The author has been practicing insurance business and regulatory law since 1974. Throughout the 37 year period there has been discussion, at varying levels of seriousness, about the prospect of regulating the insurance business on a Federal level. The underlying premise in favor of Federal regulation is always the same: 1) The existing State-based system cannot possibly be as efficient as the application of a single uniform set of laws administered at the Federal level by one or more national agencies. 2) When the existing system was created, commerce was largely conducted within the circle defined by how far a person could travel on horseback in day. Today's world requires a different approach.
It is tempting to respond to that view with a famous H. L. Mencken quote: "For every complex problem there is a simple solution ... and it is wrong." However, neither the view that a single system has to be better nor the view that there is no such thing as a simple solution to a complex problem is inherently correct. Anyone with blind faith in the one big system approach need only look at the recent meltdown events in the housing and related financial markets. The abuses that led to those problems were not only permitted under a Federal system, they were helped by it. At the same time, most of the members of our group can recite several examples of bad actors and bad practices in the insurance business where the ability to operate in one State after another has been used to the disadvantage of the public or where, in retrospect, State regulation might have performed better.
The protection of the public that is at the heart of insurance regulation deserves the kind of careful consideration which makes no assumptions and favors no particular system or solution. In this respect, the current effort by the Federal Information Office to solicit comment in twelve specific areas on ways to modernize and improve the system of insurance regulation in the United States asks good questions. While it may take some effort to look past the political context of the overall debate and the possibility that some of the questions may have been framed to favor particular solutions, the questions provide a worthwhile framework for this latest chapter of a long discussion. Given space limitations here, only a few items can be addressed and, even then, consideration of those selected is necessarily brief.
Systemic risk regulation with respect to insurance
Without question, many of the great financial risks of our times have their roots in two features of the modern financial landscape: 1) the homogenization of financial products; and 2) the concentration of the capital markets. These are facts of 21st century life. We need to deal with them.
The insurance business has features which work to its benefit in reducing risk. Among these are relatively conservative approaches to valuing investments and requirements for quality and diversification among those investments. These minimize, but do not eliminate, systemic risk. If whole asset classes (i.e., mortgages) which have been considered favorably become impaired, they threaten the financial foundation of all the interests which rely on them, including the insurance industry.
Risk based capital rules are another feature that impart stability to the insurance industry. Essentially, the amount of risk an insurer is permitted to undertake is affected by the type of risk involved, industry experience with that type of risk, and the particular insurer's own experience.
The interlocking nature of financial instruments and types of financial institutions increase systemic risk. There was a time when an annuity was a promise to pay benefits for life, not an investment vehicle. When annuities became a widely used form of investment vehicle, a broader type of risk was created. When such annuities came to be compared with other forms of investments, as opposed to insurance contracts, insurers issuing them sought to generate the rates of return necessary to compete. In an efficient market, greater return is accompanied by greater risk. Add to this attempts to achieve guarantees and outperform competitors by investing in mortgage pools and we see a classic example of systemic risk -- the herd thundering to beat each other, all headed toward the same types of investments in order to achieve comparable returns.
Financial discipline, a more careful balancing of risk and return, and true diversification are essential in reducing systemic risk -- but no industry or company within an industry can be completely insulated. The role of regulation in the process is limited but crucial. Insurers compete and it can be tempting to take risks to improve returns. Who remembers Executive Life? It offered some of the best annuity rates around -- and funded them with a class of asset which came to be known as "junk bonds" before going broke when the values of those bonds fell. The Executive Life example illustrates not only the value of conservative investments when safety is what is being sold, it also reflects the need to carefully watch and fine-tune the mechanisms in place.
More recent events demonstrate the need for responsiveness and flexibility in order to adjust to new developments.
On the State versus Federal comparison chart, State regulation is the better bet. The Federal government is in a good position to pass laws, but does not have a good track record for rapidly responding to emerging risk, especially when monied interests are pushing the other way. Recent events make the point. States do not have the same ability to make laws that apply across the land, but their ability to focus on a small geographic area may allow them to see problems sooner as well as respond more quickly. There, too, monied interests have a role, but the accountability comes quickly and more locally. The ability of States to work together but ultimately craft their own solutions better allows for a variety of approaches before a unified solution emerges. Ultimately, only trying an approach will demonstrate whether or not it works. On a Federal level, trying something necessarily occurs on a very large scale. Flexibility on a State level lends itself to creativity and to the development of better information on which to base broader solutions.
One of the ways the rest of the financial world seeks to minimize systemic risk is to buy insurance against it. This illustrates the role our industry plays in the functioning of our society. When people and the economic system look to us as a backstop, we need to avoid being part of the problem. The collective skill of the industry and its regulators is crucial to identifying and minimizing systemic risk.
In some ways systemic risk mimics the problems that used to exist with steam boilers. They blew up all the time and boiler insurance became not so much a way to fund compensation when it occurred as the means to create and enforce standards -- if your boiler met the requirement to obtain coverage, it would not blow up. At a time when every building of any size in cold climates had a boiler, making boiler explosions a thing of the past was a huge accomplishment. By the way, it was done within the context of State regulation and at a time when cooperation and the tools for achieving it were not nearly as efficient as they are today.
Our industry needs to be more conservative than many others and to set the benchmark standards. When other types of businesses go broke, investors lose. When insurers go broke, their investors lose, but so can the insureds1 and, where the causes reflect problems in lines of business, areas of society can come to a halt, with all the negative repercussions that entails.2
Capital standards and the relationship between capital allocation and liabilities, including standards relating to liquidity and duration risk
Of all financial areas, insurance should operate the most conservatively. While leverage is attractive to investors, the disturbing reality is that it works in both directions. State regulation has an excellent track record for requiring that capital and surplus exist in sufficient amounts, relative to type of risk, volume of business and experience on business written, and that capital, surplus and reserves are invested in vehicles which are both safe and liquid.
With recent financial events in mind, that statement might seem to be negated by the well-publicized and very serious problems suffered by AIG. However, as Forbes Magazine put it: "Most of the problems with its balance sheet were caused by AIG Financial Products Corp., a division that, like many investment banks, participated in financial risk-taking, including investments in credit default swaps written on collateralized debt obligations ... now considered to be toxic."3 AIG, a company well known for insurance operations, got into trouble by becoming one of the largest players in what has come to be known as the "financial services industry," -- in other words, systemic risk personified, all within one group of companies.
There was a time when banks, insurance companies and mutual funds were separate businesses, not all under one roof. What came to be seen as stodgy and boring at one point can look a lot better in the midst of economic upheaval. The insurance industry has done better than many other sectors in recent years -- for one thing, it has paid its claims - and that is a direct result of the overall effectiveness of the current system.
Those sectors which performed most poorly, indeed led the charge into the depths, were Federally regulated or funded: banking, securitized instruments, mortgage lending.
The ultimate measure of quality and efficiency in a system is that it works. The existing system works.
The State-based system has provided strong protection to insureds for generations. The Federal model, for all of its potential, cannot say the same with respect to financial services. In fact, having insurance under Federal regulation, along with the rest of the financial services industry, would create a new category of systemic risk -- systemic regulatory deficiency risk. If there is only one system, and it is run by one regulator, risk is increased.
The degree of national uniformity of State insurance regulation, including the identification of, and methods for assessing, excessive, duplicative or outdated insurance regulation or regulatory licensing process
The NAIC was formed in 1871 in response to the need for coordination of multistate insurers.4 Identifying and then promulgating uniform standards for Model Laws has been a core function of the group ever since, to the extent that its publication containing all of them consists of 6 volumes.5
The NAIC has made a concerted and successful effort to develop Model Laws which are appropriate for adoption across the country and in persuading States to adopt them. States feed information to the NAIC and work together through the Model Law process. This represents an effective, efficient, and proven method of developing national standards, while also permitting some variation, where appropriate, to reflect different conditions in different States.
The way the present system functions brings to mind the old adage: "If it isn't broken, don't fix it."
The regulation of insurance companies and affiliates on a consolidated basis
This area of consideration seems to assume that insurance companies belong within financial services conglomerates. My suggestion is that such ownership be permitted only in circumstances where membership in the group cannot hurt the insurer. The insurer's surplus should not rest, even in a small part, on the value of the conglomerate or any other part of it. Otherwise value tends to become circular and it is just excessive leverage with a different hat on.
The costs and benefits of potential Federal regulation of insurance across various lines of insurance (except health insurance)
If we were starting with a blank page, setting up a single, Federal, system might well be the lower cost approach. But we are not. The real question is whether setting up a largely brand-new Federal system is preferable to continuing an effective State system which is well into its second century of successful operation.
The State system offers several advantages: -
- It exists and works today;
- There are no setup costs;
- There are no issues about whether it knows what it is doing and can do it well in good times and bad -- its history speaks for itself.
- It is also consistent with the basic tenets of our national practice to leave to the States those areas which are susceptible to their regulation and for the Federal government to focus on areas clearly best addressed on a national basis.6
The feasibility of regulating only certain lines of insurance at the Federal level, while leaving other lines of insurance to be regulated at the State level
This is not feasible without duplication and is probably the worst solution being discussed, as it would simply leave both systems in place, with the same basic job, but subject to different sets of rules (if the rules are the same, why would there be two systems?).
The potential consequences of subjecting insurance companies to a Federal resolution authority, including the effects of any Federal resolution authority:
- On policy holder protection, including the loss of priority status of policyholder claims over other unsecured general creditor claims;
The way this comment is phrased assumes that under a Federal system policyholder claims would not receive the priority they receive under the existing State systems. If that is the case, the effect of a Federal system would be to decrease consumer protection in order to provide a benefit to business. Put simply, the claim of the paper supplier would be considered as important as the claim of the widow whose spouse's death benefits are at risk.
This would be grossly unfair:
- Insureds are often locked into an insurer -- they may not be able to change due to the passage of time (such as someone with life insurance becoming uninsurable), or the ongoing payment of benefits (such as with structured settlement annuities), or because there is a claim in process (such as a medical malpractice claim against a physician). At the time when the insured enters into the insurance contract, the insurer is authorized to do business by the applicable regulatory industry. This amounts to a seal of approval, at least as to that time, that there are requirements, those requirements are intended to protect the consumer, and the insurer is deemed sound.
- Contrast this to a business creditor. That entity is not relying on the regulator's approval -- it is relying on whatever system it uses across the board to decide on the terms it will offer its customers, likely a credit report. In addition, it typically is able to re-assess the relationship at any time. With each new order, piece of equipment leased, or other business transaction, it can decide to stop doing business with the insurer. It also has access to greater resources and typically has far greater ability to evaluate the soundness of the insurer than does an insured or prospective insured.
- If there is to be a loss, it is fairer to impose it on the general creditor, which is a general creditor by choice and undertakes the risk of that status, than to impose on the insured, who is the ultimate intended beneficiary of the entire insurance regulatory system.
If one State is paralyzed or ineffectual, that does not put the citizens of other States at risk. All 50 States can address the insurance issue involved. On the other hand, there is only one Congress and we have all seen what can happen when Congress cannot function. The country suffers. Why add to the areas already at risk, especially given the current situation, where impasse is the order of the day? Those who favor a Federal insurance regulatory system might want to wait for a better time to suggest it.
State regulation, when so much of commerce is regulated at the Federal level, emphasizes the fundamental differences between insurance and other forms of business and helps us all remember and reflect that difference. The nature of the promises made by insurers and the need for people to be able to rely on them make the business of insurance unique.
The dialogue occurring at the national level is worthwhile. It will serve to underscore areas where the existing system can be improved. The value of the State-based system must be clear and the wisdom of continuing it needs to be evaluated from time to time. Having done a good job in the past does not by itself earn the right to continue to regulate the industry in the future.
The current focus should be less on whether, in theory, regulation should occur on the Federal level, and more on whether there are examples at the Federal level that justify the suggestion that the Federal government could do a better job than is accomplished by the system already in place and proven.
1. Many types of policies are backed by industry guaranty funds, but such funds have limits and do not provide complete protection to all insureds. Examples of problems in particular lines have created problems.
2. Examples of areas where insurance availability and cost problems have affected large geographic areas include workers compensation, medical malpractice coverage, and liability coverage for entities such as day care centers.
3. Forbes Magazine, 9/16/2008; http://www.forbes.com/2008/09/16/aig-ny-capital-biz-wall-cz_cc_0916bizaig.html. In support, see http://www.investopedia.com/articles/economics/09/american-investment-group-aig-bailout.asp#axzz1buvHOKsf.
4. NAIC web site, "About the NAIC": http://www.naic.org/index_about.htm.
5. http://www.naic.org/legal_home.htm. The number and breadth of these Model Laws is such that they are categorized by group and can be seen at http://www.naic.org/committees_index_model_description.htm.
6. In this respect the question is less "Can there be a Federal system of insurance regulation?" than "Should there be?" Our Federal Constitution sets out various examples of activities well suited to attention at the Federal level (see Section 8, at http://archives.gov/exhibits/charters/constitution_transcript.html), such as immigration, currency, declarations of war, maintaining national armed forces, and also provides that powers not delegated to the Federal government or prohibited to the States, are reserved to the States (see the 10th Amendment to the Constitution, at http://archives.gov/exhibits/charters/bill_of_rights_transcript.html).