Modernizing Insurance Regulation

John H. Biggs, Matthew P. Richardson

• Publisher: Wiley
• Year: 2014
• Print ISBN: 9781118758717
• eBook ISBN: 9781118758847
• Edition: 1
• Topic: Business
• Subtopic: Insurance
• Index: Business

The future of the insurance regulation begins now

For those involved with the insurance industry, from investment professionals to policy makers, and regulators to legislators, tremendous change is coming. With insurance premiums constituting an ever-growing portion of annual U.S. GDP and provisions of the Dodd-Frank Act specifically calling for modernization of insurance regulations, the issues at hand are pervasive. In Modernizing Insurance Regulation, these issues are described against a backdrop of the political and industry discussions that surround insurance, regulation, and systemic risk. Experts Viral V. Acharya and Matthew Richardson discuss a variety of issues with top thinkers in the fields of finance, derivatives, credit risk, and banking to bring to light the most germane elements of this ongoing discussion.

In Modernizing Insurance Regulation, Acharya and Richardson call on the expertise of all the relevant stakeholders within government, academia, and industry to offer a well-rounded and independent view of insurance regulation and how the evolution of this key industry affects the U.S. economy now and in the future.

• Provides an overview of the feasibility of maintaining a state-level regulatory structure
• Offers a view of the issues from top academics, industry leaders, and state regulators
• Explores the debate surrounding the insurance industry and systemic risk
• Provides an in-depth look at upcoming changes under the Dodd-Frank Act

Modernizing Insurance Regulation provides a look into the crucial changes coming to insurance regulation and an overview of how those changes will affect almost everyone.

CHAPTER 1
Modernizing Insurance Regulation: An Overview

John H. Biggs and Matthew Richardson

Stern School of Business, New York University

INTRODUCTION

The insurance sector is an important part of the U.S. economy. For example, premiums collected by life and health (L/H) and property-casualty (P-C) insurers totaled $1.28 trillion in the United States in 2008, according to the National Association of Insurance Commissioners (NAIC).¹ Insurance allows individuals and businesses to protect themselves against potentially catastrophic financial risks. The traditional model of insurance is one in which insurers pool and diversify these idiosyncratic risks. In competitive markets, insurers price diversifiable risks on an actuarial basis, yielding tremendous utility gains to the previously exposed individuals and businesses.

Within this traditional model of insurance, it is reasonable to argue that systemwide defaults across insurance companies are unlikely because much of the risk is diversified away. If this type of risk is therefore not the primary concern, then it should not be surprising that the focus of regulation of insurance companies has been consumer protection in terms of individual firm solvency and the types of products offered. This partially explains why a regulatory system, dating back some 150 years, has revolved around state, not federal, regulations.

That said, why precisely insurance companies are regulated at the state rather than the federal level can be explained through two Supreme Court decisions, one in 1868 and the other in 1944. (See, for example, Harrington [2000], Webel and Cobb [2005], and Tyler and Hornig [2009], among others.)² In the earlier decision, in the Paul v. Virginia opinion, the Court determined that insurance was not interstate commerce and so for all practical purposes insurance companies were not subject to federal regulation. Seventy-six years later, the court reversed that decision in the United States v. Southeastern Underwriters Association case, which ruled that insurance is interstate commerce and subject to federal antitrust laws.

However, in response to the 1944 ruling, Congress elected not to take on insurance regulation and quickly passed into law in 1945 the McCarran-Ferguson Act, which permitted states to continue the regulation of insurance companies, as long as state regulation was not deficient (albeit subjecting the insurers to the antitrust laws). The latter provision affected mostly property-casualty (P-C) companies because of their use of state rating bureaus and their standardized pricing of personal insurance.

Since the passage of the McCarran-Ferguson Act, a tug-of-war between federal and state regulation has been a regular source of conflict. As the equilibrium between state and federal regulation has been disturbed by exogenous shocks in insurance products and markets, the regulatory process has been for the states and its regulatory body, the NAIC, to respond by adapting the state system to these shocks or criticisms. The NAIC is a de facto national organization, albeit made up of the chief insurance officials of the 50 states.

But there is growing evidence that the insurance industry has moved away from the traditional model, exposing itself to fragility similar to other parts of the financial sector. While this process started some 50 years ago as banks and asset management firms began to compete for similar customers, it likely escalated with the passage of the Gramm-Leach-Bliley Act in 1999. This Act effectively repealed the Glass-Steagall Act, further blurring the lines between financial services companies by allowing affiliation among banks, securities firms, and insurance companies. Insurance companies, whether through their asset holdings, their product offerings like variable annuities (VAs) and guaranteed investment contracts (GICs), or their funding, look less like the insurance companies of a few decades ago. It should not be a controversial statement that financial markets of the twenty-first century are substantially different from those of the nineteenth and twentieth centuries, suggesting possible revisions in how insurance companies are regulated.

Many large, complex financial institutions effectively failed during the most recent financial crisis. While one can argue that the insurance industry was less impacted (for the reasons given in paragraph 2), it is clear that the industry was not entirely spared—for example, from the failure of American International Group (AIG) to severe financial distress at some monoline insurers to large increases in default risk at some of the largest life insurers.

The most recent financial crisis has exposed serious holes in the architecture of the U.S. financial system. As a result, the Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, and it was signed into law by President Barack Obama on July 21, 2010. The Dodd-Frank Act did not create a new direct regulator of insurance but did impose on nonbank holding companies, possibly insurance entities, a major new and unknown form of regulation for those deemed “systemically important financial institutions” (SIFIs)—sometimes denoted “too big to fail” (TBTF)—or presumably any entity that regulators believe represents a “contingent liability” for the federal government in the event of severe stress or failure.³

Such a holding company would be subject to regulation by the Federal Reserve, where the list of companies subject to that regulation and its form is still being worked out, but now features AIG and Prudential Financial as two insurers in the SIFI list.⁴ This initiative arose due to the concern of massive support for AIG with direct funding from the Federal Reserve or the more limited bailouts of $950 million for Lincoln National and $3.4 billion for the Hartford Group under the federal Troubled Asset Relief Program (TARP). Other insurers, faced with large losses, made corporate moves so as to qualify for support from federal resources but were able to survive without actual drawdowns.

Because of the lack of any significant insurance expertise in Washington, the Dodd-Frank Act did create a Federal Insurance Office (FIO) in the Treasury Department, with a broad mandate to make recommendations and gather information but no broad regulatory responsibility. Significantly, it required that the director of the FIO submit a report to Congress with recommendations to modernize and improve insurance regulation within 15 months of the passage of the Dodd-Frank Act.

The law also provides that a person with “insurance expertise” should be nominated by the President and approved by the Senate as one of the 10 voting members of the very powerful Financial Stability Oversight Council (FSOC). It further provided that at least one other individual with “insurance expertise,” to be nominated by the NAIC, should be one of the five nonvoting members of the FSOC. In fact, three of the appointments have been made and all three are former state commissioners.

In light of the financial crisis and the somewhat benign changes to insurance regulation contained in the Dodd-Frank Act (regulation of SIFIs aside), how should a modern insurance regulatory structure be designed to deal with twenty-first-century insurance companies?

The purpose of this book is to lay out the arguments for and against various types of regulation. The book focuses in particular on three key areas of insurance regulation: (1) state versus federal, (2) systemic risk, and (3) guaranty associations. The book purposefully provides opposing arguments by leading academics, regulators, and practitioners.

This chapter summarizes the arguments laid out in the book and is separated into the following three sections, covering each of the three key areas.

STATE VERSUS FEDERAL REGULATION

As described in the introduction, the regulatory framework for insurance companies revolves around state, not federal, regulation. Aside from the advisory role of the new FIO housed in the Treasury Department, the only significant change is federal oversight of insurance companies deemed to be SIFIs. The question is whether this is sufficient for a modern insurance sector that includes companies operating across state and national lines and engaging in nontraditional insurance activities.

While not the primary focus of all the chapters of this book, almost all of the chapters touch on the issue of state versus federal regulation. The book starts with Chapter 2, by Dirk Kempthorne, CEO of the American Council of Life Insurers (ACLI) and former U.S. senator and governor of Idaho and U.S. Secretary of Commerce. While not calling for federal regulation per se, he argues that insurance regulation should be (1) uniform across different jurisdictions, (2) consistent with the business model of insurance companies (and not banks), and (3) efficient and, in particular, not duplicative. One could view points 1 and 3 as being more consistent with federal than multistate regulation. At the very least, Governor Kempthorne suggests that the new FIO will have to play a role in modernizing the system, especially with respect to coordination with international regulatory standards.

In Chapter 3, Roger Ferguson, CEO of TIAA-CREF and former vice chairman of the Federal Reserve Board of Governors, goes one step further and argues for the need for a federal regulator option for insurance companies. He argues that there has been a blurring of lines of business among financial companies, and that existing state regulation of insurance companies has led to a competitive disadvantage for those companies with a national footprint. Many of his concerns mirror those of Governor Kempthorne’s in Chapter 2. Vice Chairman Ferguson admits that the NAIC has tried to fix some of these problems for multistate insurers. Nevertheless, he argues that, because the NAIC has no jurisdictional power across the states, national insurance companies cannot achieve speed to market for products and must satisfy a complex web of regulations for managing insurance sales. In addition to these issues, Vice Chairman Ferguson explains that a federal regulator for nationwide insurance companies would be better able to handle rules within an international setting and industry-wide threats or crises. He surmises that the majority of insurance companies would remain state regulated but, for the select few national companies, a federal insurer would serve them better.

In Chapter 4, Therese Vaughan, former CEO of the NAIC, sees the state versus federal regulation issue quite differently. Vaughan views the state system for insurance companies as a much more effective way to regulate the insurance sector. She describes historical evidence of the success of the state system and cites other international agencies’ praise of its hands-on approach to regulation. Vaughan describes her experience at the NAIC and how the organization led to improvements in many of the state system’s design faults described in Chapters 2 and 3. In contrast to those chapters, Vaughan questions the benefits of uniform regulation and cites examples of how federal regulation failed with respect to banks during the most recent financial crisis. She also sees a benefit of collaboration among state regulators. That said, there is recognition that inefficiencies remain, especially with respect to life insurers focused on asset management.

Chapter 5, by Eric Dinallo, partner at the law firm Debevoise & Plimpton and former insurance superintendent for the State of New York, concurs with Vaughan’s Chapter 4. Commissioner Dinallo describes his experience in particular at regulating certain insurance subsidiaries of AIG before and during the financial crisis. He points out lapses in federal regulation and the danger of regulatory arbitrage, especially with respect to AIG’s holding company and its use of credit derivatives. In his view, the strong protections of the operating companies at the state level through ring-fencing and tight capital regulation provide a robust solvency regime in times of financial distress. Commissioner Dinallo very much questions the need to federalize existing state regulation. Interestingly, however, the chapter places the business of insurance in a historical context and questions whether some of the activities performed by modern-day insurance companies are insurance per se and not some form of other financial activity.

With respect to solvency of insurers, in Chapter 11, Peter Gallanis, who leads the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA), provides theoretical arguments and evidence in favor of the existing state-based system. In particular, Gallanis describes the success of the current state guaranty associations system in protecting policyholders over the years, with respect to both the size of the safety net and the resolution of failed insurance companies prior to 2008. In contrast, in Chapter 10, John Biggs, who is the former CEO of TIAA-CREF and an executive-in-residence at the NYU Stern School of Business, takes an opposite view. Biggs sees the system as particularly weak with a lack of uniformity and risk-based pricing across state guaranty associations. In pointing out well-known problems with systems based on post hoc assessments, Biggs is especially concerned that a number of guaranty associations did not or could not effectively participate in resolving the stress of large insurance companies in 2008 (such as AIG, Hartford Financial, and Lincoln Financial). Because there is a presumed reliance on the federal taxpayers in the event of widespread distress of large companies, and putting aside the Dodd-Frank Act’s designation and resolution of SIFIs, Biggs calls for a risk-based, prefunded, federal insurer guaranty system.

With respect to state versus federal regulation, Chapters 6 through 9 of the book discuss this issue peripherally and for the most part argue either for or against f...

Table of contents

• Cover
• Series
• Titlepage
• Copyright
• Dedication
• Preface
• Acknowledgments
• CHAPTER 1 Modernizing Insurance Regulation: An Overview
• CHAPTER 2 Life Insurance’s Importance to American Families and Industry’s Concern about Regulation
• CHAPTER 3 Why Insurance Needs a Federal Regulator Option
• CHAPTER 4 Observations on Insurance Regulation—Uniformity, Efficiency, and Financial Stability
• CHAPTER 5 Lessons Learned from AIG for Modernizing Insurance Regulation
• CHAPTER 6 Assessing the Vulnerability of the U.S. Life Insurance Industry
• CHAPTER 7 Systemic Risk and Regulation of the U.S. Insurance Industry
• CHAPTER 8 Designation and Supervision of Insurance SIFIs
• CHAPTER 9 Is the Insurance Industry Systemically Risky?
• CHAPTER 10 Modernizing the Safety Net for Insurance Companies
• CHAPTER 11 Policyholder Protection in the Wake of the Financial Crisis
• CHAPTER 12 Comparative Regulation of Market Intermediaries: Insights from the Indian Life Insurance Market
• About the Authors
• Index
• End User License Agreement