketplace due to the immense
number of independent commercial lines programs filed by insurers, within which there is an
extremely wide distribution of coverage and rate variables for each line and each class of
business. It may be prohibitively difficult to obtain among insurers like data for the purpose of
making a meaningful comparison. Further the data compilations, programming, and analysis
required may be prodigious. Therefore, while we agree to attempt to monitor certain
commercial lines markets for competitiveness to the extent we determine it is appropriate and
feasible, we cannot agree to monitor any specific commercial lines to any specific extent at
this time.
The report reflects the improvements the Department has made in its fight against
insurance fraud including the dramatic increases in cases annually referred for prosecution,
the number of indictments, and the rate of indictments and convictions. As the report
indicates, the Fraud Unit has benefited from the recruitment and retention of investigators with
extensive prior experience in law enforcement, and from strong, stable management. The
Unit has funded prosecutor services from its inception in 1994. However, commencing with
Fiscal Year 1998, the Unit has included in its intergovernmental agreements with prosecuting
agencies the requirement that the funding be applied to designated personnel dedicated to
prosecution of Fraud Unit cases. Additionally, the Legislature appropriated additional funds to
the Unit for prosecutorial services, commencing in Fiscal Year 1998. The additional funds
enabled the Unit to fund dedicated prosecutorial personnel at both the Attorney General's and
Maricopa County Attorney's Offices. These improvements significantly increased the number
of successful prosecutions resulting from Fraud Unit referrals.
As the report reflects, in its early stages, the Fraud Unit attempted to address both the
civil and criminal aspects of insurance fraud to roughly equal degrees. There are certainly
significant potential civil violations and corresponding remedies arising out of insurance fraud.
However, the Department quickly realized that meaningful impact by a relatively small Fraud
Unit requires a sharp focus on criminal cases. Implementation of that strategic objective
improved the Unit's measurable impact.
The Department is committed to continuously improve Fraud Unit performance and
impact, to achieve the Fraud Unit's destiny to lead the fight against insurance fraud in Arizona,
and to ultimately see its efforts manifest in the rates charged by insurers.
Mr. Douglas R. Norton
November 2, 1998
Page 7
Recommendation 1: The Department should revise the Fraud Unit's referral form
to capture an insurance company's unique identifier (i.e., NAIC number) and enter this
number in the fraud referral database. This will allow the Unit to identify those
companies that have not made reports of suspected fraud.
The finding of the Auditor General is agreed to and the recommendation will be
We agree with the report's finding that the fraud referral form and the Unit's database
should be refined to include an insurer's NAIC number as a unique identifier. We also agree
this will allow the Unit to better identify those insurers that have not made referrals to the Unit.
The Department's Information Services Division has already developed this improvement,
which was implemented in early October 1998. We have also already developed revised
referral forms which prompt the insurer to provide its NAIC number. At the end of each fiscal
year, the Department will determine which insurers have not made fraud referrals to the
Department and will follow-up with insurers that have not made referrals or have made what
appears to be a disproportionately small number of referrals, and will offer assistance in
correcting any fraud reporting deficiencies. Additionally, our Market Conduct Division will
continue to ascertain referral frequency as part of its preparation to examine an insurer, and
will reinforce the referral requirement as part of the examination process.
Recommendation 2: The Fraud Unit should enact formal procedures to inform
and educate insurance companies regarding case referrals.
The finding of the Auditor General is agreed to and the recommendation will be
We agree that having a formal set of procedures to inform and educate insurance
companies is important. The Fraud Unit already provides training seminars every six months
to assist in educating insurance company special investigation unit staff in current crime
trends, fraud detection methods and investigation techniques. The Unit also provides ad hoc
consultation and information to insurance companies upon request. The Unit participates in
monthly meetings of the Arizona Association of Special Investigations Units at which the Unit
shares valuable information on crime trends and Department activities while encouraging
members to file fraud cases.
We also agree it is important to keep insurers informed of the status of cases they refer
to us, and to explain why cases are closed without referral for prosecution. Commencing in
late 1996, the Unit adopted the practice of notifying the designated representative of an
insurer, usually by telephone, each time a change occurs in the status of the referral. In 1997,
that practice was added to the Unit's written policies and procedures manual. Department
surveys of Fraud Unit clients suggest the Unit is successful at keeping insurance companies
informed of the status of referrals. The Unit has now adopted the formal policy of
accomplishing this notification by written form letter. This letter advises insurers that if the
Mr. Douglas R. Norton
November 2, 1998
Page 8
referral was determined to be "unfounded," the case file, which contains explanatory
information, is available for review through a public records request.
The Department issued Circular Letter 1998-11 dated October 6, 1998 which published
the revised referral form, announced the referral status notification letter, and described the
Department's procedures to monitor and encourage referral levels.
The Department has made significant progress towards maintaining an
appropriate relationship with its independent contractors.
The Department has made significant progress in achieving appropriate relationships
with its contract personnel. Since September 1995, the Department has created 31
appropriated and nonappropriated employee positions to provide services previously provided
by contract personnel. These changes not only enable us to utilize employee personnel or
services better suited to employees than contractors, they enable us to exercise dramatically
improved internal control over contract services we continue to use. For example, some of the
new employee positions have responsibilities for review of contractor billings, as described in
your report.
The Department has recently completed conversion of the in-house market conduct
examination staff from contractor to employee positions. All market conduct contract
personnel are now assigned to field examination work. The only remaining contract personnel
provided with office space, access to administrative support, computer equipment, and office
supplies, as described in your report, provide financial analysis and examination services.
The Department will continue to exploit any and all opportunities to further refine its
relationship with its contract personnel in accordance with prevailing standards for
distinguishing contract from employee personnel. However, the optimum effectiveness of our
financial examination and analysis activities, and the maintenance of our accreditation by the
National Association of Insurance Commissioners, requires our contract personnel to have
ready access to the Department's records and automated data, as well as interaction with the
Department's employee staff. It is for that reason, and not the contractors' benefit, that the
Department provides office space, access to administrative support, computer equipment
attached to the Department's LAN and AS/400 computer systems, and attendant supplies to a
limited number of contractors engaged to provide complex financial analysis services.
The Legislature has specifically authorized the Department to utilize contract services
for precisely the kind of highly technical and specialized functions performed by the financial
analytical and examination personnel. A.R.S. § 20-148(B) provides:
The Director may from time to time contract for and procure, on a fee or part time
basis, or both, such actuarial, technical and other professional services as he may
require for the operation of his office
Mr. Douglas R. Norton
November 2, 1998
Page 9
The Legislature has also specifically authorized reimbursement of travel expenses for
the Department's contract examiner personnel, A.R.S. § 20-159((B), and this reimbursement
is a term of contracts which were duly procured for the Department by the Department of
Administration in accordance with the State Procurement Code.
A diminishing number of investigation cases are awaiting prosecution by the
Attorney General.
The Department has been working in partnership with the Office of the Attorney
General to reduce the backlog of cases awaiting prosecution. During the latter half of 1997,
the Department implemented the practice of requesting a quarterly status report from the
Attorney General's Office on all pending referrals for administrative action. The Attorney
General's Office has responded positively to these requests. This attention to the backlog has
produced results. As of October 27, 1998, only six investigation cases (excluding Fraud Unit
cases) were awaiting action by the Attorney General. All these cases are in an "active working
stage" and are expected to be resolved within 60 days from October 27. During Fiscal Year
1998, the Attorney General required an average of 93 calendar days from the date a case was
provided to the Attorney General's Office to when a notice of hearing was issued or another
form of disposition was completed. Both the Department and the Attorney General's Office
anticipate further reductions in backlog.
The Attorney General's Office notes that the administrative cases discussed in your
report comprise less than 25% of all legal matters handled by Assistant Attorneys General for
the Department. Other matters include license denial proceedings (which must be given
priority due to statutory time-frame mandates), appeals challenging previous administrative
decisions by the Department, and representation of the Department in discovery requests
arising out of receivership cases.
The Department has reduced the amount of time necessary to resolve routine
The Department reduced the average calendar days required to respond to consumer
complaints from 71 in Fiscal Year 1997 to 46 in Fiscal Year 1998, thereby meeting our internal
goal of 60 days. The Department accomplished this goal by augmenting its informational
literature available to consumers and by encouraging consumers to exhaust self help avenues
prior to the Department's intervention on certain kinds of claims-related, non-regulatory issues.
This reduced the total number of consumer complaint matters requiring the Department's
active intervention, and enabled more efficient and expeditious handling of those matters.
Additionally, the Department has requested an appropriation for an additional FTE in the
Consumer Services and Investigations Division to increase personnel available to respond to
public records requests, thereby freeing staff to concentrate on handling consumer
Mr. Douglas R. Norton
November 2, 1998
Page 10
We provide some observations to augment the report's discussion of public entity risk
First, A.R.S. § 11-952.01(L) does not require the Department to notify the state's
executive and legislative leadership unless the pool fails to comply with the Department's
recommendations to abate the insolvency. Second, a pool is required to inform the
Department of its existence, pursuant to A.R.S. § 11-952.01(G)(6). If a risk pool fails to notify
the Department of its existence, we are unable to fulfill our responsibilities with respect to the
pool. Third, pools are not required to provide to the Department, nor obtain our approval for,
their financial feasibility or operating plans prior to commencing operations.
For example, the Department first learned of the existence of the Arizona Public
Agency Employee Benefit Trust only after it had already ceased operations when a former
member requested assistance in enforcing coverage. The Arizona Municipal Risk Retention
Pool timely implemented the Department's recommendations to abate its insolvency. The
Arizona School Alliance for Workers' Compensation is in the process of attempting to
implement the Department's recommendations to abate its insolvency.
With regard to Factor # 5, the report indicated the Secretary of State's Office did not
have on file the location at which information concerning public meetings is posted. The
Department has updated its filing with the Secretary of State's Office to ensure compliance
with open meeting law requirements.
Mr. Douglas R. Norton
November 2, 1998
Page 11
We would like to commend the Auditor General's staff for the courtesy and
professionalism consistently demonstrated throughout the audit process. We found the review
to be substantive, fair, and appropriate, and we genuinely appreciate the comments and
recommendations in the report which enable us to further improve the quality of our planning
and operations.
Charles R. Cohen
Acting Director
Although in agreement with our first finding, the Department of Insurance (Department) has
taken lengthy exception to the underlying analysis for the finding. To ensure that the reader
can place in the needed context the recommendation for the Department to "target" its rate
reviews, we offer the following comments.
First, reasonable parties may disagree over the extent to which rates should be reviewed un-der
an "open competition" system. Our observation that the Department can rely more ex-tensively
on competition to regulate rates is based on the literature and philosophy behind
open competition. Contrary to the Department's claim, the literature is clear (including that
produced by the NAIC) that under a competitive rating law, competition is the primary
regulator of rates. According to the NAIC, reliance on fair and open competition to maintain
reasonable insurance prices allows insurance departments to conserve resources for other
important areas of public interest. As such, rather than reviewing thousands of individual
rates, one of the most effective things the Department can do as a regulator is help ensure an
effectively functioning marketplace.
Second, regardless of how strongly one takes a position for or against "open competition" as
a means of regulating rates, it is clear that the Department does not need to review each rate
as it has unsuccessfully attempted to do. Department officials concede there is no statutory
requirement in Arizona to review each rate. In addition, literature indicates there is large
variation in the levels of scrutiny applied to rate filings by states under an open competition
system. As noted by the Department, 3 of the 13 states we contacted do not even statutorily
require rates to be filed for review. Therefore, our recommendation to "target" reviews is not
contrary to the Department's mandate and is actually a more conservative approach than
that employed by some states. In addition, targeting reviews will likely help relieve the cur-rent
backlog of rate filings and might eliminate the need for additional rate personnel as re-quested
by the Department.
Finally, the Department expresses concern that we do not explicitly discuss reviewing rates
for unfairly discriminatory provisions as a part of our targeted approach. We did not specifi-cally
discuss this aspect of rate review only because we know that the Department already
reviews for these provisions, and we anticipated that it would continue to do so when re-viewing
rates under a targeted approach.
Click tabs to swap between content that is broken into logical sections.