[Senate Hearing 111-301]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-301

 
                       REGULATORY MODERNIZATION:
                       PERSPECTIVES ON INSURANCE

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                                   ON

          EXAMINING THE MODERNIZATION OF INSURANCE REGULATION

                               __________

                             JULY 28, 2009

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html



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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman

TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         JIM BUNNING, Kentucky
EVAN BAYH, Indiana                   MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  JIM DeMINT, South Carolina
JON TESTER, Montana                  DAVID VITTER, Louisiana
HERB KOHL, Wisconsin                 MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado

                    Edward Silverman, Staff Director

              William D. Duhnke, Republican Staff Director

                       Amy Friend, Chief Counsel

                       Catherine Galicia, Counsel

                   Charles Yi, Senior Policy Adviser

                  Joe Hepp, Professional Staff Member

                  Drew Colbert, Legislative Assistant

                       Deborah Katz, OCC Detailee

                Mark Oesterle, Republican Cheif Counsel

                Andrew J. Olmem, Jr., Republican Counsel

                    Jim Johnson, Republican Counsel

                       Dawn Ratliff, Chief Clerk

                      Devin Hartley, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                         TUESDAY, JULY 28, 2009

                                                                   Page

Opening statement of Chairman Dodd...............................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     2
        Prepared statement.......................................    36
    Senator Johnson
        Prepared statement.......................................    36

                               WITNESSES

Travis B. Plunkett, Legislative Director, Consumer Federation of 
  America........................................................     4
    Prepared statement...........................................    37
    Responses to written questions of:
        Senator Brown............................................   117
Baird Webel, Specialist in Financial Economics, Congressional 
  Research
  Service........................................................     6
    Prepared statement...........................................    95
    Responses to written questions of:
        Senator Brown............................................   118
        Senator Vitter...........................................   119
Hal S. Scott, Nomura Professor of International Financial 
  Systems, and
  Director, Committee on Capital Markets Regulation, Harvard Law 
  School.........................................................     7
    Prepared statement...........................................   104
    Responses to written questions of:
        Senator Brown............................................   120
Martin F. Grace, J.D., Ph.D., James S. Kemper Professor of Risk 
  Management, and Associate Director, Center for Risk Management 
  and Insurance Research, Georgia State University...............     9
    Prepared statement...........................................   109
    Responses to written questions of:
        Senator Brown............................................   121

                                 (iii)


          REGULATORY MODERNIZATION: PERSPECTIVES ON INSURANCE

                              ----------                              


                         TUESDAY, JULY 28, 2009

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 9:35 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Christopher J. Dodd (Chairman 
of the Committee) presiding.

       OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD

    Chairman Dodd. The Committee will come to order this 
morning. Let me just announce that when we have a quorum, we 
have an executive calendar nomination to consider that has been 
cleared on both sides, a very competent and talented woman, 
Deborah Matz, to be the Board Member designee of the National 
Credit Union Administration. And so if we achieve that number, 
we will interrupt the hearing for that purpose, and if not, 
then I will try and schedule it off the floor after a vote that 
is convenient for everyone, either this morning or later this 
afternoon.
    But pending the arrival of 12 Members, I want to thank our 
witnesses this morning and those who have gathered in the 
hearing room to listen to our hearing this morning entitled 
``Regulatory Modernization: Perspectives on Insurance.'' We had 
a hearing back in, I think, March on the subject matter, and 
this is an important issue, obviously, for all of us. As we 
talk about the modernization of financial services, insurance 
plays a very, very critical role. The insurance industry 
provides millions of Americans, as we know, in our country with 
the safety net they need both as individual homeowners, small 
businesses, as well as larger enterprises. And in times such as 
these, people are already faced with uncertainty. Millions have 
lost their jobs, their homes, and their retirement. We need to 
provide them with the peace of mind to protect the 
policyholders as well and make sure that our insurance industry 
is strong and stays strong during this time of economic 
difficulty.
    But it is a critically important industry, and it has 
played a very, very important role in capital formation 
throughout a good part of the 20th century, and as we get into 
the 21st century, the role of insurance is going to be even 
that more important.
    So we live in an uncertain world, as we all know these 
days. The economic crisis has claimed as casualties millions of 
our fellow citizens who have lost jobs and homes, retirement 
savings, and their family's economic security. But even in the 
best of times, there is always risk, and that is why the 
insurance industry exists: to provide stability to families and 
businesses.
    Today's hearing is the latest in a series examining our 
financial regulatory system and exploring ways to modernize it 
for the 21st century. At issue is what should be done to better 
regulate the insurance industry. As always, our primary concern 
is protecting working families in this Nation who have paid the 
highest and the most unfair price for our regulatory 
deficiencies.
    What to do about insurance regulation is complicated. Some 
have called for Federal regulation of insurance, while others 
strongly defend the current system of State regulation. It is 
important, obviously, that we get this right. A strong economy 
requires the effective flow of capital. Insurance, and the 
security it brings, is a key element in getting credit moving 
again.
    In my home State of Connecticut, we have had a long and 
proud history of acting as a home, the major home to insurance 
firms that provide a foundation of security for all manner of 
transactions, from the purchase of a home to the building of a 
new factory. And so there is a solid case to be made that 
State-based regulation of insurance has worked well for more 
than a century. Millions of American families, too, have relied 
on one form of insurance or another in a time of crisis--when 
they needed to rebuild their homes after a devastating fire or 
such loss or needed economic security after the loss of a 
breadwinner in their family.
    But there is also a case to be made that it is time for 
change. Insurance companies have become more global and more 
complex, and even though the insurance industry did not create 
the economic crisis, like almost every other industry, it has 
been hit hard, and as a result, many are calling us to 
modernize regulations and reflect the 21st century in which the 
insurance industry exists.
    The Administration's plan for regulatory modernization 
would create an Office of National Insurance within the 
Treasury to collect information and coordinate insurance policy 
at the Federal level. It is one of the many ideas that we will 
be considering in the coming weeks, and so today we have 
assembled an impressive panel of academics and experts. I am 
grateful to each and every one of you for being here. You are 
extremely knowledgeable on the subject matter and can provide 
some insight and thoughts as to how we might progress in this 
area of modernizing our financial regulatory structure, and 
particularly with emphasis on insurance and the insurance 
industry. So I thank you all for coming.
    I am going to turn to Senator Shelby for any opening 
comments he may have, and then unless my colleagues would care 
to be heard on the subject matter at the outset, we will turn 
right to our witnesses. Senator Shelby.

             STATEMENT OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    Over the past 2 years, we have seen how problems in our 
insurance markets can disrupt our national economy. The 
crumbling of our largest bond insurers called into question the 
value of financial guarantees these firms had issued on 
billions of dollars of securities. In addition, the spectacular 
failure of AIG sent shock waves throughout our economy and led 
to a $170 billion bailout by the Federal Government.
    These events revealed that comprehensive insurance 
regulation must be a part of our reform effort. Unfortunately, 
I believe the Administration has taken a pass on comprehensive 
insurance reform thus far. Under the President's proposal, the 
Federal Reserve would regulate only insurance companies that it 
deemed to be systemically significant. The President also 
proposes the creation of an Office of National Insurance that 
would collect information and advise the Treasury Secretary on 
insurance matters. While this concept may have some merit, it 
certainly is not comprehensive reform and leaves unanswered the 
difficult question of whether and how insurance regulation 
should be modernized for the vast majority of insurers.
    The goal of today's hearing is to answer that question, as 
well as to examine the President's reform proposal as it 
relates to insurance. In particular, I am interested in 
learning whether our witnesses believe that the Fed is an 
appropriate regulator for insurers. Does it have the expertise 
necessary to supervise complex insurance companies? Would 
establishing a separate Federal insurance regulator be a better 
choice? If a Federal regulator is established, should all 
insurers have the option of being regulated at the Federal 
level? If a Federal regulator is not established, what steps 
need to be taken to ensure that there is proper coordination? 
Last, how do we make sure that there are no gaps in our 
regulatory system like those that appear to have played a role 
in the collapse of AIG?
    Reforming our insurance regulation will be complex and very 
challenging. The level of difficulty should not prevent us from 
seeking a comprehensive solution to financial regulation that 
includes insurance.
    Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much, Senator.
    Do any of my colleagues want to make any quick opening 
comments? If not, your opening statements will all be included 
in the record. And let me just say to our witnesses because I 
know, having read over some of your testimony last evening, you 
are going to want to have it included in the record, I presume, 
because I do not know how--Travis, there is no way in 5 minutes 
you are going to have your testimony included in this record in 
5 minutes. So I will make sure that your comments and thoughts 
and additional ideas will be a part of the record. I will say 
that at the outset so you do not have to ask consent to that. 
With that, let me introduce our panel.
    Travis Plunkett is the Legislative Director of the Consumer 
Federation of America. He is a regular fixture in this 
Committee, has been sitting at that desk on numerous occasions, 
at least during my tenure in the last 2\1/2\ years, on 
numerous, numerous issues that have come before us, and we 
thank you once again for being here today.
    Baird Webel is the Specialist in Financial Economics at the 
Congressional Research Service, which provides nonpartisan 
analysis and research for members of Congress. Mr. Webel has 
authored and contributed to a number of reports related to 
insurance and the regulation of insurance, and for those of us 
who have been here and I note for new Members that the 
Congressional Research Service is an invaluable service for us 
up here. It has been a great source of nonpartisan information, 
and we thank you immensely.
    Hal Scott is certainly well known on this subject matter, 
the Nomura Professor and Director of the Program of 
International Financial Systems at Harvard Law School, where he 
has taught since 1975. He is also the Director of the Committee 
on Capital Markets Regulation. Professor Scott, we thank you 
for being here. We appreciate your participation.
    Martin Grace is the James Kemper Professor of Risk 
Management at Georgia State University. He was the Associate 
Director and Research Associate for the Georgia State Senate 
for Risk Management and Insurance Research. He is currently an 
associate editor of the Journal of Risk and Insurance, and, 
again, we appreciate your knowledge and background and 
experience in the subject matter as well, and we thank you for 
joining us today as a witness.
    With that, Travis, we will begin with you, and, again, I am 
not going to be rigid on the clock here. But, nonetheless, if 
you try and keep it at 5 to 7 minutes, I would appreciate it 
very much. Then we will turn to our colleagues for questions.

STATEMENT OF TRAVIS B. PLUNKETT, LEGISLATIVE DIRECTOR, CONSUMER 
                     FEDERATION OF AMERICA

    Mr. Plunkett. Thank you, Mr. Chairman, Ranking Member 
Shelby, and Members of the Committee. Once again, it is a 
pleasure to be before you to talk about insurance regulation 
and reforming and modernizing insurance regulation.
    Unfortunately, our insurance director, Bob Hunter, could 
not be here today. He sends his apologies. He is tending to a 
sick family member. As he mentioned in his testimony before the 
Committee in March, we are revisiting our policy positions on 
insurance regulation to learn from the regulatory failures that 
contributed to the economic meltdown.
    The first lesson that we have learned is that Congress 
should, in fact, create a systemic risk regulator for 
insurance. Our analysis indicates that there is some systemic 
risk in insurance requiring a regulator. In order to fully 
understand and control systemic risk in this very complex 
industry, the Federal Government should take over solvency and 
prudential regulation of insurance as well.
    This conclusion is made even in light of the fact that, 
looking backward, a strong case can be made that the States 
have done a pretty good job of solvency regulation of insurers 
in recent years, primarily because of the creation of NAIC's 
accreditation program. That track record was stained, however, 
last winter when NAIC agreed in secret meetings to fast-track 
several significant changes to life insurance accounting and 
reserve practices which would have weakened the financial 
condition of life insurers and misled the public about the 
financial strengthen of some of these insurers. Although NAIC 
eventually backtracked and rejected these changes, they were 
adopted by several regulators in important States with large 
insurers. Looking forward, we see no other way to understand 
and control national systemic risk other than under a single 
solvency prudential regulator.
    The second lesson for us is that the Federal systemic risk 
regulator should be housed in an agency that is also tasked 
with prudential and insolvency regulation. The office should be 
a repository of insurance expertise. It should engage in 
activities like data colleague and analysis. While this office 
should be completely knowledgeable about all aspects of 
insurance, it should not be granted vague and open-ended powers 
of preemption regarding international agreements that would 
affect State consumer protection laws or rules in areas that 
Congress has chosen not to explicitly preempt.
    The third lesson for us is that we need to create a 
financial consumer protection agency to put minimum standards 
on the books regarding credit-related insurance transactions, 
including credit and title insurance. The agency should also 
study insurance matters that are important to consumers and 
small businesses and appear before the States or the courts on 
behalf of consumers regarding personal lines of insurance, such 
as auto and homeowners coverage.
    That is what we would recommend that Congress do for 
starters regarding regulatory restructuring. Here is what we 
would recommend that Congress not do.
    First is to block the States from being the primary 
insurers of insurance regarding consumer protection. The States 
are well established in insurance regulation with great 
expertise and experience. They regulate over 7,000 insurers. 
They have 10,000 staff working on insurance matters. Over the 
years, we have documented many weaknesses in this State-based 
system, but the truth is that they are very good at some 
things, especially handling complaints for consumers, and their 
capacity to do so far outstrips current Federal capacity, for 
example, on banking in terms of handling complaints.
    However, we should not set up an optional Federal charter 
system. That system, we think, is designed to reduce consumer 
protection to exert downward pressure on the quality of 
insurance regulation. It has failed miserably at the banking 
level. Banks and thrifts switch charters freely at the Federal 
level and between the State and Federal level to avoid strong 
regulation, leading to sharp downward pressure on the quality 
of regulation. The results are obvious, and they have affected 
our economy. So we very strongly encourage this Committee not 
to take that approach to regulatory modernization.
    Finally, let me conclude by just saying that insurance is a 
mandatory aspect of life today for American consumers. States 
and lenders require many different types of coverage. If they 
do not require it, the need to act responsibly to protect one's 
family in the event of an unexpected emergency means that 
purchasing other insurance products is a virtual necessity. 
Consumers can easily be misled by the fine print, and we urge 
this Committee to continue, as it has, to put a strong focus on 
consumer protect when it looks at insurance regulation.
    Thank you all.
    Chairman Dodd. Thank you very much, Mr. Plunkett.
    Mr. Webel.

 STATEMENT OF BAIRD WEBEL, SPECIALIST IN FINANCIAL ECONOMICS, 
                 CONGRESSIONAL RESEARCH SERVICE

    Mr. Webel. Good morning. My name is Baird Webel. I am a 
Specialist in Financial Economics at the Congressional Research 
Service, and I would like to thank you, Chairman Dodd, Senator 
Shelby, and the rest of the Members of the Committee for having 
me here. I appreciate the opportunity to provide whatever 
assistance I can to the Committee as it considers insurance 
regulatory modernization.
    My written testimony provides a range of options that 
Congress could consider as it approaches revamping the 
insurance regulatory system, and I would like to highlight some 
particular aspects.
    To begin, I would just highlight that the options that I 
present, and many of the other options, are not mutually 
exclusive. Insurance is a very wide-ranging business. It is 
quite possible to envision an approach that takes different 
regulatory approaches for different aspects of the insurance 
business. You have extreme differences between life insurance 
and property-casualty insurance, between personal lines and 
commercial lines that are about big businesses. You could 
approach large and small insurers differently. You can approach 
market conduct and consumer protection differently than you 
might solvency regulation. This is not to say that one single 
regulatory body might not be the way to go, but there are 
numerous options to consider as you consider.
    The insurance regulatory reform debate is not new. It goes 
back really all the way to 1868 or so. It has been spurred 
along by this financial crisis, but many of the proposals that 
may come before Congress really predated the financial crisis.
    To some degree, many of these proposals have been in 
legislative language for quite some time. There has been a 
chance to vet them and to examine the language for various 
interest groups to consider what this language might mean, and 
for the people to line up on one side or the other as they have 
the battle over whether or not you would want to see a proposal 
enacted.
    There are some new proposals, however, and these I think 
really have not been vetted to the same degree that the older 
ones have, which is not to say that they are not good 
proposals. There are certainly old proposals that have been on 
the table for a long time and left on the table for a reason. 
And there are new proposals that maybe we do not know exactly 
what the impact might be but might be the right thing to do.
    The newest proposal, of course, is what was released by the 
Administration in the last week with legislative language 
coming out of the Treasury, and I think that particularly with 
regard to the insurance aspect of it, the Obama 
administration's plan leaves insurance relatively intact in the 
current regulatory system. The States remain the primary 
regulators of insurance under the plan. The principal two ways 
that the plan touches insurance is through the aforementioned 
Office of National Insurance, which would have some preemptive 
powers over State laws, and through the systemic risk regulator 
language.
    What is interesting, though, is that the systemic risk 
regulatory language that was released hardly mentioned the term 
``insurance.'' I think that the primary way that it does is 
actually in the phrase ``Federal deposit insurance.'' So that 
presumably insurers are included under the very broad 
definition of ``financial company'' that is in the law, but it 
does not treat a lot of the questions that would arise when you 
have the systemic regulator on top of the current system. And I 
think that these questions are sort of magnified by the split 
between a State and a Federal regulatory body.
    The relationship between two Federal regulatory bodies may 
be a little different than when you have a Federal regulatory 
body and a State regulatory body. I think there are some 
constitutional or legal questions that come up in terms of how 
does a Federal regulatory body interact, what kind of 
preemptive powers does it have, that are operative in the 
insurance realm that really do not apply to the same degree in 
the banking realm. And I think that the Administration's 
proposal is really sort of silent on exactly how these issues 
may be resolved.
    Of interest as well is the fact that the Financial Services 
Oversight Council that is foreseen in the legislation does not 
appear to have any specific representative with an insurance 
background on it. You have the heads of the various Federal 
regulatory bodies, but the draft that I saw did not include the 
head of the new Office of National Insurance on the Financial 
Services Oversight Council, did not see any representation from 
the State insurance regulators as well. And I think that that 
is just an interesting aspect of how, once again, insurance to 
a large degree at the Federal level is being seen--I mean, I 
would not say as a second-class citizen, but it is secondary to 
the banking system and, to some degree, the securities system, 
primarily because the Federal Government has not had the direct 
oversight over insurance in the past.
    I will be happy to answer any questions that the Committee 
has.
    Chairman Dodd. Thank you very much, Mr. Webel. I appreciate 
it.
    Mr. Scott, thank you again for being with us.

 STATEMENT OF HAL S. SCOTT, NOMURA PROFESSOR OF INTERNATIONAL 
 FINANCIAL SYSTEMS, AND DIRECTOR, COMMITTEE ON CAPITAL MARKETS 
                 REGULATION, HARVARD LAW SCHOOL

    Mr. Scott. Thank you, Chairman Dodd, Ranking Member Shelby, 
and Members of the Committee, for permitting me to testify 
before you today on regulatory modernization as it relates----
    Chairman Dodd. Mr. Scott, that microphone of yours, you 
have to pull it up close to you, too. I am sorry about that.
    Mr. Scott. OK. Should I start over?
    Thank you, Chairman Dodd, Ranking Member Shelby, and 
Members of the Committee, for permitting me to testify before 
you today on regulatory modernization as it relates to the 
insurance industry.
    As the Committee knows, the insurance industry represents 
an important place in the U.S. financial system. As of the 
first quarter of 2009, the total assets of U.S. life and 
property-casualty insurers were $5.7 trillion, quite 
significant when compared with total assets of U.S. commercial 
banks of $13.9 trillion. Despite being a national--indeed, 
international--business, insurance, unlike the banking and 
securities sector, is regulated almost exclusively by each of 
the 50 States instead of the Federal Government.
    I favor changing the system by creating an optional Federal 
charter, OFC, and I have three major reasons for taking this 
position.
    First, the current framework of multistate regulation is 
inefficient. One study finds that the total additional cost of 
having multistate regulation of the life insurance industry is 
about $5.7 billion each year. These costs are ultimately borne 
by the purchasers of insurance.
    Second, the current framework impedes achieving uniformity 
of standards and regulations. NAIC's attempts to attempts to 
reduce these costs have not been entirely successful. The 
surest way to solve this problem is to have Federal rather than 
State regulation.
    Third, the current system puts the insurance industry at a 
competitive disadvantage to other financial services firms 
offering competing products. Federally regulated financial 
institutions can ask their Federal regulators for nationwide 
approval of a product and receive one approval within a 
relatively shorter period of time than it takes insurers to 
obtain multistate approvals.
    And, finally, the creation of a Federal chartering agency 
would enable greater cooperation in the international arena 
among the various national insurance regulators.
    Some contend that an OFC may lead to reduced consumer 
protection since State regulators may be more responsive to 
local complaints and concerns than a Federal regulator, and I 
think to some extent this has been true in the past. However, 
the Obama administration's proposal for a new consumer 
financial protection agency, which I think should have 
jurisdiction over federally regulated insurers, should greatly 
alleviate that concern.
    Where should the new Federal regulator fit in the current 
regulatory structure? From a broad perspective, I believe the 
overall U.S. financial regulatory structure is in need of 
significant reform.
    In May 2009, the Committee on Capital Markets Regulation 
issued a comprehensive report entitled ``The Global Financial 
Crisis: A Plan for Regulatory Reform'' that called for the U.S. 
financial system to be overseen by only two or, at most, three 
independent regulatory bodies: the Federal Reserve, a newly 
created independent U.S. Financial Services Authority called 
the USFSA, and possibly another new independent investor/
consumer protection agency. I believe this model is the right 
one to replace our highly fragmented and ineffective regulatory 
structure.
    If this proposal were to be adopted, regulation of 
federally chartered insurance companies would be shared, as it 
was for banks and securities firms between the Federal Reserve, 
the USFSA, and this third investor/consumer protection agency, 
and we would envision that the Treasury Department would 
resolve regulatory conflicts for insurance companies as well as 
other financial institutions between these two or three bodies.
    Two final points. First, my testimony has assumed that 
Federal chartering will be optional. However, Federal 
regulation, if not Federal chartering, should be mandatory for 
large insurance companies since the failures of such firms pose 
risk to the financial system and taxpayers, as demonstrated by 
AIG.
    Second, the Federal Government must require these large 
insurance firms to have sufficient capital as a buffer against 
their failure and the expenditure of taxpayer funds. Our 
committee would have lodged that capital regulation authority 
with the Federal Reserve.
    However, we must bear in mind that these requirements for 
capital will have to be different than for banks, as insurance 
firms engage in very different activities and, thus, incur 
different risks.
    Thank you. I look forward to answering your questions.
    Chairman Dodd. Thank you very much, Professor Scott.
    Mr. Grace, Professor Grace.

  STATEMENT OF MARTIN F. GRACE, J.D., Ph.D., JAMES S. KEMPER 
 PROFESSOR OF RISK MANAGEMENT, AND ASSOCIATE DIRECTOR, CENTER 
   FOR RISK MANAGEMENT AND INSURANCE RESEARCH, GEORGIA STATE 
                           UNIVERSITY

    Mr. Grace. Thank you. Mr. Chairman, Ranking Member Shelby, 
and Members of the Committee, good morning and thank you for 
giving me the opportunity to testify before you today on the 
topic of insurance modernization.
    My name is Martin Grace, and I have spent my entire career 
at Georgia State University conducting research in insurance 
regulation and taxation. Since the industry is regulated at the 
State level, this has been predominantly an exercise in the 
study of State regulation. However, the question of whether the 
State is the appropriate level of regulation is becoming more 
important, and I have spent the last 4 to 10 years, depending 
on how you count it, thinking about that regulation.
    This brings me to what I am going to talk about today.
    First is the value of regulation in the insurance industry. 
There are valid rationales for insurance regulation, but the 
business of insurance is quite different than banking and has a 
need for a different style of regulation.
    Second, I have a mild but, nonetheless, important critique 
of the current proposals to regulate the insurance industry. An 
optional Federal charter is not necessarily the only way to 
think about insurance regulation, and I would like to concur 
with Professor Scott that maybe there are certain companies 
that should be regulated and certain companies that have the 
option of being regulated at the Federal level. However, the 
current proposal is cobbled together from a Federal banking law 
that goes back quite some time and decades old State insurance 
protection--consumer protection model laws.
    My third point is that something like the Office of 
National Insurance as a source of expertise and advice to the 
Federal Government about the insurance industry is needed, but 
it should not by itself be used to restructure the relationship 
between Federal and State regulation through its use of 
preemption.
    Well, we have probably heard a number of different people 
throughout the last year or so talking about why we regulate 
insurance, but I want to compare the historical rationale with 
insurance regulation to the current way people are thinking 
about it.
    Historically, insurance has been regulated to reduce 
asymmetric information between consumers and producers and 
shareholders and policyholders, and also to reduce the cost of 
alleged market power in certain product lines. These historical 
arguments are really not why we are here today. The more 
important and immediate application of regulation concerns 
systemic risk, and this is that regulators should prevent 
market failures caused by the externality of one company 
leading to the loss of consumer or commercial confidence in the 
financial system.
    Historically, insurers did not present a real contagion 
risk to the financial system, but this may no longer be true. 
Financial companies are interconnected in ways that are without 
historical precedent. A bank with an insurance operation can 
extend the contagion risk to those insurance operations.
    In insurance, the focus of regulation has been on the 
individual company and not on the group or holding company. 
This needs to change at some level to allow for the proper 
accounting of systemic risk. A State regulator cannot 
realistically regulate an insurer for its possible systemic 
risk or its effect on national and international markets 
especially in situations where the insurer within the State is 
a separately organized corporation from the corporation which 
might induce a systemic risk issue.
    We can talk a little bit about what level the regulation of 
insurance should be laid out, whether optional Federal 
chartering makes sense. You have probably heard most of these 
arguments, so I am going to skip to my final point, which has 
to do with the current role for the Federal Government in 
insurance regulation.
    The proposed Office of National Insurance is an important 
first step in any role the Federal Government may have in the 
future. Even if the Federal Government decides in the near 
future to pass on regulating insurance completely, the Office 
of National Insurance still may be an important innovation for 
three main purposes. First, there is a paucity of individuals 
at the Federal level who know its component industries, its 
market structures, its products, its taxation, or its pricing. 
Second, because of the unique nature of insurance--premiums are 
received now but claims are paid at some time in the future--
there are a number of important technical accounting and 
actuarial issues that need to be understood regarding reserving 
and pricing. This type of knowledge currently resides at the 
State level.
    Finally, there is an important issue that may arise 
depending upon the powers granted to the Office of National 
Insurance. However, while it does provide the opportunity to 
provide information to the Federal Government, especially with 
international treaties regarding solvency regulation, the main 
point here is not likely information provision to the 
negotiators of the Department of Commerce but a real 
possibility of the office having or eventually obtaining 
significant ability to preempt State laws inconsistent with 
international accords. This would be a piecemeal change of the 
insurance regulatory system that would likely lead to real 
disruptions in regulations. However, a top-down reexamination 
of the regulation of the industry would provide for a more 
systemic or systematic review of the proper role of the Federal 
and State regulatory powers.
    Thank you, and I would be happy to answer any questions.
    Chairman Dodd. Those were very, very helpful, very 
knowledgeable. And again, your full statements, I found 
tremendously illuminating. They were very comprehensive and I 
regret we don't have more time for you to go into greater 
detail, at least in your opening comments, but I appreciate 
very much what you have submitted to the Committee.
    Let me sort of pick up, if I can, Mr. Grace, on your last 
point and just quickly ask the rest of you, and again, I am not 
suggesting that those of you who have recommended more, that 
that be excluded, but at least to begin with the notion of the 
Office of National Insurance. Is it fair to assume, based on 
what I have heard, that all of you would agree that this is, at 
the very minimum, this is a step that ought to be taken? Is 
that correct? Mr. Scott, do you agree with that, as well?
    Mr. Scott. Yes.
    Chairman Dodd. Mr. Webel.
    Mr. Webel. There does seem to be a lack of information at 
the Federal level on insurance.
    Chairman Dodd. And Mr. Plunkett, you agree with that, as 
well?
    Mr. Plunkett. Yes, Mr. Chairman.
    Chairman Dodd. I thank you. That helps. In fact, in March, 
I asked a very similar question of the panel and had a similar 
response, but I think it is helpful, at least to begin on a 
point of common interest in all of this.
    Let me turn to you, Mr. Plunkett, and ask you, I have said 
many times before, I believe that consumer protection is a 
fundamental principle that should guide our deliberations, in 
thinking about that shareholder, that depositor, that borrower, 
that policy holder, if we begin by what is in their interest. 
Obviously, you want stability of your financial institutions as 
a critical component. But obviously, the confidence and 
optimism of that individual who goes and buys that policy, 
deposits that check, buys that share, takes out that mortgage, 
obviously you have got to restore the confidence of those 
individuals for them to succeed.
    But what is your view of the proper role of the Federal 
Government? We have heard the conversation here about the 
systemic risk issues, which obviously contributed 
significantly. Insurance plays a critical role. And while AIG's 
problems were not related to its insurance activities--at 
least, I think most people come to the conclusion their 
problems occurred as a result of alternative activities that 
were not part of the main function that had built AIG over the 
years--there is this risk and danger that if we don't really 
take a greater central role in the regulation of this major 
industry in the 21st century, that, in fact, we will be leaving 
a gaping whole in the systemic risk obligations.
    If we all acknowledge that that is a critical risk and the 
role that these industries could play in systemic risk, then 
why wouldn't you, while not necessarily at this juncture here, 
make that transition to a Federal charter rather than leaving 
this at the State level?
    Mr. Plunkett. Mr. Chairman, we have proposed new regulation 
by the Federal Government. In particular, we do believe there 
is systemic risk in insurance--some--for particular lines 
especially, like bond insurance. And as a result, we believe 
that prudential regulation is very associated with proper 
systemic regulation. Our recommendation is to shift prudential 
regulation from the States to the Federal level. You can't do 
systemic regulation without having the capacity to do 
prudential regulation at the same time.
    Regarding consumer protections, though, as we have heard, 
the States have the expertise. Some States have a much better 
track record than others. But we are leery of shifting consumer 
protection regulation from the State to the Federal level at 
the current time, in particular because the insurance industry 
has made it clear that they will vehemently oppose what we view 
as core aspects of consumer protection regulation.
    Finally, we have proposed a minimum standards role, as the 
President has. We have endorsed the President's call for this 
new Consumer Financial Protection Agency to regulate credit-
related insurance policies--like title insurance, credit 
insurance, mortgage insurance--because they are so closely 
associated with the credit matters that this agency will have 
authority over, but only on a minimum standards basis so the 
States could improve on those standards, if necessary.
    Chairman Dodd. Let me jump, if I can, and if any of you 
want to comment on this point as I ask other questions, you 
certainly may do so. I was intrigued, Mr. Grace, in what you 
call a mild but nonetheless important critique of the current 
proposals in your prepared statements. You say that an optional 
Federal charter is not necessarily the only way to proceed, and 
again, you made this point in your presentation to us this 
morning, and that the current proposal is cobbled together from 
a Federal banking law that is decades old, and I don't disagree 
with that conclusion.
    And yet as you point out, there has been little discussion 
of other insurance reform ideas outside of the optional Federal 
charter. I can't recall if it was you or Mr. Scott who made the 
point about having the charter--drawing a distinction between 
the charter obligations and the regulatory obligations. I think 
it was Mr. Scott who made that point.
    I worry about this notion of arbitrage, regulatory 
arbitrage that goes on. In fact, I wish we would take the word 
``optional'' out of this discussion altogether because I think 
it is sort of an antiquated idea in light of events over the 
last couple of years. Either you are going to be one or the 
other, it seems to me, and this idea of bouncing around, trying 
to choose where you want to be, I think has contributed in some 
significant way to the problems we are facing today.
    But anyway, let me ask both of you, if I can, do you think 
there should be a systemic discussion of modernizing insurance 
regulation that could review all of the available ideas, and 
again, the Office of National Insurance thing does that to some 
degree, but share with us if you would, Mr. Grace, some of 
these other ideas you think which we should be considering 
other than just the optional Federal charter.
    Mr. Grace. I was thinking that there are a number of 
different ways you could go with this, but there would have to 
be some thought about are there some companies that really are 
interstate, international in scope, and should they have the 
option to become a Federal charter? I would say, if they want 
to, yes, of course.
    But what if there were certain companies that were 
interstate, international in scope and decided not to want to 
become a federally chartered insurer? Would there be an ability 
by the Federal Government to say, you know, you really are a 
different type of organization, and because of your ties to a 
holding company system, because of your ability to perhaps 
become systemically related to a banking concern or some other 
kind of financial services company, that you become very 
important to us?
    Well, I would think that the Federal Government would want 
to have sort of the reverse option, if you will, of bringing 
that company within the Federal charter, however you might want 
to think about it.
    Chairman Dodd. So it wouldn't be necessarily--you are not 
leaving the decision up to the industry, but rather the Federal 
Government ought to be saying, in light of the activities you 
are engaged in, you don't have the option.
    Mr. Grace. Right. That is the second option. The first 
option is people--smaller companies might want to be federally 
regulated for whatever reason. And then larger companies, 
though, because of their activities, might need to be federally 
regulated, which I am agreeing with what you are saying. So it 
is an option that the Federal Government would have based upon 
certain characteristics of the complexity of the firm, the 
markets it is in, the types of activities its activities are 
related to. That would be enough to make it--I don't want to 
call it systemically important, because that is not really what 
I am saying. I just think that the company is significantly 
complicated and organized in such a way that a single State 
regulator has a difficult time putting the entire company 
together under its jurisdiction.
    Chairman Dodd. Mr. Scott, do you want to quickly comment on 
this notion of that distinction between charter and regulation? 
Is that a distinction without difference in the sense of 
allowing sort of this migration back and forth when it comes to 
the industry deciding where it wants to be? And obviously, the 
problems seem related.
    Mr. Scott. Well, on the charter point, what I was thinking 
is if you had an optional Federal charter system, not all 
insurance companies get a Federal charter. But on the other 
hand, you might build in on top of that a requirement--and, by 
the way, anyone that did get a Federal charter would be 
federally regulated, obviously. You might build on top of that 
mandatory chartering/regulation for large insurance 
institutions, and I say large and I am not saying systemically 
important--it is not an accident--because I think it is 
inherently difficult to define what is a systemically important 
institution and they are going to change from time to time and 
it has negative moral hazard problems, as has been widely 
discussed in recent weeks.
    So I think if we picked them on large, we wouldn't be 
branding people right off the box. We might get some that 
really didn't have that much real systemic risk, but if they 
are large enough, it seems to me that most of those very large 
insurance companies could, if they engaged in certain 
activities, result in systemic risk.
    So I would have at the Federal level an option for 
everybody, large or small, but large would have to be 
mandatorily regulated at the Federal level.
    Chairman Dodd. Thank you very much.
    Senator Shelby.
    Senator Shelby. Professor Scott, in the derivatives area, 
are a lot of the derivatives insured by insurance companies, in 
other words, credit default swaps and things like that?
    Mr. Scott. Well, they write--insurance companies do.
    Senator Shelby. They write insurance?
    Mr. Scott. Yes. Not in the regulated insurance company, but 
like in their holding company. I don't know that anyone has 
done it to the extent that AIG has done it.
    Senator Shelby. If an insurance company is involved in 
derivatives on the national, international scale, how could 
States regulate them?
    Mr. Scott. Well, I don't think very successfully.
    Senator Shelby. They haven't, have they?
    Mr. Scott. I would just generalize that problem to say that 
if you are talking about interstate and international 
activities, there is a limited ability of the States acting 
individually to address this problem, even when they are 
coordinated by some kind of association.
    Senator Shelby. Professor Grace, have you studied how many 
insurance firms would actually be considered as a systemic 
risk, generally speaking, of the insurance companies in this 
country?
    Mr. Grace. No, sir.
    Senator Shelby. Shouldn't that be an appropriate study 
somewhere? I am not suggesting to you academics what to do, 
but----
    Mr. Grace. I agree to some----
    Senator Shelby. ----that work could help us some.
    Mr. Grace. I agree to some extent that the problem is we 
don't--in order to study something, we have to know what it is, 
and I think that is sort of a chicken-and-the-egg problem.
    Senator Shelby. In how you define it?
    Mr. Grace. Exactly, sir.
    Senator Shelby. How you define it. I guess what I am trying 
to get at, what percentage of insurance companies would be 
subject to bringing the system, the financial system down?
    Mr. Grace. I thought about that question sort of 
hypothetically and then I said, how many companies look like 
AIG? I said, how many in the United States? And I couldn't come 
up with any. I said, how many worldwide, and there might be 
some. I am not an expert on international companies. But their 
organization was so different than the typical United States 
insurer. But there are other types of risks that insurers 
engage in that in different circumstances might yield problems.
    Like one of the things, and I am not an expert in this 
area, but the National Association of Insurance Commissioners 
is concerned about lending of securities by life insurers, 
which has some option-like characteristics and how do you 
reserve for those types of things is very important.
    Senator Shelby. Sure.
    Mr. Grace. And most State regulators may not even be aware 
of the extent of this type of activity because it is just not 
public. People don't talk about it. They don't think about it.
    Senator Shelby. But aren't a lot of the problems that we 
have encountered that insurance, and, of course, banks, too, 
are involved in things without adequate capital to back up what 
they are involved in, the risk that they take?
    Mr. Grace. Yes, I agree, and this leads me to--perhaps not 
in this testimony, but in other things I have written, I have 
been critical of the NAIC for not really pushing on capital 
adequacy. Thirty years ago, Congress pressed the NAIC on 
solvency regulation quite hard and they did a number of things 
to modernize how they examined and how they thought about risk-
based capital for insurers. But, you know, those laws are now 
15 years old and there are many other approaches that are 
probably more sophisticated. Whether or not they are totally a 
major improvement, I am not sure, but there are just a lot of 
things that have been talked about and done, the States just 
haven't moved on yet.
    Senator Shelby. Professor Scott--and I will address this 
question to both of you professors here--do you believe that 
the States can adequately oversee the failure of other large 
insurance companies, looking at how involved and how complex 
they are, not only in this country, but internationally?
    Mr. Scott. In short, no, I don't believe they can, and 
Senator, I think it has to do with the way the States deal with 
insurance companies. As you know, one insurance company can be 
licensed for different products in multiple States. So the 
problem is, where is the overview? What does it all add up to, 
when we take each of these separate State operations, because 
what we saw in the financial crisis were problems for firms, 
OK, as a result of their cumulative activity in many areas, and 
certainly in the banking system.
    And so most States can have the overall view, it seems to 
me, of what is going on in a particular insurance company which 
is composed of all these separate companies that are chartered 
in individual States.
    Senator Shelby. Professor Grace, have you got any comment?
    Mr. Grace. Yes. I think it is very difficult for States to 
resolve insurance insolvencies, if you are talking about after 
the bankruptcy. And in part, because----
    Senator Shelby. You are speaking of large insurance 
companies?
    Mr. Grace. Yes.
    Senator Shelby. Ones that are really involved in 
everything?
    Mr. Grace. In part, because States do not have a bankruptcy 
code the same way the Federal Government does and there is no 
bank, or corresponding uniform bank bankruptcy code that 
applies to insurance. So it is a State-run enterprise from top 
to bottom and there are no State bankruptcy judges. There are 
just a lot of costs involved in dealing with these things and 
they are just not experienced at it.
    Senator Shelby. I know you said you hadn't done any 
studies. You have done a lot of research, both of you, in this 
area. But we have, I don't know how many insurance companies 
doing business in our country, State to State, 50 States. Most 
of them would not cause or bring about a systemic risk. So I 
think whatever we do, that has got to be separated, has it not, 
at some level. Otherwise, we are wasting our time and we are 
waiting for the next crisis, are we not?
    Mr. Grace. The NAIC has something they call a Nationally 
Significant Company, and it has a certain level of assets and 
writes in 17 or more States. That is a nice dividing line. That 
group of companies writes about, I want to say 50 percent of 
the business in the entire United States.
    Senator Shelby. Was AIG considered one of those----
    Mr. Grace. Yes, it was. Yes, it was. And there probably, if 
you think about just the insurance groups, there may be only 
350 groups. But if you think of State Farm, for example, they 
have 20 companies within their group. So the number of agents 
that you have to oversee in this is a countable number. There 
are 7,000, I think we heard, companies in the United States, 
but----
    Senator Shelby. Quickly, is the Fed really the appropriate 
agency to regulate insurance companies, because they have no 
history there. In my judgment, I think they have failed as a 
regulator of the holding companies. And if it has no expertise, 
no history in insurance regulation, does it have a good record 
on consumer protection? A lot of people, including my Chairman 
here, would probably argue against that. What do you think, 
Professor Scott?
    Mr. Scott. Well, I would distinguish, Senator, between 
regulation and supervision. So if we talk about regulation, let 
us take probably the most important form of regulation, which 
is capital requirements----
    Senator Shelby. Is that a question of degree there, 
supervision, regulation?
    Mr. Scott. Supervision is sort of going in and examining 
what people are doing and checking, sort of like we do with 
large banks, or actually all banks----
    Senator Shelby. OK.
    Mr. Scott. ----as opposed to writing rules, OK, as to what 
people can do. Now, I think if you are going to pick an agency 
that had expertise in capital, it would be the Fed. Yes, it is 
true that the Fed has not regulated the capital for insurance, 
but I think it is true that the Fed has thought much more 
deeply than any other regulatory agency about capital in 
general. They have been part of the Basel process, et cetera.
    On supervision, however, OK, that is hands-on supervision 
of insurance companies, I don't think the Fed should do that. 
Indeed, our committee doesn't think, or had thought maybe--some 
thought would be an option--I, personally, would say we should 
have a unified prudential regulator, OK, who should do that for 
insurance, banking, and securities, not the Fed.
    Senator Shelby. Do you have any comment? I know my time is 
up, but----
    Mr. Grace. I think I agree with Professor Scott. I would 
think someone whose focus is capital, you know, all they are 
doing is thinking about prudential regulation, would have a 
much stronger interest in doing it properly.
    Senator Shelby. Thank you.
    Chairman Dodd. Thank you very much.
    Senator Reed.
    Senator Reed. Well, thank you very much, Mr. Chairman, and 
welcome.
    Professor Scott, with an optional Federal charter, I 
presume, and I want your opinion, that we would also have to 
construct a Federal guarantee fund, a Federal reinsurance fund 
to complement----
    Mr. Scott. In my written testimony, Senator, I talk about 
this. I think in large part, there has been pretty good 
experience with State guarantee funds, but that said, I don't 
think it is feasible to have Federal regulation and State 
guarantee funds. I mean, it is sort of the opposite of what we 
had with State chartered banks. You have the States chartering 
the banks and regulating them, and if they didn't do a good 
job, the Federal Deposit Insurance Corporation paid the bill. 
This would be the reverse. You have the Federal Government 
regulating them but the States paying the bill if they fail. So 
I think you have to put those two things together, and so we 
should have to create a Federal guarantee fund for the 
federally chartered or mandatorily regulated insurance 
companies.
    Senator Reed. Another aspect of this is that to the extent 
that State laws would be preempted, would your view be a total 
preemption of State laws or leave it to us?
    Mr. Scott. I don't know if I would go total, and, of 
course, what is total given the court's recent decision is 
questionable. I certainly wouldn't go so far as to preempting 
State Attorney Generals from enforcing the law.
    But when it comes to consumer protection, which I think is 
the sort of crux of the matter of preemption here, yes, I would 
say if they are federally regulated, there should be preemption 
now. I think there is a very legitimate question, OK, as to 
whether Federal consumer protection would be adequate. As long 
as it was left with the banking agencies, I think there would 
be a big question about that. But if at the same time we create 
this Federal authority, we have a strong Federal Consumer 
Protection Agency, OK, then I think that concern should be 
greatly alleviated.
    Senator Reed. Mr. Plunkett, just a quick comment on this 
issue of the consumer protection and then I am going to turn to 
Professor Grace. Go ahead, please.
    Mr. Plunkett. Senator, thank you. We actually agree with 
the professor on one key point, which is that prudential 
regulation needs to be at the Federal level, but not through an 
optional charter. It should not be optional. That drives 
standards down.
    On consumer protection, we propose the opposite kind of 
competition to improve standards, which means on the agency 
that the President has proposed, we start with credit-related 
insurance products and we set minimum standards at a high 
level. That will assure quite a bit of uniformity, And then if 
there are exceptional circumstances, the States can exceed 
that. That is the right way from our point of view to do 
consumer protection for starters.
    Senator Reed. Thank you. Professor Grace, it seems that 
there are two general ways insurance companies can get in 
trouble. They can have a subsidiary, like AIG Financial 
Products, that deals with credit default swaps that is very 
loosely regulated, and not by the insurance regulator, or their 
own underwriting and insurance investing is the problem. In 
fact, AIG had both of those things.
    I would suspect whatever we do, is that subsidiary company 
with the subsidiary that might get in trouble will be a 
financial holding company regulated by the Federal Reserve. I 
think our approach would be to give that--not to be deferential 
to the functional regulators, but to have the whole broad 
suite, particularly for large companies. So in effect, I think 
that that part will be addressed quite specifically. It will be 
a financial holding company that will fall in like all the 
other financial holding companies.
    The other part, though, is I think where we really have to 
focus some attention. That is the investments and the 
underwriting of the insurance company, which now is 
traditionally done by the States. Traditionally, it is done by 
the States. So to what extent should we have a company that has 
no subsidiaries, it is a vanilla insurance company, because of 
size alone, does it make sense to bring that into the Federal 
orbit?
    Mr. Grace. It depends on what comes with that. I would 
think that if there are benefits to the insurer for basically 
saying--having one standard for consumer protection across 
every State, they are going to want to do that. But you are 
right that the plain vanilla insurance company is not going to 
have the same kind of problems, insolvency-related problems, 
that one that has multiple different types of subsidiaries 
doing all different types of financial services products. But 
if the insurer thought it was in its best interest to get, in 
exchange for some Federal oversight, but to get that one set of 
duplicative costs wiped off its books, I think it would want to 
do that.
    But I just want to comment a little----
    Senator Reed. Go ahead.
    Mr. Grace. Sorry. I think optional Federal regulation, if 
we just went with that, is a one-way street. Unlike banks, I 
think it would be very difficult for insurers to go back to 
being regulated by the State, because I think at the biggest 
companies, they are already being regulated by 50 different 
States. And they go to one, the Federal regulator, they are not 
going to want to go back to the 50. It is not like going from 
bank regulator to bank regulator. It is a very different 
regulator.
    Senator Reed. Thanks very much. Thank you, Mr. Chairman.
    Chairman Dodd. Thank you very much.
    Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank each 
of you for your testimony.
    Mr. Plunkett, on the consumer protection piece, just based 
on your experience, is there a different level of need for life 
insurance than there is for property and casualty?
    Mr. Plunkett. It is a very good question----
    Senator Corker. At the State level.
    Mr. Plunkett. Yes. There are some differences. Life 
insurance, especially term, is more of a national market. 
Property-casualty, often regional markets, local markets. So 
the uniformity already exists in many cases in the types of 
products that are being offered. Whether life is overseen at 
the State or the Federal level, though, we have to ensure that 
there is not this, once again, regulatory structure that keeps 
standards lower than they should be for life insurance.
    Senator Corker. So there is a greater need at the State 
level for consumer protection in property and casualty, 
generally speaking, than there is in life?
    Mr. Plunkett. Well, I think what I was saying, Senator, is 
there is greater variance at the State level. The need is just 
as high. But in terms of the differences between the policies, 
the need for local know-how in regulating, it is greater with 
property-casualty.
    Senator Corker. OK.
    Mr. Plunkett. I mean, think about all the hazards in your 
State that might be different than, say, earthquakes in 
California.
    Senator Corker. OK. Mr. Grace, you have focused some on 
capital requirements. In that same vein, is it not different 
for life insurance companies than it is for property and 
casualty as it relates to capital requirements?
    Mr. Grace. Well, the capital requirements are different, 
but I don't know if the regulation of them needs to be done by 
two different people. I don't know if that makes a lot of 
sense. The difference really is that a life insurance contract 
is generally a long-term contract so investments are made for 
long-term, while a P&C contract is really a short-term contract 
and investments are made for short-term. So even though the 
risk-based capital formulas are different, they are not so 
different that we need to have two different levels of 
regulation to look at them.
    Senator Corker. But I guess from our perspective, there are 
two issues at hand. There is the one of trying to figure out 
the issues of risk to the public, systemic risk, and then there 
is the issue of trying to resolve this sort of family feud that 
exists between whether these guys are going to be regulated at 
the State or Federal level. Those are two different issues. And 
from the standpoint of just us looking at overall systemic 
risk, there is a difference, is there not?
    Mr. Grace. Well----
    Senator Corker. I mean, are we going to find much systemic 
risk in the P&C category?
    Mr. Grace. Oh, OK. No, I don't--well, it just depends on 
who--because AIG really was a P&C company with some life 
business and financial products. So it just depends on what 
you--the plain vanilla P&C company is going to be simple, in 
essence. But who knows what the company looks like.
    Senator Corker. Well, then to that point--and then we will 
get you, Mr. Webel--Mr. Scott, you were mentioning that large 
companies, quote, ``need to be regulated at the Federal 
level.'' How large is large?
    Mr. Scott. I cannot answer that, Senator, but I don't think 
that is an unanswerable question. In the area of capital 
regulation at the Fed, Members may be aware, we took the 20 
largest banking organizations and separated them out to 
different ways of calculating their capital. I don't know where 
that cutoff, I don't recall what it was, but we made a cutoff, 
OK. And I think you could make a cutoff here. It is not going 
to be perfect, but I would submit it is better than trying to 
figure out who is systemically important.
    And remember, that could change from day-to-day. I mean, 
people invent new products. Look at AIG. If we looked at them 
10 years before they came into financial products, they would 
have looked a lot differently. So I think you are generally 
going to--you are not going to capture everybody. It could be 
over-inclusive to some extent and under-inclusive. But you are 
going to get it 95 percent right with size and I think that is 
as good as you can do.
    Senator Corker. So I am going to ask one last question and 
start with you, Mr. Webel, since you have been raising your 
hand at a couple of these, and you might answer the other 
questions, too. But we keep talking about systemic risk and it 
is in vogue how because of the things that have happened. I 
just wonder, is our emphasis on systemic risk or having a 
regulator to see all, the Fed or the Council or whoever it 
might be, is that misplaced and would we be better off just 
making sure that the regulation we have for entities, you know, 
the issue of a clearinghouse for derivatives, looking at what 
mortgage brokers are doing out there as it relates to the type 
of loans that are being originated, looking at rating agencies, 
would we be better off focusing on the individual regulatory 
pieces, or are we sort of bailing out, if you will, by trying 
to create somebody who is the Wizard of Oz or who knows all and 
can solve all by being a systemic risk? Mr. Webel, since--and 
that is my last question.
    Mr. Webel. Senator, I think--I mean, I think it is a very 
well-phrased question and a very good one. It has been easy to 
go that route of a systemic risk regulator because we were just 
presented with a systemic crisis. But I will admit I do have--I 
have had a little bit of difficulty as I have thought about it, 
coming up with the situation where if you had really good 
prudential regulation at the firm, that you would end up with a 
systemic crisis coming out of the firm.
    That essentially if, to take the example, the Office of 
Thrift Supervision had done perhaps a better job overseeing AIG 
and had either made them keep more capital for the derivatives 
they were writing, if the securities lending program had 
operated in a better way either through OTS or through the 
insurance regulators, AIG shouldn't have failed. If AIG doesn't 
fail in the way they do, there isn't a systemic risk.
    So I think it is a very good point that if you rerun the 
crisis the way it happened, what would a systemic risk 
regulator have done? There were papers coming out of the Fed in 
2005 that there is a housing bubble. Well, is the Fed going to 
act in 2005 to drive down the value of all the houses in the 
United States? I don't think it is going to happen. So we may 
be putting a little too much faith in the idea that we are 
going to have someone at 20,000 feet that is going to stop 
these kind of things.
    Mr. Grace. I agree, if I could interrupt. The chance of 
that--we had a number of different regulators looking at AIG 
and one more looking at it and being right, I don't know how 
high it is. I mean, I think everybody was looking at AIG but 
sort of passing the buck. I guess the only thing is if there 
wasn't a buck-passer but one that was relied upon at the bottom 
to make a decision, that is the only reason that a systemic 
risk regulator would work. But we had regulators looking at 
AIG, as you were saying.
    Chairman Dodd. Thank you very much.
    Senator Warner--or Senator Johnson.
    Senator Johnson. Mr. Plunkett, Professor Scott, and 
Professor Grace, late last week, the Treasury sent up its 
legislative language to create an Office of National Insurance. 
In your opinion, is anything missing in this proposal that, if 
included, would make it more effective in monitoring and 
regulating insurance companies? Does this proposal do enough to 
address the insurance issues brought to light by the AIG 
situation? Mr. Plunkett.
    Mr. Plunkett. Thank you, Senator. We support the 
information function of the office. We support eventually 
considering the office as the prudential or systemic regulator 
for insurance. And as you know, we have proposed systemic and 
prudential regulation to be vested at the Federal level, but 
not optionally.
    The big question in our mind is the authority granted in 
the legislation to the agency and the Secretary of the Treasury 
regarding preemption, interpretation of international treaties, 
and then preemption. It does exclude, from what we can tell, 
some State consumer protection functions, such as insurance 
rates, premiums, sales, underwriting, antitrust, and insurance 
coverage.
    We are going to be examining that language, though, to make 
sure it is not too broad and does not lead to a conclusion of 
an international agreement then that, directly or indirectly, 
preempts State efforts to improve consumer protection.
    Senator Johnson. Professor Scott.
    Mr. Scott. Senator, I do not think it goes far enough. As I 
have testified, I think we need a system for optional Federal 
charters, plus mandatory regulation for large insurance 
companies, which is beyond what the Administration has 
recommended.
    I would also say that if we go in that direction, I do not 
believe that this regulator should be part of the Treasury 
Department, that is, an office. I think it should be 
independent of the executive branch, much as the SEC and the 
Fed are.
    Senator Johnson. Professor Grace.
    Mr. Grace. Thank you, Senator. I guess the way I am 
thinking about it now, this is a good first step, and let us 
see how the first step goes. I would not want to--I mean, I 
agree with Professor Scott in sort of the long-run game here, 
but I would like to actually have a discussion--or I would like 
to conceive of the Federal Government having a discussion of 
what to do next after it has information. And, you know, just 
adding things right at this stage does not make sense yet.
    Mr. Johnson. For all the panelists, the Treasury's 
regulatory restructuring, the white paper, says that it will 
support proposals which increase national uniformity through 
either a Federal charter or effective action by the States. Do 
you believe a Federal chart or action by the States will be 
most effective in increasing national uniformity? Mr. Plunkett.
    Mr. Plunkett. Senator, for now, for the most part, we would 
like to keep consumer protection regulation at the State level. 
We have supported authority in the President's Consumer 
Financial Protection Agency to, on a minimum standards basis, 
regulate credit-related insurance products, credit insurance, 
title insurance, et cetera.
    The NAIC has to do a better job on consumer protection from 
our point of view, and we are looking to you all to spur them 
along on that front.
    Senator Johnson. Mr. Webel.
    Mr. Webel. If the goal is uniformity, I do not know that a 
Federal charter is absolutely necessary, but I think that 
Federal action certainly is. The NAIC has been in existence 
with the goal of harmonization since 1871. Getting 50 State 
legislatures together to try to enact the same sets of laws I 
think has proven to be unrealistic. So whether it is a Federal 
push that says we are going to have the States set standards 
and it is going to apply it everywhere, or whether it is the 
Federal standards directly, I think one can debate over which 
is better. But I think that if you want uniformity, you need a 
Federal push.
    Senator Johnson. Mr. Scott.
    Mr. Scott. I agree with that, but I would also add that in 
order to achieve this uniformity, you would have to have 
Federal preemption. Otherwise, you would not achieve uniformity 
because each State in the consumer protection area would be 
free to enact laws that were different than what the Federal 
standard was.
    Again, I would come back that I would not lightly want to 
see this happen unless we were very confident that we had a 
very strong Federal consumer protection presence, which I 
think, by the way, the Obama proposal would give us.
    Senator Johnson. Professor Grace.
    Mr. Grace. I think I agree in substance with what everyone 
has said--well, the last two speakers. The States are just not 
proactive, and even if you have a proactive State that wants to 
do a better job, getting its neighbor or the other 48 to go 
along with it is a long, long, hard process. If you look at 
just the harmonization efforts that have been going on, model 
laws are proposed all the time, and, you know, 30 or 40 is a 
good number. We rarely see 50. There might be some, but it is 
only a handful.
    So I would suggest that a Federal charter would do better 
at increasing uniformity.
    Senator Johnson. My time is expired.
    Chairman Dodd. Thank you very much, Senator.
    Senator Johanns.
    Senator Johanns. Mr. Chairman, thank you, and I find it to 
be a fascinating conversation. I will warn each of you that the 
guy asking the questions now is a former Governor and a former 
mayor. And here is what troubles me about what I am hearing 
today, and I am not picking on you, Professor Grace. But, you 
see, if I took your argument to a logical extreme, the solution 
to all the world's problems is to pass a Federal law that 
preempts every State law on every subject, and then we will 
just have a big powerful Federal Government that kind of tells 
the States what to do in every area. And, you see, as a former 
Governor and mayor, I am just so enormously troubled by that. I 
do not even think the Constitution anticipated that.
    Here is what my comment is leading to, however. It seems to 
me that we are mixing things up today. Maybe there is a policy 
reason for a Federal charter. Maybe there is not. But I think 
that is a policy debate that we somehow have to hash out and 
figure out whether that is the right approach. And there are 
pros and cons on both sides of that.
    Then there is this whole other issue of the kind of risk 
that AIG engaged in, which, upon reflection, looks stupid to 
me, but it is the kind of risk that literally could bring the 
economy down.
    Now, that seems to me a whole different area of regulation 
than whatever you want to call it--Federal charter, optional 
Federal charter, et cetera. And by, you know, working these two 
together, it seems to me like we are ending up with a gummed-up 
mess here.
    Anyone want to wade into that and offer some comments on 
that? Professor, I started on you, so I think it is fair you 
get the first shot at this.
    Mr. Grace. Thank you, Senator. Anyone who knows me thinks 
of me as, I guess, a small-government libertarian, and when 
they hear me talk about this, their eyebrows go up. But I am 
focusing on a very narrow segment of the industry, I think. I 
am thinking about big companies who operate nationwide, and if 
you think about the optional Federal charter, they would have 
one regulator. That would lower their costs. If you think about 
the types of burdens imposed by State regulation that do not 
necessarily have any value--if 50 States are doing exactly the 
same thing slightly differently, is that slight difference 
really valuable? And I think the answer to that is not always. 
So that is why I have sort of gone to that level of allowing 
companies to opt to have a single standard for regulation.
    But going to your second point, if you have a company that 
engages in significant activities that are different than 
insurance outside the jurisdiction of the insurance regulator 
and that imposes a risk to the entire economy, the State cannot 
do that. So these two types of regulation, as you rightly 
pointed out, are different. But they get mixed together for the 
reason I am just discussing.
    Senator Johanns. Mr. Webel.
    Mr. Webel. I think the gummed-up mess that you are seeing 
is partly because we have taken the old debate that you had 
preexisting, and then we had a financial crisis, and so 
everybody piles the new arguments on to the old ones, and 
particularly----
    Senator Johanns. If I might just interject there, because I 
think you have touched upon something. Post-9/11, everything 
became if you could box it under the title of ``national 
security,'' then you had a better chance of getting this, that, 
or the next thing done, or getting a Federal grant or Federal 
funding or Federal something. And that is almost what I am 
sensing here today, is we do have a policy issue here on the 
Federal charter or the optional Federal charter, but I think 
that is really a very vastly different debate than regulating 
systemic risk engaged in by insurance companies.
    Mr. Webel. Well, I think the question, the place where they 
intersect, besides just an opportunism to try to get ones you 
previously wanted passed passed, is sort of coordination 
between the regulatory bodies. You know, if you envision a 
Federal Reserve or a new Federal systemic risk regulator 
interacting with Federal banking regulators, that is a little 
easier, to some degree, to envision how that is going to work 
than interacting with 50 different State insurance regulators--
which is not to say you could not set up a good systemic system 
where you had a Federal systemic risk regulator and the 50 
insurance regulators. It is something that it is kind of an 
easy thing to say, well, you know, if we are going to have this 
Federal body at the top doing the systemic risk, you know, 
doesn't it make sense to some degree to have a Federal body 
that they interact with that is actually overseeing especially 
the day-to-day operations of these huge insurers?
    Senator Johanns. Mr. Plunkett.
    Mr. Plunkett. Senator, if I could just jump in on one part 
of your comment, I think you are absolutely right to be 
skeptical of the notion that Federal preemption is going to 
solve all problems. We only have to look at to the banking 
sector, in the Office of----
    Senator Johanns. Look at the Madoff case.
    Mr. Plunkett. ----the Comptroller of the Currency, or the 
OCC preempting the States on lending and then replacing those 
State standards with virtually nothing. So Federal preemption 
does not solve all problems, and uniformity by itself should 
not be the goal. The goal should be high-quality regulation at 
the highest level of uniformity that is possible.
    Senator Johanns. Yes, Professor.
    Mr. Scott. I think you are right that we are mixing two 
issues together, but they are both important issues. The 
objectives of the optional Federal charter, of course, which 
was a debate that we got engaged in long before the financial 
crisis, were to achieve efficiency and uniformity and to reduce 
cost. That is the objective.
    The objective with mandatory regulation of large or 
systemically important institutions is addressed to the risk to 
the financial system of insurance companies or others engaging 
in certain activities. A totally different concern.
    On the other hand, both involve possible Federal action, 
either because we would allow a particular insurance company to 
get a Federal charter or we would require a particular 
insurance company. Both would lead to some kind of Federal 
regulation of insurance companies.
    So I think it is for that reason that we are putting them 
together, but you are quite right, the objectives that are 
sought to be achieved by an optional Federal charter and 
mandatory regulation are very different.
    Senator Johanns. I am out of time, Mr. Chairman, but I will 
just wrap up with this thought: Your testimony, your written 
comments, the Chairman is right, they were really very good, 
very thought provoking. If there is any research that is done 
out there or if there is any interest to offer some thoughts on 
this issue of systemic risk management, regulation, whatever, 
versus this whole other issue of optional charter, Federal 
charter, or Federal charter, I would be happy to receive it, 
because, again, I see a distinction here. I have met with so 
many people on the Federal charter, and they come in and they 
talk about, ``Well, you know, Mike, when you were Governor in 
your State, we could get things done, but in other States we 
could not, and that is not efficient.'' And so it threw me for 
a loop when all of a sudden systemic risk and optional Federal 
charter got entangled together. I do see the intersection, but 
I do think there are some pretty fundamentally different policy 
issues here.
    I would hate to have this get swept along on this whole 
issue of systemic risk management when really I think there is 
a pretty important States rights issue here. There are 
efficiency issues. I mean, there are good arguments on both 
sides of this, and I would hate to get that all mixed together 
in a way that does not make sense.
    Thank you, Mr. Chairman.
    Chairman Dodd. Well, Senator, thanks very much. I tell you, 
you bring a wonderful perspective to this, I think. It is a 
very clear point you were making. It is sort of what we have 
been wrestling with on all these matters and how to move, and 
to some extent I suppose argues for the notion of having this 
Office of Insurance at the Federal level to allow this to go 
forward. At the same time, again, I think there was a 
legitimate point made by Senator Corker on systemic risk. We 
can get so fixated on something that we lose sight of the means 
by which to deal with things. But that one probably has a more 
immediacy to us to be able to identify that when that occurs. 
But you raise some very, very good points, I think, and I thank 
you for it immensely as well.
    Senator Johanns. You know, if I just might warn the 
panelists, I think the next Senator up is also a former 
Governor.
    Chairman Dodd. I was going to make that point. It is going 
to be a tough road here.
    Senator Warner, former Governor of Virginia.
    Senator Warner. Thank you, Mr. Chairman, and I want to 
thank my colleague from Nebraska for, I think, teeing up--I 
think you teed up a very good point that--you know, and I come 
as a nonbiased party to this optional Federal charter or State 
charter debate, and this panel has been helpful.
    I do think, though, that, you know, of the various 
frustrations sitting on this Committee, one of the most 
frustrating aspects, for me at least, in this last 6 months has 
been our Federal Government response to the AIG crisis. And I 
think one of the things, you know, sitting here time after time 
when we hear Administration officials and others say we have 
got to pay out 100 cents on the dollar to counterparties and a 
complete lack of knowledge at the Federal Government level of 
how to even get their arms around this entity, does argue in 
some form, whether it is this Office of National Insurance or 
something else, at least somebody in the Federal Government 
understanding what is happening in the insurance world and 
being prepared to deal with consequences in the case of AIG, 
where there was no appropriate resolution ability at the State 
level and the American taxpayers ended up getting--footing the 
bill.
    So I want to comment, again, following up on Senator 
Corker's comments as well, I do think we kind of struggle to 
define what a systemic risk is going to be. And we have not got 
it right. Senator Shelby and I have talked about this at times. 
But my hope--and, again, one of the reasons why I am not a fan 
on giving this responsibility to the Fed and thinking an 
independent systemic risk council with an independent chair is 
a better option--is that the very presence of that type of 
entity out there, hopefully never having to be called upon, can 
be that check on the day-to-day prudential regulators to do a 
better job so they never have to get one of their problems 
bumped up to a systemic risk council. My hope would be we would 
have a systemic risk council that would have this ability to 
see above the silos, but hopefully rarely, if ever, have to be 
called upon to act.
    So I want to come back to the panel on as we struggle 
through, one of the things we have not talked about this 
morning, you know, one of the things we hear on the financial 
side a lot are the ``too-big-to-fail'' issues, something that, 
again, I think most of us never want to hear again after the 
resolution of whatever reform we put forward.
    I would like the panel to comment, though, on, you know, 
one of the ways we have thought about on the financial side is 
can we put in place higher capital requirements, so, in effect, 
the way Chairman Bair from the FDIC has constantly said, let us 
put a price on getting too big. We cannot draw an arbitrary 
line. I think that is too much intervention in the marketplace. 
But can we put a price of getting too big? Is there also 
ability to have additional capital requirements or some other 
burdens that we could put on for those entities--AIG, again, 
being a classic example that seems to have gotten away from the 
traditional insurance model and went off into this whole new 
product range that clearly had ramifications not only for its 
new products division or its financial services division, but 
indirectly had implications for its insurance division, which 
was still relatively healthy. How do we--what are the kind of 
barriers to prevent the ``too-big-to-fail'' circumstances 
within the insurance area? Increased capital being one. Are 
there other increased capital or other requirements that might 
be put on different product placements? Anybody on the panel.
    Mr. Grace. I will start. I think you are right. In fact, I 
have had numerous conversations with my colleagues about how do 
you make something too big to fail, and you essentially 
increase the cost of holding capital, and so companies will 
not--it has to be the right cost. I am not just talking about a 
crazy tax. I am talking about one that reflects the social cost 
of having to bail the company out.
    Senator Warner. A smart tax?
    Mr. Grace. No. An intelligent tax. But the idea being that 
it would be related to the risk of the company, not just an ad 
hoc tax placed on all companies. So it would be basically 
having significantly relevant risk-based capital holdings.
    Senator Warner. So both increased capital, but then as you 
got into----
    Mr. Grace. Yes.
    Senator Warner. If you choose to do a whole series of what 
would be viewed by someone as a risky product line, there would 
be additional cost to it.
    Mr. Grace. Right. Every type of activity has some risk to 
it, and you would be charged for engaging in that risk. But it 
would be--as I said, it is not a tax unrelated to the company. 
It is a tax directly related to what the company does.
    Senator Warner. If everybody could answer fairly quickly, 
because at the Chairman's discretion, I would like to get one 
more question.
    Mr. Scott. Senator, I think capital is our first line of 
defense against systemic risk, and there should be more capital 
for more risk.
    That having been said, our track record on setting those 
capital requirements for banks has not been very good. So let 
us not fool ourselves----
    Chairman Dodd. I was going to make that point to you, by 
the way, especially the Fed be the one to set capital 
standards. Had the Fed gotten its way earlier, we would be in 
much deeper trouble on this point.
    Mr. Scott. I would say that there is a collective 
responsibility here in all the regulatory agencies, and the 
fact that the Fed did not get it right, in my view, is not the 
reason not to give it to the Fed in the future, because I still 
think they have more expertise. But putting that aside, as I 
said in my written testimony--and I think in my oral 
testimony--capital requirements for insurance companies are a 
different set of issues than they are for banks because their 
activities are different. And so we do not have Basel process. 
Some insurance companies have used Basel, but we have to think 
very hard about how to set capital requirements.
    In terms of, yes, should riskier firms have more capital, 
for sure. Banning----
    Senator Warner. But somebody still has to define whether 
you are a riskier firm by your product line.
    Mr. Scott. Exactly. So I am saying, you know, our whole 
risk-based capital approach depends on an adequate 
determination of risk.
    Senator Warner. Which would be a difficult assessment to 
make at a State level.
    Mr. Scott. Exactly. It has been for banks, so let us not 
fool ourselves it is going to be easy for insurance companies.
    Then I think there is another part of your question which 
says should we kind of ban certain activities. I mean, if you 
are kind of creating a bomb that is going to blow up, maybe 
this is not a capital issue, this is should we have these kinds 
of products. And, you know, I think if we could be sure we were 
just doing that on a very selective basis, it would be OK. But, 
again, you know, to be now defining exactly what products firms 
can offer per se I think gets you into a very difficult----
    Senator Warner. Mr. Webel.
    Mr. Webel. I would just point out one other thing that you 
are going to hear as you start talking about this, and that 
would be essentially the competitiveness of the American 
financial services industry. And right now, in noninsurance 
financial services we run a very, very large trade surplus in 
the financial services.
    There will be people who will come to you when you start 
talking about putting on higher capital charges and say 
essentially, you know, you are going to be costing American 
jobs that are going to go to London or go to Tokyo or go to 
wherever where they do not put these same kind of requirements 
on. It is an argument--whether or not it is a good one----
    Senator Warner. We heard that before, and it was not like 
the U.K. was spared----
    Mr. Webel. Well, the extreme to this, I think, can go to 
Iceland, where you end up with banks that are several times GDP 
and do you really want a financial----
    Senator Warner. Buyer beware----
    Mr. Webel. ----services industry that large. But I just 
wanted to--you will hear that.
    Senator Warner. Mr. Chairman, can I get one--I know Mr. 
Plunkett quickly, and can I get one more question in?
    Chairman Dodd. Go ahead.
    Mr. Plunkett. Senator, I will just add, of course, looking 
at capital is important for proper risk assessment. Risk 
assessment can also relate to not necessarily size but the 
sensitivity of the line of insurance that is being offered, 
bond insurance being the obvious example there, but also lines 
you might not necessarily think of first, such as title 
insurance, highly concentrated market, handful of insurers 
control the market, if one of them got in trouble financially 
actually could have effect, especially regionally, on mortgages 
and the real estate market in some parts of the country.
    Senator Warner. Mr. Chairman, thank you for letting me have 
one more question in. One issue that has not been that touched 
on today and something that Senator Corker and I have been 
working on, I think we both share a frustration that we have 
not had a robust enough resolution authority in the financial 
sector, and Senator Corker has taken the lead and I am 
supportive of his efforts to look at how we can, at least in 
the financial sector, deal with the FDIC with some level of 
expanded authority and a premise that when somebody is failing, 
we ought to have a mechanism to allow that entity to go ahead 
and fail and not simply be propped up by taxpayer funds and 
limp along.
    One challenge is to kind of put a ring around some of that 
area, resolution in the financial sector, as we kind of get 
into the notion of resolution in the insurance field. My 
rudimentary understanding is that at the State level you have 
got kind of mutual funds that insure each other, but as we see 
in the case of AIG, when you have got these behemoths, you 
know, no single State resolution authority is going to be 
nearly enough. And how do we get to a resolution authority 
around these larger institutions in insurance, number one? And, 
number two, do you have any ideas on--I personally believe we 
need to have some mechanism in a sense of a prefunding of 
resolution so that we do not end up as taxpayers being caught 
basically footing the bill for the resolution of an actor that 
has taken undue risks. And even if you then have a post facto 
charge to the remaining players in the industry, the bad actor 
never has it all contributed beforehand to paying for their own 
demise.
    So a long question about resolution authority. Again, if we 
can go down the line quickly, realizing I have gone way beyond 
my time.
    Mr. Grace. Yes, I agree. There is just--you have asked a 
very complicated but important question. The States, the way 
they have been set up to deal with this, the amount that they 
would bear depends upon the number of policies or the value of 
the policies that are in their State, and they are net of any--
they are only for the extraordinary amounts above whatever 
assets are left in the company. So the amount that the States 
actually have to bear is not very much, but remember, most 
States that deal with this, deal with very small companies 
failing. They do not deal with a big company failing.
    And so I know really do not know, you know, the ability, 
what would happen--you know, I guess I can conjecture all sorts 
of bad things, but I do not really have a feeling for what the 
bad things might be for a State that is subject----
    Senator Warner. The big question we have, we have no 
resolution authority for the whole nonbank half of the 
financial world that in many ways caused our problem.
    Mr. Scott. Senator, I applaud your efforts in addressing 
this issue because I think it is very important.
    I think we would--the Committee on Capital Markets 
Regulation recommended that there be an extended resolution 
authority, something like the Obama administration has 
proposed.
    I think where that would fit into insurance is that any 
federally chartered, either as a result of an optional charter 
or mandatorily chartered and regulated because of systemic 
risk, that any of those companies should be subject to the same 
resolution authority that hedge funds would be, et cetera, some 
Federal mechanism.
    In terms of the funding, which I think is extremely 
difficult, I really think we need to study that more carefully. 
I do not think there have been any good studies of the 
advantages or disadvantages of prefunding, ex post funding for 
this new resolution authority. So I do not have a view on that 
right now.
    Mr. Webel. The lack of resolution authority certainly seems 
a hole in the aftermath of the crisis. I have heard some 
interesting arguments, though, that, you know, maybe the 
regular bankruptcy procedure which is in place--Lehman went 
through it--was not as disruptive in Lehman's case as everybody 
sort of thought it was going to be going in. So that I think 
that it is--it may be interesting to try to do some thought 
experiments of, OK, if AIG had gone into bankruptcy what 
happens? You know, there may be some lesson learned from Lehman 
having gone through bankruptcy versus AIG not having gone 
through bankruptcy.
    Mr. Plunkett. Senator, I will just flag for you the 
situation with the State guarantee funds when you bring the 
very important discussion you are having on resolution down to 
sort of the consumer level, we have in our testimony an 
assessment of the fragility in some cases of the State 
guarantee funds, particularly regarding life insurance, and our 
concern that they may not be able to handle multiple--not just 
a single, but multiple failures. And with the exception of New 
York, to your point on prefunding, these funds are not 
prefunded. They are postfunded. And that is a concern.
    Senator Warner. I apologize, Mr. Chairman, for going on so 
long.
    Chairman Dodd. Not at all. This is very important. This is 
a good discussion.
    Let me pick up on something Senator Corker raised earlier. 
Again, all of us who go around talk about these issues, at 
every gathering you go to, if there is any interest in the 
subject matter, we spend a lot of time talking about the 
various lines of insurance, types of insurance, and the 
tendency to sort of lump everything together here, I think 
raises some issues.
    I mean, basically, States under the present system do three 
things. One is you deal with solvency. Two, you set rates. And 
three, market activities, what your responsibilities are to 
consumers at a local level.
    And it seems to me that there are different risk 
assumptions based on the various kinds of insurance products. 
Obviously, you have title insurance, automobile insurance, for 
instance, property and casualty in a way also falls in this 
where there are some unique qualities or characteristics that 
make sort of a local involvement--at least I understand the 
value of that.
    Going back to the point you made earlier, Travis, about the 
one I have made a distinction on in terms of life insurance, 
again, in the term area, there seems to be more of a national 
scope on that. There are different risk assumptions, as you 
point out. There are different capital needs and requirements 
in a life insurance industry than there is in an automobile 
insurance or property and casualty-related areas.
    And I wonder if in a sense you might pick up on this. I 
can't recall whether or not just Mr. Plunkett responded to this 
question, but do the rest of you have any--I guess you did, Mr. 
Webel, you talked about it a little bit--this distinction here. 
My impression was that at the conclusion of Senator Corker's 
question, you didn't think the distinctions were that 
significant that they would warrant necessarily treating these 
different insurance products differently from a State 
regulatory standpoint or a national or a Federal charter.
    Do all of you sort of agree with Travis Plunkett about 
that, or Mr. Webel, that really is a distinction here we 
shouldn't dwell on so much? Go ahead.
    Mr. Scott. I sort of would agree with your statement, but I 
would add and come back to another point, which is I am 
troubled by splitting up the regulation of the same firm at the 
Federal level with some product, at multiple State levels with 
other products. Where is the big picture? It is the failure of 
the overall firm that is going to impact the financial system, 
not just a subsidiary in a particular State. So I think this is 
a risk of the separation and say, oh, let us keep property and 
casualty at the States. Let us have life insurance at the 
Federal level. Then you have a single firm being regulated by 
multiple States and the Federal Government for different parts 
of their business.
    Chairman Dodd. How do you do that, though? I mean, some 
States have tough laws on who gets to drive a car. They have 
written tough laws about kids being in the car alone, driving 
at night and so forth. So there is going to be a different--
some States say, at age 15, go ahead and drive the car, and 
that is about it. I mean, I am exaggerating here to some 
degree, but the point is, now you are an insurance company. 
There are two very different models and you are going to charge 
at different rates, and certainly I have the right to do it, it 
seems to me, based on State law in that area.
    Having a Federal regulator try and sort that out and set 
rates in two different States with two various sets of laws 
that are very different seems to me to raise some very serious 
questions about----
    Mr. Plunkett. Senator, there is one more difference, as 
well, at the State level. They have different insurance 
regimes. Some States are no fault. Some States aren't, for 
example, with auto.
    Chairman Dodd. Yes?
    Mr. Webel. I don't know whether--well, first of all, under 
the optional Federal charter bills that have been introduced, 
the answer to that question is the States can't set rates. So 
the way that the bills to some degree answer that is, well, you 
are not going to worry about that because we are specifically 
saying the States can't set rates.
    I think that the thing is, I mean, the insurance companies 
have to do this. I mean, the insurance companies are operating 
in all these States in these different regimes. It seems--I 
mean, I think that there really are very good arguments on both 
sides, that yes, on the one hand, it is local. The local 
insurance regulators are going to understand that market the 
best. But you have a national insurance company that is able to 
operate in these States. You are telling me that a national 
insurance regulator would be incapable of figuring it out, too? 
As I said, there doesn't--there seem to be really good 
arguments on both sides.
    Chairman Dodd. Senator Shelby.
    Senator Shelby. Senator Dodd and I have been on this 
Committee together more years than people would dream, over 50 
years, and I believe we are grappling here in the Banking 
Committee with maybe the most challenging, complex piece of 
legislation or proposed legislation that we have ever had. I 
was just thinking a minute ago, bifurcated regulation, how do 
you do this and what are the consequences of it?
    I can see, and I don't know, I think I asked Professor 
Grace how many insurance companies do we have in this country 
that are doing business? What size are they? What are their 
risks? How many would be subject to systemic meltdown? And I 
think a lot of that would be size and what they are involved 
in. I can see an optional Federal charter for some people, but 
others, maybe they don't want to. Maybe they are too small. 
Maybe they don't operate in enough States. I don't know that.
    But whatever we do, and Senator Warner, Senator Corker, 
Senator Johanns, and I guess all of us to some extent have 
raised these questions. We haven't fleshed it out yet, but we 
have got to do this and do it right.
    Something comes to mind. If you have a systemic regulator 
to companies that are systemic risk, what you want to do is 
prevent a meltdown and so forth. In a sense, if you create the 
systemic regulator, you are creating a Federal Insurance Czar, 
at least for certain big companies that are in this area. So 
how this intersects the so-called ``Insurance Czar,'' someone 
to deal with things that Senator Corker and Senator Warner are 
trying to grapple with, how do we create some entity that could 
deal with another AIG, for example, and wrap it up, take it 
over, do something? We don't have that mechanism today, but 
will this do it? I don't know. I see some intersections here, 
but they are not clear yet and maybe all of you guys can help 
us clear it.
    Thank you, Mr. Chairman.
    Chairman Dodd. Senator Corker.
    Senator Corker. Yes, sir, Mr. Chairman. Thank you for 
another great hearing. I was just going to make a closing 
statement, but something was brought up I just want to chase 
for a second.
    Mr. Scott, you mentioned that the Capital Markets Group you 
are a part of has recommended supporting what the 
Administration has come forth with as it relates to resolution. 
We actually--I thought it was----
    Mr. Scott. Senator, something like it. We are not on all 
fours with it, but in that direction, yes.
    Senator Corker. We have been working on--I mean, I think a 
lot of people have felt that what the Administration has 
brought forth is really sort of codifying TARP. In other words, 
they have the ability per what they have laid out to actually 
use taxpayer monies not to resolve a company, but actually to 
keep a company alive through conservatorship and then put it 
back out. And I think many of us have thought we would be 
better off just having a resolution entity that could resolve 
it appropriately, but certainly not create the moral hazard 
that I just described that we see in the Administration's 
proposal. I am not trying to harp on them. I don't think most 
people are going to buy that anyway, but I just wondered if you 
would give any editorial comments in that regard.
    Mr. Scott. Senator, I think for most institutions, we 
should resolve them and the shareholders and the debt holders 
should take a hit. But we still have to build into the system, 
and we have got it for banks today without any reform, call it 
open bank assistance, call it what you want, to keep alive a 
bank, the significantly large, systemically important bank 
whose failure, that is resolving it, closing it in a sense, 
would have a huge impact on the financial system. We have to 
build in the possibility of doing that.
    We should do it on only extreme circumstances, OK, and 
maybe AIG, if we had had resolution authority, we wouldn't have 
had to have kept it alive. But we have to build a system to 
give us that capability. But bound it, OK, in having it go 
through a lot of hoops, get approvals, maybe ultimately the 
President or whatever, but I think you have got to have that 
capability in any system you design.
    Senator Corker. Thank you. I am not sure I agree with that 
answer, but I appreciate you clarifying that.
    Mr. Chairman, we have had a number of hearings and they 
have been very good. I think today, we saw that there is a 
difference between the financial risk to citizens versus other 
kinds of risk that exist. I know you chased that, talked about 
that some in your questioning.
    I fear that we have this sort of personality culture here 
even in our Government. We have a lot of czars to solve 
problems. It is like instead of doing the heavy lifting, really 
getting to the bottom of issues, we find some person that we 
have a lot of faith in, and a lot of proposals have certainly 
talked about the Fed coming in, and certainly the Fed is an 
important position in our country.
    I do hope that we will examine--I know you made a comment 
later--this whole systemic risk issue. I mean, do we need to be 
concerned about systemic risk? Yes. But do we need someone who 
does that and in doing so takes on large amounts of powers, and 
in essence it keeps us from actually digging in and creating 
legislation to solve many of those problems ourselves. Instead, 
we sort of punt, if that makes any sense, to some omnipotent 
person that is going to in essence solve all these problems.
    So I really appreciate some of the comments you made and I 
do hope that we might even consider having a hearing that is 
sort of an antisystemic regulator hearing, where we have people 
come in and talk about solving it by actually putting in place 
proper disciplines throughout the system that would actually 
keep that from happening.
    But again, I thank you so much for----
    Chairman Dodd. No, not at all, and I appreciate you coming. 
And this is, as Senator Shelby and I have said, this is a very 
dynamic process we are involved in. I make this point over and 
over again. Maybe people are not believing me on this. But 
being involved in both the health care debate and this 
discussion is instructive to me, because in a sense, the health 
care debate is just loaded with ideology and politics. We have 
all come to that.
    This discussion, the fundamental difference is that my 
sense of the 23 or 24 of us that sit on this Committee 
particular, is there is a great appetite for trying to figure 
out what works. Now, maybe there are some who are going to 
bring some luggage to this debate that will show up along the 
way. But my sense is, and certainly in every conversation I 
have had with Senator Shelby, with Senator Corker, with others, 
is let us figure out what works and draft something and try to 
put something together that makes sense, recognizing that this 
is a unique opportunity--and but, frankly, but for the crisis, 
if you want to call it that, we are in, we probably wouldn't 
get close to doing it. But the fact of the matter is, we don't 
want to miss the opportunity that the crisis has posed to 
really go back and reflect--not that we are going to solve 
every problem.
    I take great exception to people who think, if we do this, 
we will never, ever, ever again face problems like this. Yes, 
we will. I promise you, we will. And so we ought to get rid of 
that notion altogether.
    We are trying to look back in that rear view mirror and say 
what happened here, where were the flaws. If there was an 
absence of regulation, do we need some? If there was regulation 
but it wasn't being exercised, why, and what is happening? I 
think that deliberate approach in thinking this thing through 
has been tremendously rewarding, I think, for all of us.
    And it is still very dynamic, Bob, I tell you. I am 
certainly--I am still very agnostic on a lot of these 
questions. I am very anxious to hear debates. I am intracted 
about the Council idea and the Fed. But I am not there yet. I 
am willing to listen to that debate about the Fed and the role 
it can play. And I am willing to listen to smart, bright people 
who spend their lives thinking about this before I settle on an 
answer.
    So I want to confirm your ambition here, and that is that 
we are going to do our job here over the coming weeks, even in 
this break in August, our staffs working, meeting with people, 
talking about these various ideas, and then try to come 
together as a group of Democrats, Republicans, but more 
importantly, as Members of this Committee who I think share 
that notion of trying to figure this out and get together 
around some ideas here that make some sense, with the full 
knowledge we are not going to solve every problem known to 
mankind and we are not going to necessarily create Mount 
Olympus here with people who sit on high and are going to solve 
every problem in the future we may have. So it is a good point 
and I thank you for making it.
    Senator Shelby. Mr. Chairman.
    Chairman Dodd. Senator Shelby.
    Senator Shelby. I think we have got ourselves in a real jam 
in this country when we come up with the doctrine of ``too big 
to fail'' and then we say, gosh, we have got to create a 
systemic regulator to deal with this. How do we prevent it in 
the future? There will be failures in the future.
    Mr. Webel brought up something earlier, and I think I 
understood it. I thought we always had a resolution authority 
for companies who did not make it on their own, and that is the 
Bankruptcy Court. We will never know what would have happened 
to AIG or to the markets and everything else. But the sky 
didn't fall when Lehman went under, and as he mentioned, a lot 
of people thought Lehman maybe came out of that better than a 
lot of people thought. That is arguable.
    But I believe if we enshrine--and that is where we are 
headed--the ``too-big-to-fail doctrine,'' we are going to have 
problems down the road because we are picking companies, our 
banks, insurance companies. That is going to become an 
unsettling event or syndrome in the marketplace of banks, 
securities, insurance, and so forth, and I think we had better 
deal with this.
    Mr. Webel, I think you wanted to say something.
    Mr. Webel. Yes. I have agreed with some of the people who 
that have started to talk about size instead of systemically 
significant, because size is a lot easier to deal with than 
systemic significance.
    Senator Shelby. Yes.
    Mr. Webel. Where it kind of starts to break down, though, 
is the experience with bond insurers. These were not huge 
companies. These were companies that, by all rights, they 
weren't complicated. They weren't necessarily even complicated 
companies. I mean, the State of New York did----
    Senator Shelby. Bond insurance?
    Mr. Webel. Right.
    Senator Shelby. Regulated by the States?
    Mr. Webel. You know, the State of New York oversaw most of 
them, and I think the people there are pretty competent. They 
could have done--I don't think it was outside of their absolute 
competence to oversee companies of that size.
    So the question is, when you are thinking about 
systemically significant, where do you slot the bond insurance 
experience into the narrative? Would that have been covered by 
a systemic regulator? If not, were they systemically 
significant? I mean, they certainly had a huge ripple impact on 
all of our States and municipalities and how they were able to 
borrow, or not borrow, as the case may be. So that sort of 
outlier is just something to think about as we go forward.
    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Dodd. Let me just say, too, because again, Bob 
Corker has raised this and I couldn't agree more on this whole 
notion--if you don't need any better example, I think the AIG 
one. Had there been a resolution mechanism as an alternative to 
what we confronted in September of last year----
    You know, again, it has been pointed out, Richard Breeden, 
the former Chairman of the SEC, he and I have had lengthy 
conversations. He was the one, I think the trustee, I think on 
WorldCom, if I am not mistaken. It took 4 years, but they 
disassembled that operation. It exists today and employs 
thousands of people. I am told they are a rather vibrant 
company in many ways. It didn't disappear, but it was 
reorganized and restructured in a way that didn't involve--no 
one was involved in shoring it up. I mean, there was a 
mechanism by which you could deal with it.
    And I think your point that you made, Mr. Scott, is 
worthwhile, and that is sort of where I am on this, and that is 
I want to get rid of this ``too-big-to-fail'' notion altogether 
and that you ought to have the flexibility and the creativity 
and the imagination enough to be able to respond to situations 
in a variety of ways. Today, we have two, and that is pump 
billions of dollars into them or let them fail. It seems to me 
to be creative enough to say there are circumstances in which 
you ought to be able to manipulate this in a way that doesn't 
end up costing the taxpayer billions of dollars, and 
simultaneously doesn't cost thousands of jobs if you can 
reorganize something.
    I think that could have been done with AIG, in a way. So I 
appreciate your point. How that works is challenging, but 
clearly, a resolution mechanism is critical. I don't know how 
we word that, but I sense among our Members up here there is a 
strong appetite for including something like that, and I think 
the point, Bob, you made a week or so ago, I think, that had 
that alone been in place, you might have had a different 
response to a lot of what occurred, in a sense. Had that 
vehicle been out there, that in itself might have had the 
desired effect of slowing things down. I think that was the 
point you were making a week or so ago.
    Anyway, thank you all very much. It has been very 
instructive. We may have some additional questions from Members 
who couldn't be here this morning, so we will keep the record 
open for a while and we thank you. We would like to have you 
stay in touch with us on this matter, obviously a complicated 
one, and we invite your participation with us.
    The Committee will stand adjourned.
    [Whereupon, at 11:28 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]

            PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY

    Thank you, Mr. Chairman. Over the past 2 years, we have seen how 
problems in our insurance markets can disrupt our national economy. The 
crumbling of our largest bond insurers called into question the value 
of the financial guarantees those firms had issued on billions of 
dollars of securities.
    In addition, the spectacular failure of AIG sent shockwaves 
throughout our economy, and led to a $170 billion bailout by the 
Federal Government. These events reveal that comprehensive insurance 
regulation must be a part of our reform effort.
    Unfortunately, the Administration has ``taken a pass'' on 
comprehensive insurance reform. Under the President's proposal, the 
Federal Reserve would regulate only insurance companies that it deemed 
to be ``systemically significant.''
    The President also proposes the creation of an Office of National 
Insurance that would collect information and advise the Treasury 
Secretary on insurance matters. While this concept may have some merit, 
it certainly is not comprehensive reform and leaves unanswered the 
difficult question of whether and how insurance regulation should be 
modernized for the vast majority of insurers.
    The goal of today's hearing is to answer that question, as well as 
to examine the President's reform proposal as it relates to insurance. 
In particular, I am interested in learning whether our witnesses 
believe that the Fed is an appropriate regulator for insurers.

    Does it have the expertise necessary to supervise complex 
        insurance companies?

    Would establishing a separate Federal insurance regulator 
        be a better choice?

    If a Federal regulator is established, should all insurers 
        have the option of being regulated at the Federal level?

    If a Federal regulator is not established, what steps need 
        to be taken to ensure that there is proper coordination?

    Lastly, how do we make sure there are no gaps in our 
        regulatory system, like those that appear to have played a role 
        in the collapse of AIG?

    Reforming insurance regulation will be complex and challenging. The 
level of difficulty, however, should not prevent us from seeking a 
comprehensive solution to financial regulation that includes insurance. 
Thank you, Mr. Chairman.
                                 ______
                                 
               PREPARED STATEMENT OF SENATOR TIM JOHNSON

    Mr. Chairman, I am pleased you are holding an insurance hearing 
today. As this Committee considers financial regulatory restructuring 
proposals, I have said many times that insurance regulation must be a 
component of reform. I appreciate your recognition of that with this 
hearing.
    During the last two Congresses I introduced legislation to 
modernize the current system of insurance regulation. I remain 
concerned that the State-by-State regulatory system is outdated, 
inefficient, and bad for consumers. I am also deeply troubled that 
there remains no Federal agency to collect data on insurance companies, 
products and risks, to provide a voice on national insurance issues, 
and to represent our country on international insurance issues. 
Insurance plays a key part in a functioning economy and it should have 
appropriate regulation.
    Late last week, the Treasury sent up their legislative proposal to 
create an Office of National Insurance within the Department of the 
Treasury. I think this is a step in the right direction. I look forward 
to hearing the witnesses' views on this proposal and other proposals to 
modernize the regulation of insurance.

                PREPARED STATEMENT OF TRAVIS B. PLUNKETT

          Legislative Director, Consumer Federation of America
                             July 28, 2009





















































































































                   PREPARED STATEMENT OF BAIRD WEBEL

   Specialist in Financial Economics, Congressional Research Service
                             July 28, 2009

    Mr. Chairman, Ranking Member, my name is Baird Webel. I am a 
Specialist in Financial Economics at the Congressional Research 
Service. Thank you for the opportunity to testify before the Committee. 
This statement responds to your request for hearing testimony aiding 
the Committee's deliberations about modernizing the regulation of 
insurance. It begins with a brief introduction focusing on insurance 
and the recent financial crisis, and differentiating between lines of 
insurance. Following this is a discussion of seven broad options for 
the Federal Government's role in insurance regulation. These options 
should be seen as encompassing a continuum, and it may be possible to 
combine aspects from different options, particularly for different 
lines of insurance. Finally, the testimony includes a brief summary of 
recent proposals addressing insurance regulation at the Federal level.
    CRS's role is to provide objective, nonpartisan research and 
analysis to Congress. CRS takes no position on the desirability of any 
specific policy. The arguments presented in my written and oral 
testimony are for the purposes of informing Congress, not to advocate 
for a particular policy outcome.
Insurance Regulation and the Recent Financial Crisis
    As reaffirmed by Congress in the McCarran-Ferguson Act of 1945, \1\ 
the primary locus of insurance regulation currently rests with the 
individual States. Since the passage of this act, however, both 
Congress and the Federal courts have taken actions that have somewhat 
expanded the reach of the Federal Government into the insurance sphere. 
Examples of this include Employee Retirement Income Security Act of 
1974 (ERISA), \2\ which effectively federalized health insurance 
regulation for a large swath of the American population; various court 
decisions limiting the phrase ``the business of insurance'' contained 
in McCarran-Ferguson; \3\ and the Liability Risk Retention Act (LRRA), 
\4\ which preempted the ability of nondomiciliary States to regulate 
certain types of property/casualty insurance.
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     \1\ 15 U.S.C. 1011-1015.
     \2\ P.L. 93-406, 88 Stat. 829.
     \3\ See CRS Report RL33683, Courts Narrow McCarran-Ferguson 
Antitrust Exemption for ``Business of Insurance'': Viability of ``State 
Action'' Doctrine as an Alternative, by Janice E. Rubin.
     \4\ P.L. 97-45 as amended by P.L. 98-193 and P.L. 99-563, 15 
U.S.C. 3901 et seq.
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    Nevertheless, the Gramm-Leach-Bliley Act of 1999 (GLBA), \5\ which 
enacted the most sweeping financial regulatory changes since the Great 
Depression, specifically continued to recognize the States as the 
functional regulators of insurance. GLBA also removed legal barriers 
between securities firms, banks, and insurers. This legal freedom, 
along with improved technology, has been an important factor in 
creating more direct competition among the three groups. Many financial 
products have converged, so that products with similar economic 
characteristics may be available from different financial services 
firms with different regulators and different regulation.
---------------------------------------------------------------------------
     \5\ P.L. 106-102, 113 Stat. 1338.
---------------------------------------------------------------------------
    Increasing competition between insurers, banks, and securities 
firms has played a role in increased industry demands for a wide-
ranging federalization of the insurance industry. These demands have 
typically focused on various inefficiencies in navigating the multiple 
regulators in the State system as well as what some characterize as the 
overbearing content of some State regulation, particularly State rate 
and form regulation.
    The financial crisis can at least partly be traced to failures or 
holes in the financial regulatory structure. This has given increased 
urgency to calls for overall regulatory changes and Federal oversight 
of insurance. While insurers in general have appeared to weather the 
crisis reasonably well so far, the insurance industry has seen two 
significant failures, one general and one specific. The first failure 
was spread across the financial guarantee or monoline bond insurers. 
Before the crisis there were only about a dozen bond insurers in total, 
with four large insurers dominating the business. This type of 
insurance originated in the 1970s to cover municipal bonds but the 
insurers expanded their businesses since the 1990s to include 
significant amounts of mortgage-backed securities. In late 2007 and 
early 2008, strains began to appear due to exposure to mortgage-backed 
securities. Ultimately some smaller bond insurers failed and the larger 
insurers saw their previously triple A ratings cut significantly. These 
downgrades rippled throughout the municipal bond markets, causing 
unexpected difficulties for both individual investors and 
municipalities who might have thought they were relatively insulated 
from problems stemming from rising mortgage defaults.
    The second failure in the insurance industry was a specific 
company, American International Group (AIG). \6\ AIG had been a global 
giant of the industry, but it essentially failed in mid-September 2008. 
To prevent bankruptcy in September and October 2008, AIG was forced to 
seek more than $100 billion in assistance from, and give 79.9 percent 
of the equity in the company to, the Federal Reserve. Multiple 
restructurings of the assistance have followed, including up to $70 
billion through the U.S. Treasury's Troubled Asset Relief Program 
(TARP). AIG is currently in the process of selling off parts of its 
business to pay back assistance that it has received from the 
Government; how much value will be left in the 79.9 percent Government 
stake in the company at the end of the process remains an open 
question.
---------------------------------------------------------------------------
     \6\ See CRS Report R40438, Ongoing Government Assistance for 
American International Group (AIG), by Baird Webel.
---------------------------------------------------------------------------
    The near collapse of the bond insurers and AIG could be construed 
as regulatory failures. One of the responsibilities of jobs of an 
insurance regulator is to make sure the insurer remains solvent and is 
able to pay its claims. Since the States are the primary insurance 
regulators, some may go further and argue that these cases specifically 
demonstrate the need for increased Federal involvement in insurance. 
There are aspects of both the bond insurer crisis and AIG's failure 
that may mitigate the arguments for Federal involvement, particularly 
because AIG was also regulated by the Federal Office of Thrift 
Supervision.

Lines of Insurance and Federal Involvement in Insurance
    The insurance industry is not monolithic, but rather very diverse, 
serving multiple markets. Companies range in size from multiline 
insurers serving the entire country to small ``captive'' insurers that 
may insure a single company. In general, insurers fall into two broad 
segments: life insurers and property/casualty insurers. Some companies 
are organized as stock companies, whereas others operate as mutual or 
fraternal companies. Some companies are very large in size, whereas 
others are midsize or small. Some companies specialize in large 
commercial accounts, whereas others write personal lines of business 
such as homeowners, automobile, or individual life and health policies. 
Still others concentrate on reinsurance, or the selling of insurance to 
insurance companies to assist them in spreading their risks.
Life Insurance
    Life insurers \7\ in general face long-term and relatively stable 
risks and losses. Life insurance contracts typically last decades and 
actuarial tables are well developed. It may be impossible to estimate 
which individual people are going to die in a given year, however, with 
a large pool, actuaries can be very accurate in projecting the overall 
number of deaths and thus the overall losses a life insurer will likely 
incur. This increases the importance of the investment side of the life 
insurance business to generate profits. If life insurers face solvency 
problems, it is likely to be a result of poor investment decisions 
rather than huge unexpected losses. The risks covered in life insurance 
are much more uniform across the country and policyholders are 
relatively likely to be covered by a policy purchased in a different 
State from their current residence. Life insurers also offer many 
annuity products, which combine aspects of insurance and investment 
products. These annuity products also represent a significant exposure 
to investment gains and losses for life insurance companies.
---------------------------------------------------------------------------
     \7\ Health insurers are often included within the category of life 
insurers. Since health insurance is largely outside of the scope of the 
Committee's interest, this analysis concentrates purely on life 
insurance.
---------------------------------------------------------------------------
Property/Casualty Insurance
    Property/casualty insurers face a very different set of economic 
challenges. Most property/casualty contracts are relatively short-term, 
often 6 months or 1 year. The risks to these insurers can be much more 
variable than those faced by life insurers. In some lines, catastrophic 
losses can occur that will wipe out years of previously accumulated 
premiums. Accordingly, investment returns are important to the 
business, but to a lesser degree than they are in life insurance. 
Property/casualty policies can be much more localized and tailored to 
specific risks in specific areas. With relatively short-term contracts, 
policyholders are much less likely to maintain their policies as they 
move from State to State. Property/casualty policies are often required 
by a third party. For example, purchase of State licensed auto 
insurance is a common requirement for auto licensing and banks often 
require specific insurance purchases for a property loan. The near 
mandatory nature of some property/casualty insurance purchases has 
tended to engender increased regulatory oversight and various 
mechanisms to ensure availability and affordable pricing for consumers.
    Such differences have led to suggestions for different Federal 
involvement for different lines of insurance. The most common proposal 
in the past has been to provide for a Federal charter for life insurers 
while leaving property/casualty insurers in the State system. During 
the recent financial crisis, life and property/casualty insurers 
sometimes favored different Government policies. Several life insurers 
have sought and received assistance through TARP, even going so far as 
to convert their corporate form to a Federal bank or thrift holding 
company to qualify for the assistance. Property/casualty companies have 
generally shunned Federal aid, with one industry group arguing 
strenuously that property/casualty insurers typically do not present 
systemic risk and the Federal Government should avoid providing 
assistance to them. \8\
---------------------------------------------------------------------------
     \8\ See, for example, an op-ed by the President and CEO of the 
Property Casualty Insurers Association of America, David A. Sampson, 
``Property, casualty insurers don't pose systemic risk'', The Hill, 
April 27, 2009, available at http://thehill.com/opeds/property-
casualty-insurers-dont-pose-systemic-risk-2009-04-27.html.
---------------------------------------------------------------------------
Options for Insurance Regulatory Reform
    Seven particular options for Federal involvement are presented in 
the following sections. These options range from minimal, or no, 
Federal involvement to a Federal takeover and complete restructuring of 
insurance regulation. To some degree many of these options have 
elements that are not mutually exclusive. Congress could take various 
aspects and apply them differently, for example, to different lines of 
insurance or to different aspects of regulation. Most of these options 
have been present in some form in proposals that predate the recent 
crisis.

1. Do Nothing
    While insurers have unquestionably been affected by the financial 
crisis, the instruments and practices generally identified as driving 
the crisis, the outsized losses, and the bulk of the Federal assistance 
are concentrated in other areas of the financial services industry. 
This may be due to good regulation, good business practices, or simply 
good fortune for insurers, and it may very well change in the future, 
but for the moment the financial crisis is focused elsewhere. It could 
be argued that effort and attention should also be focused on the areas 
in crisis. One could even go further and argue that in such a time of 
general market uncertainty, it is not helpful to the market to 
introduce additional regulatory uncertainties. ``First do no harm'' may 
be applicable to sick financial markets as well as sick medical 
patients. On the other hand, making regulatory changes now, before 
insurers might be facing failure, could help prevent such failures from 
occurring at all.

2. Create a Federal Office of Insurance Information
    One of the correlates of the absence of direct Federal regulatory 
authority over insurance has been a relative lack of awareness, 
information, and expertise on non-health insurance matters within the 
Federal Government. Other testimony before Congress has indicated that 
the Office of Thrift Supervision, which oversaw AIG, had only one 
insurance expert on staff \9\ and informal inquiries have indicated to 
CRS that the Treasury Department does not have all that many more.
---------------------------------------------------------------------------
     \9\ Testimony by Max Stier, President and CEO, Partnership for 
Public Service, before the House Oversight and Government Reform 
Subcommittee on the Federal Workforce, Postal Service, and the District 
of Columbia, April 22, 2009. Retrieved through CQ Congressional 
Testimony.
---------------------------------------------------------------------------
    This lack of information and insurance expertise has been noted 
before the crisis, and how large an impact it had on the crisis may be 
debated; however, the crisis has generally shown how important accurate 
information can be. Much of the market uncertainties can be traced to 
lack of information about specific companies' exposures to mortgage-
backed securities. Lack of information on the size of and exposures to 
the credit default swap market has also complicated regulatory 
responses to the crisis. Should a significant crisis event arise 
involving large insurers, additional information and expertise on the 
issues at the Federal level would likely be helpful.
    Some, particularly those strongly supporting the current State 
regulatory system, have expressed concern that such a Federal office 
might be essentially a precursor to an eventual Federal regulator. An 
alternate response to address such concerns might also be to increase 
cooperation and communication between Federal officials and the 
National Association of Insurance Commissioners (NAIC). The NAIC is 
currently a major source of information regarding insurance issues and 
would likely be significant source of information for any Federal 
office. This would particularly be the case if, as was included in the 
proposed Insurance Information Act (H.R. 5840 in the 110th Congress/
H.R. 2609 in the 111th Congress), the Federal office would be largely 
limited to collecting publicly available data.

3. Harmonization of State Laws Via Federal Preemption
    Most stakeholders in the insurance industry recognize the need for 
some harmonization, if not uniformity, of insurance regulation among 
the different State regulators. The NAIC has served as the primary 
forum for this since its founding in 1871. For harmonization to occur 
through State efforts, however, every State legislature must pass 
substantially similar legislation, a very difficult task. Federal law, 
however, would have the power to preempt State legislation and create 
such harmonization without State legislative approval. This is the 
approach, for example, taken by the Liability Risk Retention Act, which 
preempts most State insurance regulation of risk retention groups, 
except for regulation by the home State regulator. Application of 
similar principles to other areas, such as surplus lines or the 
licensing of agents, has been a feature of several bills in the past 
few years. Federal preemption of State regulation of the business of 
insurance is a congressional prerogative, and even the McCarran 
Ferguson Act which declared a policy of ``the continued regulation and 
taxation by the several States of the business of insurance,'' \10\ 
recognizes the congressional authority to regulate the insurance 
industry.
---------------------------------------------------------------------------
     \10\ 15 U.S.C. 1011.
---------------------------------------------------------------------------
    This approach could be argued to be a ``best of both worlds'' 
approach, combining the experience and many of the strengths of the 
State regulatory system while ensuring greater efficiency through the 
ability of insurers to operate throughout the country. Much of the 
effectiveness of this approach, however, would depend on the specific 
details chosen. As an approach, it is very broad. Congress could choose 
to preempt specific aspects relating to a single line of insurance, or 
a State's entire approach to insurance regulation. Without specifics 
about what State laws are being preempted and what they might be 
replaced with, it is difficult to analyze the partial preemption 
approach. If one were specifically trying to address issues related to 
the financial crisis, it may be difficult to do so through piecemeal 
Federal preemptions. Much of crisis management and avoidance will be a 
question of individual regulatory decisions, which are more difficult 
to address through broader preemption efforts.

4. Create a Federal Systemic Risk Regulator
    One new regulatory option being discussed in the current financial 
crisis is the concept of a ``systemic risk regulator.'' The Committee 
has held an entire hearing devoted to the subject, so I will focus on 
the systemic risk regulator and the insurance system.
    Given the near systemic collapse that the financial system 
experienced last September, the need for someone to look after the 
entire system may seem self-evident to some. As concepts for a systemic 
risk regulator have become more advanced, however, the difficulties of 
going from the concept of needing someone to look after the system to 
how this concept would work in practice have become more apparent. 
Particularly with regard to the insurance regulatory system, there are 
a number of questions to consider, including:

    Do any insurers present a systemic risk? If so, what 
        criteria would be used to identify these systemically 
        significant institutions?

        In the past, a familiar concern was that financial institutions 
        may become too big to fail. In the recent crises, however, the 
        concept of ``too interconnected to fail'' has also been 
        injected into the debate. Metrics for ``interconnectedness'' 
        are even less clear than those for size. Historically, insurers 
        have generally not been considered to present systemic risks; 
        insurers' liabilities are much more stable than those of banks 
        and insurers have not suffered from depositor runs like banks 
        have. The recent crisis, however, has brought a different sort 
        of run on financial institutions, namely the withdrawal of 
        short term credit and demand from other counterparties for 
        collateral payments. Such a ``run'' brought AIG down and other 
        insurers might be vulnerable, although none have failed since 
        AIG.

    Who would make the decision on which institutions would 
        fall under the systemic regulator's purview?

        The State insurance regulators would most likely expect some 
        role in the process of identifying systemically significant 
        insurers. If the insurance regulators and the systemic 
        regulator disagree, however, a mechanism must be in place to 
        arrive at a final decision.

    Would a systemic regulator have day-to-day oversight over 
        insurers judged to be systemically significant?

        If it were to have day-to-day oversight, then the systemic risk 
        regulator would be tantamount to a Federal insurance regulator, 
        which is the heart of the Federal chartering debate and will be 
        explored further later in this testimony.

    If not, what specific preemptive powers would a systemic 
        regulator have over the State regulators' decisions?

        A particularly controversial aspect of such preemptive powers 
        may surround regulation of insurance rates. Many States require 
        specific regulatory approval for insurance rates. If these 
        rates were insufficient to cover an insurer's risks, thus 
        making insolvency more likely, it could directly concern a 
        systemic risk regulator.

    Would the systemic regulator have resolution authority over 
        failed systemically significant institutions or would this be 
        left to the State regulators and the guarantee funds?

        The failure of large institutions like AIG and Lehman Brothers, 
        who did not fall under existing resolution provisions as banks 
        do, has been identified by many as a particular issue to be 
        addressed by a systemic risk regulator. Broader Federal 
        resolution authority could, however, have a significant impact 
        on the current system for resolving insurance company failures. 
        Under current law, failed insurance companies are resolved by 
        the State insurance regulators and guarantee funds. Generally, 
        insured policy holders are paid off by the guarantee funds 
        under certain guidelines with the guarantee funds then 
        occupying a senior position with regard to claims on insurer 
        assets. What position individual policyholders or guarantee 
        funds might have under a Federal resolution authority, however, 
        is up to whatever laws would be approved by Congress. The 
        current Treasury proposal for resolution authority does not 
        change the current authority over insurance subsidiary assets. 
        If the enacted resolution authority did change this, a systemic 
        risk regulator might have an incentive to use the assets of a 
        company such as AIG to satisfy creditors who are themselves 
        systemically significant rather than directing these assets to 
        satisfy policyholder claims.

    What impact would identifying particular insurers as 
        systemically significant have on the marketplace, particularly 
        on competitors of these firms?

        Competitors of AIG today have voiced many complaints that AIG 
        is using Federal support to undercut their prices. If an 
        insurer were identified as systemically significant, and thus 
        presumably one that is not allowed to fail, this could give 
        such firms a competitive advantage. If this occurs, others 
        would presumably seek to merge or otherwise grow in size so 
        they might gain this advantage. This could have the paradoxical 
        effect of making a future crisis worse as more financial 
        institutions would have the potential to spread systemic harm 
        in the event of their collapse.

    Would being identified as systemically significant promote 
        risk taking in these institutions, and thus make future crises 
        more likely?

        This problem of ``moral hazard'' is well known in the insurance 
        industry. In order to deal with it on the individual level, 
        insurers institute a variety of policies, such as deductibles 
        and copayments. Identifying an institution as systemically 
        significant implies it will not be allowed to fail, which also 
        creates moral hazard. To address this, a systemically 
        significant designation could also include other policies, such 
        as increased capital requirements or other regulatory scrutiny.

5. Create a Federal Solvency Regulator
    Regulation of insurers can be broken down broadly into oversight of 
the company's interaction with customers (market conduct or consumer 
protection regulation) and oversight of its future ability to pay 
claims (solvency or prudential regulation). In the United States, 
regulation of both aspects is done by the individual States. Some other 
countries, however, separate these functions and have two distinct 
agencies for the two tasks. In theory, this could allow for increased 
focus on both tasks as each agency only has one goal. Adapting this 
approach to the United States could lead to the possibility of 
assigning consumer protection functions to the individual States, while 
giving solvency regulatory powers to the Federal Government. Such an 
approach would also dovetail with some arguments already advanced in 
the optional Federal chartering debates. Proponents of the State 
regulatory system often cite consumer protection as a particularly 
successful area for the States and one in which the States can give 
much more individual attention to citizens than they are likely to 
receive from a Federal bureaucracy, while proponents of a Federal 
chartering system cite the increased complexity of financial 
instruments and company balance sheets which makes solvency regulation 
more difficult, thus requiring additional expertise which would 
presumably come with a Federal regulator.
    The operation of such a mixed system would ideally include 
substantial communication and trust between the consumer protection 
regulators and the solvency regulators. Establishing this trust in the 
aftermath of a Federal takeover of solvency regulation could be a 
challenge. Another flashpoint might be the regulation of rates, as 
mentioned previously. Rates have a direct impact on insurer solvency, 
but regulation of rates is seen by many as a bedrock aspect of consumer 
protection. To limit conflict between the States and Federal 
regulators, implementing legislation would need to clarify what power 
the Federal solvency regulators might have to overrule State 
regulators, or vice versa.

6. Establish a Federal Insurance Charter
    The debate over the possibility of a Federal charter for insurers 
has been ongoing for the past several years with the Committee hearing 
previously from both the proponents and opponents of the idea. A common 
proposal has been for an Optional Federal Charter (OFC) for insurers 
modeled on the dual banking system.
    Current focus on the idea of a Federal insurance charter dates 
largely to the passage of GLBA, which specifically reaffirmed the 
States as the functional regulators of insurance but also unleashed 
market forces encouraging a greater Federal role. This has led to 
increasing industry complaints of overlapping, and sometimes 
contradictory, State regulatory edicts driving up the cost of 
compliance and increasing the time necessary to bring new products to 
market.

    Arguments advanced for Federal chartering have included the 
following:

    The regulation of insurance companies needs to be 
        modernized at the Federal level to make insurers more 
        competitive with other federally regulated financial 
        institutions in the post-GLBA environment.

    The recent financial crisis has shown that some insurers 
        present systemic risk and should be regulated by a regulator 
        with a broad, systemic outlook.

    Insurance needs a knowledgeable voice and advocate in 
        Washington, DC.

    The current system is very slow in approving new products, 
        putting insurers at a distinct disadvantage in product creation 
        and delivery.

    Insurers have difficulty in expanding abroad without a 
        regulator at the national level.

    Consumers will benefit from a greater supply of insurance 
        and lower cost to consumers as insurance companies are forced 
        to compete on a national scale.

    Arguments advanced for State regulation have included the 
following:

    State regulated insurers have performed relatively well 
        through the financial crisis, underscoring the quality of State 
        regulation.

    State insurance regulators have unique knowledge of local 
        markets and conditions and are flexible and adaptable to local 
        conditions.

    The diversity of State regulation reduces the impact of bad 
        regulation and promotes innovation and good regulation.

    Strong incentives, such as direct election, exist for State 
        regulators to do the job effectively at the State level.

    A substantial and costly new Federal bureaucracy would need 
        to be created in a Federal system.

    States would suffer substantial fiscal damage should State 
        premium taxes be reduced by the Federal system.

    A ``race to the bottom'' could occur under an optional 
        Federal charter as State and Federal regulators compete to give 
        insurers more favorable treatment and thus secure greater 
        oversight authority and budget.

    In the abstract, the Federal chartering question could be simply 
about the ``who'' of regulation. Should it be the Federal Government, 
the States, or some combination of the two? In practice, however, OFC 
legislation has had much to say about the ``how'' of regulation. Should 
the Government continue the same fine degree of industry oversight that 
States have practiced in the past? The OFC bills that have been 
introduced to this point have tended to answer the latter question 
negatively--the Federal regulator that they would create would exercise 
less regulatory oversight than most State regulators. This deregulatory 
aspect of past and present OFC bills can be as great a source of 
controversy as the introduction of Federal regulation itself.

7. Completely Reform the Financial Services Regulatory System
    The question of Federal involvement in insurance regulation could 
expand beyond the confines of insurance and instead be subsumed within 
a more comprehensive reform to the whole approach to regulating the 
U.S. financial system. General financial regulation in the United 
States is carried out by an overlapping set of bodies created at 
various periods during the past 150 years. Historically, the regulatory 
body was dictated by the charter of a given institution: banks were 
regulated by various banking regulators, thrifts by thrift regulators, 
insurers by insurance regulators, etc. Although GLBA aimed to refocus 
the system along functional lines, so that, for example, insurance 
regulators would regulate insurance activity whether it was carried out 
by banks or by insurers, regulation has still largely fallen along 
institutional lines. Simplification of the regulatory system is not a 
result that most observers would ascribe to GLBA. Even before the 
financial crisis, arguments were advanced that the system needed a 
significant overhaul, perhaps by combining overlapping institutions or 
completely rethinking the structure of the regulatory system. Several 
other countries have confronted similar policy choices in the past two 
decades with two regulatory models gaining favor: a ``unitary'' 
regulator and a ``twin peaks'' model.
    A unitary model calls for a single regulator to oversee financial 
institutions regardless of the charter type or business activity that 
the institutions engage in. Such a regulator could oversee all aspects 
of financial activity, from systemic stability to individual 
institution solvency to consumer protection. Advantages of such an 
approach include a focus on financial regulation that avoids consumer 
confusion about who to call in the case of problems; clear regulatory 
authority over innovations in the financial system; and no possibility 
that financial institutions would ``game the system'' by playing one 
regulator off against another. The strengths of a unitary system when 
the regulator gets things right, however, are also its weakness if the 
regulator gets things wrong. With only one regulatory body, there are 
few checks and balances. If a mistake is made, it can more easily 
affect the whole system rather than be isolated within a particular 
type of institution or geographic area. Examples of countries adopting 
a unitary approach include Japan and the United Kingdom.
    A twin peaks model typically separates the regulatory authority 
between solvency and consumer protection functions, with separate 
entities responsible for each. Such an approach arguably can offer many 
of the same advantages of a unitary system with relative uniformity of 
regulation across different financial institutions regardless of 
charter and an even clearer regulatory focus within each of the two 
regulators. Overlap between the two regulators could be minimized, but 
having two voices in the system offers at least the possibility of 
minimizing the impact of regulatory mistakes rippling throughout the 
system. Examples of countries adopting a twin peaks approach include 
Australia and the Netherlands.
Recent Proposals/Legislation Reforming the Insurance Regulatory System
President Obama's Financial Regulatory Reform Plan
    In June 2009, the Treasury Department released a report entitled 
``Financial Regulatory Reform: A New Foundation,'' outlining President 
Obama's plan to reform financial regulation in the United States. Since 
the release of the overall plan, legislative language to implement 
various aspects of the plan has also been released. The plan is 
generally portrayed as a middle of the road approach to reform the 
overall system. It does not foresee revamping the entire system 
following the unitary or twin peaks model, but it would substantially 
change the financial regulatory system, including explicitly 
introducing systemic risk oversight by the Federal Reserve, combining 
the Office of Comptroller of the Currency and the Office of Thrift 
Supervision into a single banking regulator, and creating a new 
Consumer Financial Protection Agency.
    Most of the regulatory changes under the President's plan would be 
focused on areas other than insurance. Most insurance products, for 
example, are excluded from the jurisdiction of the new Federal consumer 
protection agency. In general, the States would continue their 
preeminent role in insurance regulation. Insurance regulation, however, 
would be specifically affected through two aspects of the President's 
plan, the regulation of large financial companies presenting systemic 
risk and the creation of a new Office of National Insurance (ONI) 
within the Treasury.
    Systemic risk regulation would be the primary responsibility of the 
Federal Reserve in conjunction with a new Financial Services Oversight 
Council made up of the heads of most of the Federal financial 
regulators. The powers to regulate for systemic risk enumerated in the 
draft legislation extend to all companies in the United States engaged 
in financial activities. While the draft legislation does not 
specifically name insurers as subject to Federal systemic risk 
regulation, the language would seem to include them under the Federal 
jurisdiction. Companies judged to be a possible threat to global or 
U.S. financial stability may be designated Tier 1 Financial Holding 
Companies and subject to stringent solvency standards and additional 
examinations. Such companies would also be subject to the enhanced 
resolution authority rather than standard bankruptcy provisions. While 
the draft language does make reference in some places to State 
functional regulatory agencies, it is unclear exactly how the Federal 
Reserve as regulator of the financial holding company would interact 
with the State regulators of the individual insurance subsidiaries. 
Under the current regulatory system, where there are some federally 
regulated holding companies that are primarily insurers, the Federal 
regulators generally defer to the State insurance regulators. Whether 
or not this deferral would continue under the new legislation may be an 
open question.
    While systemic risk regulation would likely apply to a relatively 
small number of insurers, the called-for creation of an Office of 
National Insurance (ONI) could have a broader impact. Unlike the 
similarly named office in other legislation, such as H.R. 1880, 
President Obama's ONI would not oversee a Federal insurance charter and 
have direct regulatory power over insurers. This ONI would operate as a 
broad overseer and voice for insurance at the Federal level, including 
collecting information on insurance issues, setting Federal policy on 
insurance, representing the United States in international insurance 
matters, and preempting State laws where these laws are inconsistent 
with international agreements. These functions are similar to those of 
the Office of Insurance Information (OII) to be created by H.R. 2609. 
The ONI under President Obama's plan would seem to have more authority, 
however, than the OII under H.R. 2609. For example, the ONI would have 
subpoena power to require an insurer to submit information rather than 
relying voluntary submissions and publicly available information.

The National Insurance Consumer Protection Act (H.R. 1880)
    Representatives Melissa Bean and Edward Royce introduced H.R. 1880 
in the House on April 2, 2009.
    This bill would create a Federal charter for the insurance 
industry, including insurers, insurance agencies, and independent 
insurance producers. The Federal insurance regulatory apparatus would 
be an independent entity under the Department of the Treasury and would 
preempt most State insurance laws for nationally regulated entities. 
Thus, nationally licensed insurers, agencies, and producers would be 
able to operate in the entire United States without fulfilling the 
requirements of each individual 50 States' insurance laws.
    H.R. 1880 would also address the issue of systemic risk by 
designating another entity to serve as a systemic risk regulator for 
insurance. The systemic risk regulator would have the power to compel 
systemically significant insurers to be chartered by the Federal 
insurance regulator. Thus, although the bill shares some similarities 
with past optional Federal charter legislation, and would allow some 
insurers to choose whether to obtain a Federal charter, it can not be 
considered purely an optional Federal charter bill.

The National Association of Registered Agents and Brokers Reform Act of 
        2009 (H.R. 2554)
    This bill was introduced by Representative David Scott along with 
34 cosponsors on May 21, 2008.
    H.R. 2554 would establish a National Association of Registered 
Agents and Brokers (NARAB). NARAB would be a private, nonprofit 
corporation, whose members, once licensed as an insurance producer in a 
single State, would be able to operate in any other State subject only 
to payment of the licensing fee in that State. The NARAB member would 
still be subject to each State's consumer protection and market conduct 
regulation, but individual State laws that treated out of State 
insurance producers differentially than in-State producers would be 
preempted. NARAB would be overseen by a board made up of five 
appointees from the insurance industry and four from the State 
insurance commissioners. The appointments would be made by the 
President and the President could dissolve the board as whole or 
suspend the effectiveness of any action taken by NARAB.

The Nonadmitted and Reinsurance Reform Act of 2009 (H.R. 2571/S. 1363)
    Representative Dennis Moore and 21 cosponsors introduced H.R. 2571 
on May 21, 2009, while Senators Mel Martinez, Bill Nelson, and Mike 
Crapo introduced S. 1363 on June 25, 2009.
    These bills would address a relatively narrow set of insurance 
regulatory issues. In the area of nonadmitted, or surplus lines, 
insurance, the bills would harmonize, and in some cases reduce, 
regulation and taxation of this insurance by investing the ``home 
State'' of the insured with the sole authority to regulate and collect 
the taxes on a surplus lines transaction. Those taxes that would be 
collected may be distributed according to a future interstate compact, 
but absent such a compact their distribution would be up to the home 
State. These bills also would preempt any State laws on surplus lines 
eligibility that conflict with the NAIC model law and would implement 
``streamlined'' Federal standards allowing a commercial purchaser to 
access surplus lines insurance. For reinsurance transactions, they 
would invest the home State of the insurer purchasing the reinsurance 
with the authority over the transaction while investing the home State 
of the reinsurer with the sole authority to regulate the solvency of 
the reinsurer. \11\
---------------------------------------------------------------------------
     \11\ See CRS Report RS22506, Surplus Lines Insurance: Background 
and Current Legislation, by Baird Webel.
---------------------------------------------------------------------------
The Insurance Information Act of 2009 (H.R. 2609)
    Representative Paul Kanjorski and four cosponsors introduced H.R. 
2609 on May 21, 2009.
    This bill would create an ``Office of Insurance Information'' for 
nonhealth insurance in the Department of the Treasury. The Deputy 
Assistant Secretary heading this office would be charged with 
collecting and analyzing insurance information and establishing Federal 
policy on international insurance issues, as well as advising the 
Secretary of the Treasury on major insurance policy issues. State laws 
or regulations that the head of the office finds to be inconsistent 
with the Federal policy on international insurance issues would be 
preempted, subject to an appeal to the Secretary.

The Increasing Insurance Coverage Options for Consumers Act of 2008 
        (H.R. 5792, 110th Congress)
    This bill was introduced by Representative Dennis Moore, along with 
Representatives Deborah Pryce, John Campbell, and Ron Klein, on April 
15, 2008.
    H.R. 5792 would have amended the Liability Risk Retention Act (15 
U.S.C. 3901, et seq.) to allow risk retention groups and risk 
purchasing groups to expand into commercial property insurance, while 
adding requirements on corporate governance including the addition of 
independent directors on risk retention group boards and a fiduciary 
duty requirement for group directors. The bill would have required risk 
retention groups be chartered in a State that has adopted 
``appropriate'' or ``minimum'' financial and solvency standards. It 
would also have strengthened the current preemption from State laws 
enjoyed by risk retention and risk purchasing groups. \12\
---------------------------------------------------------------------------
     \12\ See CRS Report RL32176, The Liability Risk Retention Act: 
Background, Issues, and Current Legislation, by Baird Webel.
---------------------------------------------------------------------------
2008 Treasury Blueprint
    In March 2008, then-Secretary of the Treasury Henry Paulson 
released a ``Blueprint for a Modernized Financial Regulatory 
Structure.'' Although the recent financial crisis had begun at that 
time, the Treasury blueprint was not primarily a response to the 
crisis, but instead an attempt to create ``a more flexible, efficient, 
and effective regulatory framework'' \13\ A wide-ranging document, the 
blueprint foresaw a completely revamped regulatory structure for all 
financial services. The final structure envisioned in the Treasury 
blueprint has been described as ``twin peaks plus.'' The 2008 Treasury 
model was to ultimately create a prudential regulator overseeing the 
solvency of individual companies, a business conduct regulator 
overseeing consumer protection, and a market stability regulator 
overseeing risks to the entire system. As an intermediate step, it made 
two specific recommendations on insurance regulation. First, it called 
for the creation of a Federal insurance regulator to oversee an 
optional Federal charter for insurers as well as Federal licensing for 
agents and brokers. Second, recognizing that the debate over an 
optional Federal charter was ongoing in Congress, it recommended the 
creation of an ``Office of Insurance Oversight'' in the Department of 
the Treasury as an interim step. This office would be charged with two 
primary functions: (1) dealing with international regulatory issues, 
including the power to preempt inconsistent State laws, and (2) 
collecting information on the insurance industry and advising the 
Secretary of the Treasury on insurance matters.
---------------------------------------------------------------------------
     \13\ U.S. Treasury, ``Treasury Releases Blueprint for Stronger 
Regulatory Structure'', press release, March 31, 2008, http://
www.ustreas.gov/press/releases/hp896.htm.
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                                 ______
                                 
                   PREPARED STATEMENT OF HAL S. SCOTT
   Nomura Professor of International Financial Systems and Director,
      Committee on Capital Markets Regulation, Harvard Law School
                             July 28, 2009

    Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the 
Committee for permitting me to testify before you today on regulatory 
modernization as it relates to the insurance industry.
    As the Committee knows, the insurance industry represents an 
important place in the U.S. framework of financial regulation. As of 
the first quarter of 2009, the total assets of U.S. life and property-
casualty insurers were $5.7 trillion, quite significant when compared 
with total assets of U.S. commercial banks of $13.9 trillion. \1\ 
Despite being a national (indeed international) industry within the 
financial sector whose size can be measured in the trillions, 
insurance--unlike the banking or securities sector--is regulated almost 
exclusively by each of the 50 States instead of the Federal Government.
---------------------------------------------------------------------------
     \1\ Federal Reserve, Statistical Release Z.1 (June 11, 2009).
---------------------------------------------------------------------------
    This structure comes from a bygone era and, in the wake of the 
ongoing global financial crisis, must be reconsidered and changed. I 
believe reform, at least initially, should come by way of establishing 
an optional Federal charter (OFC).
    My testimony is organized in three parts. \2\ Part I addresses the 
case against the status quo and the need for an OFC. Part II outlines 
how an OFC regime should be structured, and Part III introduces some 
additional issues to consider in reforming insurance regulation in the 
United States.
---------------------------------------------------------------------------
     \2\ Portions of this testimony are excerpted from my prior work on 
the subject, namely Martin F. Grace & Hal S. Scott, ``An Optional 
Federal Charter for Insurance: Rationale and Design'', in The Future of 
Insurance Regulation in the United States 55-96 (Martin F. Grace & 
Robert W. Klein, eds. Brookings Press, 2009), and the Committee on 
Capital Markets Regulation's recent report entitled ``The Global 
Financial Crisis: A Plan for Regulatory Reform'' (May 2009).
---------------------------------------------------------------------------
I. The Need for an Optional Federal Charter
    In contrast to other financial services, such as securities and 
banking, Congress has not sought to exercise either concurrent or 
preemptive authority over insurers. Indeed, the McCarran-Ferguson Act 
of 1945 explicitly found State regulation of insurance to be in the 
public interest and provided that no Federal law should ``invalidate, 
impair, or supersede'' any State insurance regulation or tax. \3\ The 
net result of congressional abstention has been that more than 50 
regulators currently regulate insurance within their jurisdictions. Yet 
it has not always been assumed that the States should be the exclusive 
regulators of insurance. There have been numerous proposals for a 
Federal role in insurance regulation since the time of the National 
Banking Act, which set up the dual-chartering provisions for the 
banking industry in the 1860s. Indeed, many such proposals have been 
put forward recently. For example, in April 2009 Representatives 
Melissa Bean (D-Ill.) and Ed Royce (R-Calif.) introduced H.R. 1880, the 
National Insurance Consumer Protection Act, which sets forth a scheme 
for an OFC for life and property-casualty insurers (as well as 
reinsurers), largely modeled on the National Bank Act of 1864.
---------------------------------------------------------------------------
     \3\ P.L. 15, March 9, 1945 (codified at 15 U.S.C. 1101-15).
---------------------------------------------------------------------------
A. The Case for Abandoning the Status Quo
    The status quo is undesirable for at least three reasons: (1) 
State-based regulation is inefficient; (2) the current system stifles 
uniformity, innovation, and speed to market; and (3) the fragmented 
framework puts the insurance industry at a competitive disadvantage 
with other firms offering the same products. We need to create an OFC 
to remedy these problems, although I acknowledge the political 
difficulties of doing so.
    1. State-Based Regulation Is Inefficient--The most basic problem 
with the current framework of multistate regulation is its sheer 
inefficiency. The precise costs of that inefficiency are somewhat 
difficult to calculate. A simple cost comparison between current State 
and Federal financial regulatory systems is only partially informative, 
because each State agency has a slightly different mission. For 
example, some States expend a great deal of time on rate regulation and 
issues related to pricing, profitability, and market conduct. Other 
States have relatively little price regulation but may spend more 
resources and time on other issues salient to voters in the State.
    Scholars and economists that have attempted to quantify the costs 
associated with multistate regulation agree they are significant. For 
example, Professor Steven Pottier of the University of Georgia finds 
that the total additional cost of having multistate regulation of the 
life insurance industry is about 1.25 percent of net premiums annually. 
\4\ This translates into approximately $5.7 billion each year. While 
these figures are for the life insurance industry, one would expect 
similar results for property-liability firms.
---------------------------------------------------------------------------
     \4\ Steven W. Pottier, ``State Insurance Regulation of Life 
Insurers: Implications for Economic Efficiency and Financial 
Strength,'' in Report to the American Council of Life Insurers (2007).
---------------------------------------------------------------------------
    Like many others, I believe that if a significant portion of 
insurance regulation was aggregated at the Federal level, many of these 
duplicate costs would be eliminated. The outcome would be lower 
regulatory costs to the Government and lower compliance costs to the 
regulated firms. For example, every State undertakes regulation of 
insurance agents. According to Professor Laureen Regan of Temple 
University, the average life agent has about nine State licenses. \5\ 
This cost is born by the agents, their employers, and their customers. 
Further, every State licenses the companies operating within its 
jurisdiction. The average property-liability company holds 16 State 
licenses and the average life-health company holds twenty-five. \6\ An 
optional Federal charter with one licensing regime could eliminate 
these multiple layers of cost.
---------------------------------------------------------------------------
     \5\ Laureen Regan, ``The Option Federal Charter: Implications for 
Life Insurance Producers'' in Report to the American Council of Life 
Insurers (2007).
     \6\ National Association of Insurance Commissioners, Annual 
Statement (Kansas City, MO, 2006).
---------------------------------------------------------------------------
    A particular industry or product should be regulated at the 
jurisdictional level best able to capture all the costs and benefits of 
regulation within its limits. In layman's terms, the more interstate 
the business, the stronger the argument is for Federal regulation. 
There was a time in American history when the sale and provisioning of 
insurance of differing kinds was primarily a local business. But that 
time has long passed. Based on information available from the National 
Association of Insurance Commissioners (NAIC), Professor Martin Grace 
and I calculated that for 2006, out-of-State insurers provided over 80 
percent of all insurance in the United States. \7\ In certain 
categories of insurance, the numbers are even more striking. While the 
in-State market share for property-liability insurers is 18.13 percent, 
for life-health insurers the average in-State market share is only 7.52 
percent. \8\
---------------------------------------------------------------------------
     \7\ Martin F. Grace & Hal S. Scott, supra note 2 at 61-64.
     \8\ Id. at 65.
---------------------------------------------------------------------------
    2. State-Based Regulation Threatens Uniformity, Innovation, and 
Speed to Market--Related, but distinct from the inefficiency of 
multistate regulation, is the potentially negative effect of the status 
quo on the uniformity of standards and regulations, product innovation, 
and the speed with which new products enter the marketplace. The 
promulgation of Federal laws and regulations--particularly those with 
the requisite force to preempt State laws--would, by definition, be 
uniform throughout the United States. Uniformity not only produces 
greater cost efficiency but also enables consumers and regulators to 
monitor the compliance of a particular company or product with a set of 
standards applied across State boundaries.
    Multistate regulation has arguably impeded the ability of the 
insurance industry to provide consumers with improved products. If 
products are approved quickly, then firms can compete more efficiently 
on product innovation and design. However, if products are approved 
slowly, the incentive for insurers to develop and market new ideas is 
reduced. The problem is exacerbated if a product is approved in one 
State with a certain set of conditions and in another State with a 
different set of conditions, as is presently the case. NAIC's attempts 
to reduce these costs have not been entirely successful. Most recently, 
NAIC has tried to improve the process by the formation of the 
Interstate Insurance Product Regulation Commission (IIPRC) for life 
insurance, an interstate compact. According to information on the 
IIPRC, 36 States and related jurisdictions were members as of July 
2009. However, five large insurance States are missing from the 
compact: New York, California, Illinois, Florida, and Connecticut. \9\
---------------------------------------------------------------------------
     \9\ See http://www.insurancecompact.org/. New York, Illinois, and 
California do have proposed legislation.
---------------------------------------------------------------------------
    3. State-Based Regulation Creates Horizontal Inequity with Other 
Financial Industries--A final point is that the current multistate 
framework puts the insurance industry at a competitive disadvantage to 
other financial services firms offering competing products. 
Noninsurance financial institutions can ask their Federal regulators 
for nationwide approval of a product and receive an answer within a 
relatively short period of time, compared to the time it takes for 
insurers to obtain State approval. This provides these other financial 
institutions a significant advantage over insurers for the marketing of 
similar products. \10\ Furthermore, States are often more restrictive 
on product offerings than is the Federal Government. For example, 
federally regulated financial institutions are permitted to use 
relatively aggressive hedging strategies, which can reduce their risk, 
whereas insurers typically are not. \11\ The market is quickly and 
dramatically changing, yet States typically resist allowing insurers to 
use the strategies commonly used by other financial institutions. It 
may be that State regulators are apprehensive because they lack the 
resources to monitor and evaluate these strategies. A Federal regulator 
with better analytical resources could permit life insurers to engage 
in investment and hedging strategies that would be more appropriate, 
more efficient, and less risky.
---------------------------------------------------------------------------
     \10\ Kelly Greene, ``Mutual Funds Pitch Alternative to 
Annuities'', Wall Street Journal, at D8 (Jun. 9, 2008).
     \11\ Martin F. Grace, et al., ``Insurance Company Failures: Why Do 
They Cost So Much?'' (Washington: American Council of Life Insurers 
2007).
---------------------------------------------------------------------------
B. The Benefits of an OFC
    As explained above, the status quo no longer represents an 
effective means of regulating the U.S. insurance industry. The question 
thus becomes whether the addition of an optional Federal charter \12\ 
will bring more benefits than costs. Although there are costs arising 
from maintaining regulation at two levels of Government, such costs 
should be more than offset by the efficiencies of the emerging Federal 
system. Some also contend an OFC may lead to reduced consumer 
protection since State regulators may be more responsive to local 
complaints due to the political consequences of not doing so. However, 
the Obama administration's proposal for the new Consumer Financial 
Protection Agency, which, as discussed below, should have jurisdiction 
over federally chartered insurers, may greatly alleviate that concern. 
Furthermore, an OFC would reduce the negative externalities imposed on 
out-of-State customers and insurers resulting from the current State-
based regulatory system. Finally, the creation of a Federal chartering 
agency would enable greater cooperation in the international arena 
among the various national insurance regulators. In sum, the need for 
an OFC is clear, and the ongoing financial crisis presents a compelling 
reason and an unparalleled opportunity for meaningful reform of U.S. 
insurance regulation.
---------------------------------------------------------------------------
     \12\ At this time, I do not advocate a mandatory Federal charter 
for all insurance companies, though a mandatory role for the Federal 
Government may be necessary with respect to certain large insurance 
firms. See Part III.A.
---------------------------------------------------------------------------
II. Design of the Regulator of Federally Chartered Insurance Companies
    Apart from possessing the requisite technical expertise, the 
Federal entity created to regulate, supervise, and enforce a new OFC 
regime will have to be situated within the U.S. financial regulatory 
structure. There is also an important issue of whether the Federal 
regulator should charter lines of business or firms.

A. Place in the Regulatory Structure
    From a broad perspective, I believe the overall U.S. financial 
regulatory structure is seriously in need of reform. A rapidly 
dwindling share of the world's financial markets is supervised under 
the fragmented, sectoral model still employed by the United States. In 
May 2009, the Committee on Capital Markets Regulation (CCMR) issued a 
comprehensive report entitled The Global Financial Crisis: A Plan for 
Regulatory Reform that called for the U.S. financial system to be 
overseen by only two, or at most, three independent regulatory bodies: 
the Federal Reserve, a newly created independent U.S. Financial 
Services Authority (USFSA), and possibly another new independent 
investor/consumer protection agency. \13\ I believe this model is the 
right one to replace our highly fragmented and ineffective regulatory 
structure.
---------------------------------------------------------------------------
     \13\ Committee on Capital Markets Regulation, The Global Financial 
Crisis: A Plan for Regulatory Reform 203-210 (May 2009), available at 
http://www.capmktsreg.org/research.html.
---------------------------------------------------------------------------
    Under the CCMR approach, the Federal Reserve would retain its 
exclusive control of monetary policy and its lender of last resort 
function as part of its key role in ensuring financial stability. In 
addition, its regulatory power would be enhanced to deal with systemic 
risk, such as exclusive control of capital, liquidity and margin 
requirements, as well as payment and clearing and settlement. The 
USFSA, on the other hand, would regulate all other aspects of the 
financial system, including market structure, permissible activities, 
and safety and soundness for all financial institutions (and possibly 
consumer/investor protection with respect to financial products if this 
responsibility were lodged within the USFSA). It would comprise all or 
part of the various existing regulatory agencies, such as the Office of 
the Comptroller of the Currency, the Office of Thrift Supervision, the 
Federal Deposit Insurance Corporation, the Securities and Exchange 
Commission, and the Commodities Futures Trading Commission. For its 
part, the Treasury Department would coordinate the work of the two (or 
perhaps three) regulatory bodies, and would be responsible for the 
expenditure of public funds used to provide support to the financial 
sector.
    If the U.S. financial regulatory structure is consolidated and 
improved as CCMR has recommended, then regulation of federally 
chartered insurance companies would be shared, as it would be for 
banks, between the Federal Reserve and the USFSA. The chartering 
authority itself would reside within the USFSA, which would also have 
resolution authority over all insolvent institutions, including 
federally chartered insurance companies. Regulation of insurance would 
thus be independent of the Executive Branch, insulated to some extent 
from political pressures while, at the same time, integrated into the 
overall supervisory framework. The USFSA would work closely with the 
Federal consumer-investor protection regulator--whether it is a 
division within the USFSA or an independent entity along the lines of 
what the Obama Administration envisions. If there is to be a Federal 
charter, then Federal--rather than State--consumer protection laws 
should apply to those institutions. \14\ Some have opposed an OFC out 
of concern that consumer protection would be weakened but this need not 
be the case if a strong, dedicated agency or division of a USFSA were 
created. Furthermore, if a robust Federal consumer protection regulator 
is created, any regulations promulgated by it should entirely preempt 
any relevant State laws or regulations. The same should be true with 
respect to other financial services industries where strong Federal 
consumer protection laws and regulations apply. The need for State 
enforcement may exist under our current weak Federal protection of 
consumers--a need, with its attendant multistate inefficiencies, which 
would not exist in the presence of strong Federal consumer protection.
---------------------------------------------------------------------------
     \14\ Note that the Consumer Financial Protection Agency proposed 
by the Obama Administration does not have consumer protection authority 
over insurance companies. This makes sense as long as these insurance 
companies are exclusively State-regulated. Otherwise, there could be 
irreconcilable conflicts between State safety and soundness and Federal 
consumer protection requirements. To the extent that Federal consumer 
protection requirements overrode State safety and soundness concerns, 
the States, through State guaranty funds, would have to bear the cost. 
If insurance companies become federally chartered, however, both safety 
and soundness and consumer protection regulation could be conducted, 
and reconciled in some fashion, at the Federal level.
---------------------------------------------------------------------------
    We must also consider what a Federal regulator should look like if 
the current sectoral regulatory structure remains in place, i.e., if no 
USFSA-type structure is created. In this respect, it is useful to 
consider how State insurance regulators are organized and funded. The 
typical State insurance regulator is constituted as an autonomous 
agency, formally part of the executive branch, with one chief official 
appointed by the governor. No State insurance regulator appears to 
operate through a multimember commission. A minority of States has an 
elected chief official for insurance, but this structure cannot be 
constitutionally replicated within the Federal administrative 
structure. Another minority of States brings insurance regulation 
within another executive department, which is usually devoted either to 
commerce and consumer affairs or to banking and other financial 
services. State experience suggests that the Federal regulator of 
insurance should be independent of the executive branch--unlike the 
recommendation of the Bush Treasury Department's Blueprint which 
proposed an Office of National Insurance to be part of the Treasury 
Department. \15\
---------------------------------------------------------------------------
     \15\ U.S. Dep't of the Treasury, ``Blueprint for a Modernized 
Financial Regulatory Structure'' 126-133 (Mar. 2008), available at 
http://www.treas.gov/press/releases/reports/Blueprint.pdf.
---------------------------------------------------------------------------
    In addition, the latitude currently given to State insurance 
departments in the setting and collecting of fees suggests that a 
Federal insurance regulator should be self-funding, at least in part. 
Self-funding would further enhance the regulator's degree of 
independence from the political process.

B. Licensing of Firms or Products
    Currently, insurance companies are organized and chartered by the 
States as life-health companies, as property-liability companies, or as 
specialty companies such as title insurers. Legally, a life-health 
insurer can offer various lines or products within its general area, 
such as term life policies, whole life policies, and annuities. 
Similarly, a property-casualty insurer may offer personal auto and 
homeowners, as well as commercial lines like commercial multiperil and 
workers' compensation. So one insurance firm may be chartered through 
different companies to conduct different insurance businesses in the 
same State. Thus, it is common for a number of affiliated insurance 
companies to belong to a group owned by a parent or holding company.
    Some prior proposals, such as the Bush Treasury Department's 
Blueprint, have contemplated Federal chartering by business line, as 
currently exists among the States. \16\ Many have advocated keeping 
property and casualty insurance at the State level. Thus, for a given 
insurance holding company or parent firm, some of its companies and 
products would be chartered and regulated at the Federal level and 
others at the State level. It would therefore be possible for firms to 
have the choice of being regulated at the Federal level for some 
businesses but not others. \17\ I might note that there is a very 
strong case for a Federal licensing option for reinsurance, as this is 
not a consumer product that directly affects the welfare of the 
citizens of a particular State. Although proposals for the Federal 
chartering of distinct business lines have merit, I do not believe they 
are optimal.
---------------------------------------------------------------------------
     \16\ See U.S. Dep't of the Treasury, Blueprint for a Modernized 
Financial Regulatory Structure 129 (Mar. 2008), available at http://
www.treas.gov/press/releases/reports/Blueprint.pdf  (``An OFC should be 
issued specifying the lines of insurance that each national insurer 
would be permitted to sell, solicit, negotiate, and underwrite.'').
     \17\ Minimum capitalization requirements vary by line and by 
State. During the 1990s the National Association of Insurance 
Commissioners (NAIC) sought to harmonize State regulation by adopting 
model minimum risk-based capitalization (RBC) requirements for most 
lines (including life and property-casualty). See for example N.Y. Ins. 
L. sec. 4103; see also. Kathleen Ettlinger, et al., ``State Insurance 
Regulation'' (Malvern, PA: Insurance Institute of America 2005). A 
multistate, multiline insurer generally must meet the greater of its 
minimum RBC requirements or the minimum capital requirements of each 
State in which it is licensed to do business. There is no reason that a 
Federal regulator could not promulgate solvency regulations that would 
be not only equally sensitive to the different risks posed by different 
product lines but also more uniform.
---------------------------------------------------------------------------
    The cleanest and most efficient solution would be to license firms, 
rather than sectors, lines, or functions. Indeed, we have no Federal 
historic experience with the licensing of lines of business: the entire 
national bank or securities firm experience is based on the chartering 
or licensing of firms, not products. I see no reason to depart from 
that practice in this context. Indeed, the financial crisis teaches us 
that one regulator should have authority over an entire firm. It is bad 
enough to divide responsibility at the Federal level for a single firm; 
it would be even worse to do so as between Federal and several State 
authorities.
    An important question related to the operations of the Federal 
regulator is whether it should establish a guaranty fund system similar 
to those present in many States. These funds are in place to compensate 
for the losses suffered by third parties and policyholders due to 
insurance company insolvency. If licensing and regulation of insurance 
activities were to be conducted at the Federal level, for firms 
choosing Federal charters, State guaranty funds would then be at risk 
for Federal regulatory failures. This is the reverse of our past 
problems with State-chartered banks whose regulation put the Federal 
deposit insurance system at risk. This is an inherently unstable 
situation.
    I recommend simply installing a Federal guaranty fund for federally 
chartered insurers. Such a fund would successfully tie Federal 
regulation to a Federal guaranty. There might also be some subsidiary 
benefits of a Federal fund. It would imply uniformity of protection for 
federally chartered insurers. In addition, if a diverse group of 
insurers choose to operate under Federal charter, then there might be 
better pooling of risk as compared with State funds, which have a more 
limited geographic base from which to draw members.

III. Additional Issues To Consider: Mandatory Federal Charter and 
        Capital Requirements
    As I hope to have demonstrated above, State-by-State regulation is 
simply not an effective means of regulating what is truly a complex 
national industry. What is more, I hope to have established a 
persuasive case for an optional Federal charter. Before I bring my 
testimony to a close, there are two additional issues I would like to 
raise for the Committee's consideration.

A. Mandatory Federal Charter for Large Institutions
    The above discussion assumes that Federal chartering will be 
optional. However, it may well be that Federal regulation, if not 
chartering, should become mandatory for large insurance companies over 
a certain asset threshold. Firms that are too big, too interconnected, 
or too complex to fail impose added costs to the Government and, 
ultimately, the taxpayer in the form of Government assistance. These 
institutions are ``systemically important,'' although I do not 
recommend that they be so identified ex ante and publicly by 
regulators, in order to minimize moral hazard and avoid an implicit 
Federal guarantee. In addition, such determinations will be difficult 
to make and could rapidly change for some firms, like hedge funds. In 
most cases, use of a simple metric like size would avoid these 
problems.
    A traditional insurance company may pose less of a systemic risk 
than the typical bank for a number of reasons--they have less leverage 
and interconnectedness. Nevertheless, as the AIG case shows, there are 
certain large insurers that have a potential for imposing systemic risk 
on the economy. To date upwards of $150 billion in taxpayer funds have 
been used in some form or another to bail out AIG. If such firms are to 
be rescued by the Federal Government, it seems reasonable to insist 
that the Federal Government have supervisory and regulatory powers over 
such firms. To be sure, AIG was the exception rather than the rule in 
the insurance industry. AIG's troubles stemmed not from its traditional 
insurance activities but from the derivative business of its holding 
company. That said, the key derivative was the credit default swap, 
which is essentially a type of insurance against the default of a 
specified firm. The failure of an insurance company to honor either its 
derivative or insurance obligations could raise systemic risk concerns.

B. Capital Regulation
    The final issue--but in many ways the most fundamental of all--is 
how to establish an effective capital adequacy regime for insurance 
companies as well as more traditional financial institutions. At the 
center of the global financial crisis was the complete failure of our 
regulatory system to ensure that financial institutions maintained 
sufficient capital cushions. When banks found their individual balance 
sheets unable to sustain declining asset values, capital firewalls 
proved inadequate to prevent the contagion from spreading throughout 
financial markets.
    The case of AIG, as noted above, illustrates the potential for 
insurance companies to suffer similar erosion in their capital bases, 
which can lead to systemic tremors and Government bailouts. A mandatory 
Federal charter for certain large institutions will bring with it 
Federal prudential supervision. But I believe more than supervision is 
needed for large insurers--they should also be subject to robust 
capital requirements established by Federal regulation in conjunction 
with those requirements set for other similarly sized, federally 
regulated financial institutions. The overall methodology for setting 
capital adequacy standards for insurance firms should be different than 
that used for banks and lending institutions, taking into account the 
differing nature and risk of the industry. \18\ Exactly how to set such 
capital requirements for insurance companies--particularly in light of 
the failure of the existing Basel II framework for banks--is beyond the 
scope of this hearing but should be an important part of this 
Committee's agenda.
---------------------------------------------------------------------------
     \18\ See Hal S. Scott, ed., Capital Adequacy Beyond Basel: 
Banking, Securities, and Insurance 3-14 (Oxford University Press 2005).
---------------------------------------------------------------------------
    Thank you and I look forward to answering your questions.
                                 ______
                                 
           PREPARED STATEMENT OF MARTIN F. GRACE, J.D., Ph.D.
  James S. Kemper Professor of Risk Management and Associate Director,
   Center for Risk Management and Insurance Research, Georgia State 
                               University
                             July 28, 2009

Introduction
    Mr. Chairman, Ranking Member Shelby, and Members of the Committee 
good morning and thank you for the opportunity to testify before the 
Committee on the topic of modernizing insurance regulation.
    My name is Martin Grace. I am the James S. Kemper Professor of Risk 
Management at the J. Mack Robinson College of Business at Georgia State 
University. I am also the Associate Director of the Center for Risk 
Management Research and an Associate at the Andrew Young School of 
Policy Studies. I have been at Georgia State for 21 years coming to GSU 
from the University of Florida where I earned a law degree and a Ph.D. 
in economics. Previous to that I attended the University of New 
Hampshire where I earned my undergraduate degree.
    My entire career at Georgia State has been spent conducting 
research in insurance regulation and taxation. Since the industry is 
regulated at the State level, this has been predominately an exercise 
in the study of State regulation. However, the question of whether the 
State is the appropriate level of regulation is becoming more important 
and I have spent the last 4 years thinking about that question.
    This brings me to what I have been asked to talk about today. I 
will focus on three main points in today's testimony.

     First is the value of regulation in insurance industry. 
        There are valid rationales for insurance regulation, but the 
        business of insurance is quite different than banking and has a 
        need for a different style of regulation.

    Second, is a mild but nonetheless important critique, of 
        the current proposals to regulate the insurance industry. An 
        Optional Federal Charter (OFC) is not necessarily the only way 
        to think about insurance regulation. The current proposal is 
        cobbled together from a Federal banking law and decades old 
        State insurance model laws.

    Third, something like the Office of Insurance Information, 
        as source of expertise and an advice to the Federal Government 
        about the insurance industry is needed, but it should not by 
        itself be used to restructure the relationship between Federal 
        and State regulation.

    The question of who should regulate the insurance industry has been 
debated in the United States since the time of the Civil War. Insurance 
continues to be regulated by the States despite several challenges to 
their authority over the years. The States' authority over insurance 
was supported in various courts' decisions until the Southeastern 
Underwriters case in 1944. In Southern Underwriters, the Supreme Court 
determined that the commerce clause of the Constitution applied to 
insurance and that insurance companies (and agents) were subject to 
Federal antitrust law. The Court's ruling caused the States and the 
industry to push for the McCarran-Ferguson Act (MFA) in 1945, which 
delegated the regulation of insurance to the States.
    At that time, the majority of insurance companies favored State 
over Federal insurance regulation. However, today the bulk of insurance 
is written by national (and international) companies operating across 
State borders. Many of these insurers have come to view State 
regulation as an increasing drag on their efficiency and 
competitiveness: these insurers now support a Federal regulatory 
system. This is reflected in recent proposals that would establish an 
optional Federal charter (OFC) for insurance companies and agents. The 
proposal would allow them to choose to be federally regulated and 
exempt from State regulation. As you are quite aware, there is fierce 
opposition to an OFC from the States and from State-oriented segments 
of the industry.
    One of the main problems with the OFC approach is that it is based 
upon a structure designed in the 1860s through the National Banking Act 
and cobbled together with State consumer protection language. The OFC 
approach is based on a view of the world that had changed significantly 
in the last 2 years. While the authors of the proposal now add a 
systemic risk regulator to the mix, they still beg some questions about 
who should be subject to Federal regulation.
    The current problem facing insurance regulation, though, is quite 
different from regulatory issues of the past century. Today's problem 
is not based on regulation of solvency, market conduct, or insurance 
pricing which have been undertaken by the States. It is, instead, the 
problem of systemic risk which, for the most part, has not been an 
issue with the insurance industry. Further, systemic risk is of 
national rather than State in scope. Specifically, the types of market 
failures used historically to justify regulation of the insurance 
industry have been ones that pertain to local markets. This is in 
direct contrast to the effects a failure of a company like AIG has on 
national and international markets.

Why Regulate Insurance?
    Economists believe the role of Government is to rectify market 
failures. \1\ In the insurance industry, potential market failures are 
due, in essence, to imperfect information. Customers cannot, for 
example, observe the behavior of insurance company management. For a 
life insurance consumer, this might be important because of the long 
time between when a contract is purchased and when a payout might 
occur. Also, there is no effective way to discipline the insurer's 
management. For example, a life insurance consumer cannot ``punish'' a 
``bad'' company by exchanging his long term policy for one with another 
insurer. Thus, economists would argue that Government can and should 
monitor a firm's solvency position and take action to prohibit insurer 
actions which reduce the value of life insurance contracts.
---------------------------------------------------------------------------
     \1\ See Skipper and Klein (2000) for a more thorough treatment of 
how economists think about the regulation of insurance.
---------------------------------------------------------------------------
    A second potential market failure is related to the imperfect 
information embodied in the insurance contract itself. An insurance 
contract is a complicated financial agreement, so the Government could 
standardize contracts or approve contract language to reduce errors and 
misunderstandings in the contracting process. \2\
---------------------------------------------------------------------------
     \2\ This standardization is common in personal lines products 
(like homeowners and auto), but it does not always solve all problems 
as there are new problems with contract interpretation that are costly 
to resolve. The Katrina wind/water litigation is just an example of 
this problem.
---------------------------------------------------------------------------
    A third informational problem might arise from an insurer's 
strategy and marketing structure. Because insurers have different 
marketing (direct versus independent agents) approaches and different 
levels of capital backing, shopping for the right policy is costly to 
consumers because they do not have the information to make accurate 
judgments about the services and the quality of services provided by 
insurers. Arguably, the Government could guarantee a level of service 
after a claim or set prices so that a consumer would know that the 
contract is priced fairly. In addition, prices could be set to keep 
insurers from using their market power to exploit consumers through 
higher prices. This last rationale is often provided for price 
regulation of insurance, even though most personal lines insurance 
markets (which are the most likely to be regulated) are competitive 
markets. There are many competitors in these markets which reduces the 
likelihood of any one of firms being able to influence prices 
(Tennyson, 2007).
    These arguments form the standard historical rationales for 
insurance regulation. A further rationale, with a more immediate 
application in banking regulation, is that regulators should prevent 
market failure caused by the externality of one bank failure leading to 
a loss of consumer confidence in the financial system and other bank 
failures should be prevented. Banks have solvency regulation to protect 
depositors and to defend the banking system from contagion risk. 
Historically, insurers did not present a real contagion risk to the 
financial system, but this may no longer be true. Financial companies 
are now interconnected in ways that are without historical precedent. 
Holding companies have evolved which contain many different types of 
regulated and unregulated firms. A bank with an insurer as part of its 
operations can extend the contagion risk to its insurance operations. 
Alternatively, an insurer with a large and unregulated derivative 
trading business which suffers large losses can trigger questions about 
the overall soundness of the insurance operations. Counter parties to 
trades by such an unregulated entity can cause significant harm and 
potentially disrupt the banking system. In insurance, the focus of 
regulation has been on the individual company and not on the group or 
holding company. This needs to change, at some level, to allow for the 
proper accounting of systemic risk. \3\ A State regulator cannot 
realistically regulate an insurer for its possible systemic affects on 
national and international markets especially in situations where the 
insurer within the State is a separately organized corporation from the 
corporation which might induce a systemic risk issue.
---------------------------------------------------------------------------
     \3\ Prior to the introduction of the National Insurance Consumer 
Protection Act and the creation of a systemic risk regulator, I thought 
legislation that granted the Federal Reserve the right to assess 
systemic risk through the use of normal administrative agency powers of 
investigation would be sufficient for any firm that might create 
systemic risk. New legislation which sets up a formal systemic risk 
regulator will likely spell out these powers and their scope in more 
detail.
---------------------------------------------------------------------------
The Level at Which Regulation Should Be Applied
    Ideally regulation should be applied at the level where the 
greatest costs and benefits due to the regulation arise. A simple 
example would be the proper placement for restaurant safety inspections 
versus airplane safety inspections. Local governments would be the 
obvious choice for restaurant cleanliness because local patrons would 
obtain the benefits and bear the costs of the safety inspections. In 
contrast, airplane safety inspections costs and benefits are national 
in scope and air travel is conducted nationwide. Thus it makes sense 
for air safety to be regulated at the national level.
    A large percentage of insurance premiums are written interstate. If 
there are interstate externalities to insurance regulation, then it 
makes sense for the Federal Government to regulate it. Phillips and 
Grace, in a 2007 paper, document some of these interstate externalities 
in terms of how States can export the costs of regulation to other 
States. The authors were not able to measure the benefits of 
regulation, so it is not possible to provide a conclusion about the 
role of Federal versus State regulation.
    Some of the benefits of State regulation are that local tastes and 
preferences are best met by State legislatures responding to local 
voters' concerns about the insurance industry. This is often touted as 
a rational for federalism. Yet, I suspect that with some exceptions 
(price regulation, for example) a few voters could discuss their 
State's insurance regulations. Due to diverse State regulations, 
nationwide companies often have significant compliance costs which 
increase the price of insurance without providing any benefits provided 
by a federalist laboratory. States do not look to see if there is a 
better way to regulate insurance. So, there is tremendous inertia in 
State's regulatory processes and it is a rare event that causes all 
States to act together.
    If the criterion for a State-based insurance regulatory system to 
be successful is that States must regulate to minimize compliance 
costs, then the current State regulation of insurance is doomed to 
failure. One of the major rationales for Federal regulation is 
reduction of nationwide insurer costs of trying to satisfy multiple 
States' regulators. The NAIC has stated that it is trying to reduce 
these types of costs through model legislation and interstate compacts. 
Its good intentions notwithstanding, it is not capable of getting the 
States to operate quickly and efficiently together. Even Congress 
cannot obtain quick compliance from the States. In the Gramm-Leach-
Bliley Act of 1999, Congress mandated that the States set up a 
nationwide licensing system for agents. After 10 years, not all of the 
States participate in this system to reduce multistate licensing costs. 
\4\
---------------------------------------------------------------------------
     \4\ A recent report (NAIC, 2008) states that 43 States are in 
compliance. What is important is that three important States (FL, NY, 
and CA) are not in compliance some 9 years after enactment of the 
Gramm-Leach-Bliley Act. Without the large States participation, 
compliance costs are not reduced and the supposed benefits of increased 
State cooperation as a reason for avoiding an OFC bill are illusory.
---------------------------------------------------------------------------
    In 2007, for example, the NAIC proposed the Military Sales Model 
Practices Regulation as a result of a law enacted by Congress in 2006. 
This regulation is designed to protect young soldiers, sailors, 
marines, and airmen from aggressive sales tactics directed at military 
personnel. As of late last year, only 18 States have enacted it. 
Presumably, this was an important issue for Congress, yet it has not 
been adopted by a majority of States in its first 2 years. Depending on 
universal action among the States to enact laws that prompt action is 
just not feasible. Grace and Scott (2009) document a number of other 
examples which suggest that joint actions by the States are never going 
to be able to solve national problems regarding compliance costs and 
uniformity quickly and efficiently.

The Potential Federal Role and Regulatory Modernization
    There is a role for the Federal Government in insurance regulation. 
Where it can succeed and be economically valuable is in the area of 
removing the costs of conflicting State laws and reducing the effect of 
systemic risk on all financial markets. Reduction of compliance costs 
is the rationale behind the 2009 OFC proposal introduced by 
Representatives Bean and Royce called the National Insurance Consumer 
Protection Act. The new proposal includes the role of a systemic risk 
regulator who will have the authority to mandate that certain insurers 
be federally chartered companies. \5\ With the exception of this 
concept, there is little modern thinking in the NICPA about how 
insurance regulation should work.
---------------------------------------------------------------------------
     \5\ Essentially, there is a double option on the table now. From 
the description in the press, insurers could opt to become federally 
chartered, but the Federal Government could opt to regulate a State 
chartered company if part of a holding company that might create a 
systemic risk.
---------------------------------------------------------------------------
    The authority of the systemic risk regulator is very important. It 
is only now being discussed. However, how this is undertaken can cause 
significant disruptions in markets. If the risk regulator's authority 
is associated with a ``too-big-to-fail'' certification, then the 
underlying competitive insurance market might be at risk. Firms 
designated as ``too big to fail'' will have an implicit incentive to 
take on more risk (sell more insurance and other risky products) 
knowing the Government will provide assistance. A rational firm may 
decide not to compete in that market. Thus underlying insurance markets 
are likely to wither away leaving only those firms that are too big to 
fail.
    If all insurers are subject to the systemic risk regulator's 
jurisdiction, there is no signal that every firm is too big to fail. 
However, most insurers will never be systematically important but will 
be subject to another layer of regulation that does little for its 
customers, its shareholders, or society in general. Even large, 
significant insures operating nationwide are not necessarily important 
from a systemic risk perspective. So the question becomes how does one 
determine whether a firm should be subject to risk regulation? Ideally, 
one would want firms undertaking risk outside of insurance risks to 
fall under the authority of the risk regulator. For example, suppose a 
future AIG-like company petitions its primary regulator to exempt its 
``Financial Products'' subsidiary from insurance regulation. Because of 
that exemption, the firm should fall under the jurisdiction of the risk 
regulator. The risk regulator can examine the risk and require 
appropriate reserving techniques if needed. \6\ By having to show the 
risk regulator the insurer's underlying business model a specific 
finding can be made if a systemic risk is possible and remedies to 
mitigate the systemic risk can be implemented. Ideally what the risk 
regulator's job would be is to prevent possible systemic risks through 
evaluation by a competent regulator.
---------------------------------------------------------------------------
     \6\ Note, though, that if New York did not exempt the AIG 
Financial Products subsidiary and treated it like a bond insurer it 
would have had some level of reserves. Further, because it would have 
to place reserves for each new bond insured it would have also limited 
the scope of the sale of CDSs as well as the scope of the eventual 
losses.
---------------------------------------------------------------------------
    One of the dangers of merely just prohibiting financial innovation 
is that economically valuable innovations would never evolve. However, 
permitting financial innovation without proper reserving is also 
harmful to society. Thus, the risk regulator must be more sophisticated 
about these products than a typical State insurance department in two 
ways. First, it must be able to understand the product and its risks. 
Second, it must appreciate the rewards of such innovation.

Problems With Current Federal OFC Proposals
    As mentioned above, the OFC proposal is cobbled together from 
banking and insurance law. There has been little discussion of the 
structure of a regulatory body from a fresh perspective. A recent paper 
by Grace and Scott (2009) examined a portion of the issue from an 
administrative law viewpoint and showed how little discussion there was 
of how a Federal insurance regulator should be organized. There are a 
number of regulatory models available in the United States. For 
example, there is the multicommissioner, administrative body like the 
SEC. This is in direct contrast to the single administrator overseeing 
the Office of the Comptroller of the Currency. There is also an 
independent (from the executive branch) administrative agency like the 
Federal Reserve Board of Governors. Again, this contrasts directly with 
the administrator of the Office of the Comptroller of the Currency. The 
fact that the 2009 OFC proposal merely copies the structure of the 
banking system and begs the question why is the national banking system 
structured this way? The Treasury Blueprint as well as others (see, 
e.g., Brown (2008)) discuss other options. What is noteworthy is that 
these options were not conditioned on the current financial crisis. The 
Blueprint's proposal is to use a three-pronged regulatory approach with 
a systemic risk regulator, a solvency regulator, and a market conduct 
regulator that would oversee all financial services including 
securities and commodities trading. This would be a major innovation in 
financial regulation in the United States. The OFC bills, in contrast, 
are not innovative from the perspective of what is regulated or how the 
regulation is accomplished as the approach in both bills (with the 
exception of a systemic risk regulator) is to shift traditional 
regulatory powers from the States to the Federal Government.
    Other methods of regulation of the insurance industry are also 
possible. Some insurers have joined unofficial self-regulatory 
organizations like the Insurance Marketplace Standards Association 
(IMSA) to increase their ability to understand their customers and to 
increase the likelihood that their policies will more closely meet the 
needs of those customers. These types of standards are different from 
State-based rules which are often decades old and have not suffered an 
across-the-board reexamination, except after a regulatory failure. From 
a practical point of view, Congress is not likely to delegate 
monitoring powers to private entities for some time. The approach of 
organizations like IMSA, can assist in the development of modern 
approaches to market conduct regulation.
    In sum, there has been no real systematic discussion of 
modernization of the regulatory approach over the last decade outside 
of allowing for greater integration of financial services through 
enactment of the Gramm-Leach-Bliley Act of 1999 (GLB). Other than 
allowing banks and insurers to be owned by a common parent, GLB did not 
change the content of insurance regulation beyond mandating that States 
attempt to resolve interstate differences in agency licensing. Other 
important substantive aspects of insurance regulation have not been 
reexamined. For example, there has been little, until recently, 
discussion of the proper and economically efficient regulation of risk.
    In addition, solvency regulation has not been scrutinized since 
Congress made States and the NAIC do so in the late 1980s and early 
1990s. Bank regulators have adopted aspects of the Basel accords, but 
insurance regulators have not. Many insurers are complying with Basel 
II by developing their own capital models and the tests which support 
the models. They are not required to do so by law but are doing it to 
be responsible stewards of capital. To be fair, there has been an 
attempt to standardize certain product approval processes through the 
use of the new Interstate Insurance Product Regulation Commission. 
However, the Commission has taken time to get started and was created, 
at least in part, to stave off any OFC type of regulation. This history 
of insurance regulation suggests that State regulation in this area is 
reactive. Regulation only changes because of a crisis or Congressional 
pressure. It is interesting that Congress (and not the States) also 
proposed the SMART Act that would have preempted the States' ability to 
regulate and transferred that authority to the Federal Government. This 
proposed Act started a conversation about regulation, but it did not 
address the fundamentals--just what level of regulation is appropriate 
for insurance. The OFC bills have structured this debate in such as way 
as to eliminate discussion of reform. Given that many aspects of 
regulation are important, more reform ideas should be on the table.

A Role for an Office of Insurance Information
    A proposed Office of Insurance Information (OII) is an important 
first step in any role the Federal Government may have in the future. 
Even if the Federal Government decides in the near future to pass on 
regulating the insurance industry the OII still may be an important 
innovation for three main purposes. First, there is a paucity of 
individuals at the Federal level who know its component industries, its 
market structures, its products, its taxation or its pricing. Further, 
because of the unique nature of insurance (e.g., premiums are received 
now and claims are paid at some future time), there are a number of 
important technical accounting and actuarial issues that need to be 
understood regarding reserving and pricing. This type of knowledge 
currently resides at the State level.
    One could argue that the NAIC or National Council of Insurance 
Legislators (NCOIL) could provide this type of information to the 
Federal Government, but there is no real incentive for them to do so 
unless these organizations think by doing so they can postpone or 
reduce the likelihood of any eventual Federal regulation. Further, 
having to rely upon other organizations which have their own agendas 
for the needed insurance expertise has its own costs.
    Finally, there is an important issue that may arise depending upon 
the powers granted to the OII. Because financial markets are 
international in scope the Federal Government is often on the forefront 
of negotiation with other countries about regulation and international 
cooperation in regulation. By providing negotiators with information 
about the industry better policy can be made. However, the main point 
here is not likely information provision to negotiators, but the real 
possibility of the OII having (or eventually obtaining) the ability to 
preempt State laws inconsistent with international accords. Many 
foreign companies (and governments) view State insurance regulation as 
a barrier to entry (See, e.g., Cooke and Skipper, 2009). The OII and 
the Federal Government, through preemption, could conceivably dismantle 
the current system of State regulation.
    This would be a piecemeal change of the insurance regulatory system 
that would likely lead to real disruptions in regulation. However, a 
top down reexamination of the regulation of the industry would provide 
for a more systematic review of the proper role of the Federal and/or 
State regulatory power.

The Role of the State and Federal Governments in the Future of 
        Insurance Regulation
    The future role of States in insurance regulation is in question. 
There are serious barriers to coordination among the States which 
prohibit them from being effective regulators on certain issues. There 
is also a dearth of expertise on insurance at the Federal level. In 
addition, because of the predominance of nationwide operations, there 
are potential externalities that can be remedied by a Federal approach 
to regulation. To be fair, there are also potential problems with 
Federal regulation that need to be addressed. State regulation does 
protect the industry from bad regulation in the sense that if a State 
were to make a serious error regarding regulation, the negative effects 
of the error will likely be most felt in the State with the ``bad'' 
regulation. In contrast, a mistake at the Federal level hurts the 
entire industry nationwide. Further, merely copying State regulation 
without thinking about the merits of the regulation is also 
inefficient. A third and final problem with Federal regulation is the 
possibility that risks that previously were insured in private markets 
may become more socialized in the sense that Federal regulations may 
reduce the ability of private insurers to set risk based prices.

Conclusion
    The policy debate regarding the regulation of insurance concerns 
the appropriate level of regulation for the industry. Ideally, the 
appropriate level of Government would be the one that would be able to 
contain all of the benefits and costs of regulation within the State 
(or Federal level) borders. Further, it is possible solvency and market 
regulation conduct arguably can be conducted at the Federal level at 
lower cost to society than separate State regulation of these same 
activities. Evidence suggests there are some economies of scale in 
these activities and the costs of regulation are spread beyond the 
borders of a single State.
    Insurance regulation needs to move beyond this level of discussion. 
It is important, but the other aspects of regulatory improvements must 
not be forgotten. The proposed 2009 version of the OFC bill does 
address the issue of systemic risk. While this is important to prevent 
future events like AIG, it is not clear how relevant it is for a 
supermajority of other insurers. However, if a risk regulator bill is 
passed, one could predict we would have a better understanding of the 
relationships between various aspects of the financial service 
industries. This is a beneficial aspect of the law, but there is still 
avoidance of real subject matter regulatory reform.
    Finally, I am pessimistic about the role for the State in the 
future of insurance regulation. States have absolutely no ability or 
incentive to be proactive. At best they are reactive and cannot reach 
anything like a consensus when one is needed. The perfect example is 
the inability for every State to integrate its agency licensing system 
or join an interstate product licensing commission, even in the face of 
Federal preemption of a significant part of regulatory authority. Thus, 
a State-based understanding and appreciation of systemic risk and how 
it should be treated in a holding company structure is not likely to be 
implemented on a relatively uniform base any time soon.

Extended Bibliography
Baily, Martin Neil, Robert E. Litan, and Matthew S. Johnson. 2008. The 
    Origins of the Financial Crisis. In Fixing Finance Series, 
    Washington: The Brookings Institution.
Butler, Henry N., and Larry E. Ribstein. 2008. A Single-License 
    Approach To Regulating Insurance. Regulation 31.4 (Winter):36-42.
Commissioners, National Association of Insurance. 2008. Producer 
    Licensing Assessment Aggregate Report of Findings. Kansas City, MO: 
    NAIC.
Cooke, John, and Harold D. Skipper. 2009. An Evaluation of U.S. 
    Insurance Regulation in a Competitive World Insurance Market, In 
    The Future of Insurance Regulation, edited by M.F. Grace and R.W. 
    Klein. Washington: The Brookings Institution Press.
Congleton, Roger D. 2009. On the Political Economy of the Financial 
    Crisis and Bailout of 2008. Fairfax, VA: Center for the Study of 
    Public Choice, George Mason University.
Cummins, J. David. 2000. Deregulating Property-Liability Insurance: 
    Restoring Competition and Increasing Market Efficiency, Washington: 
    Brookings Institution Press.
Day, John G., United States Department of Transportation Automobile 
    Insurance and Compensation Study. 1970. Economic Regulation of 
    Insurance in the United States. Washington: USGPO.
Grace, Martin F. 2009. A Reexamination of Federal Regulation of the 
    Insurance Industry, Networks Financial Institute Policy Brief No. 
    2009-PB-02. Available at SSRN: http://ssrn.com/abstract=1350538.
Grace, Martin F., and Robert W. Klein. 2009. Insurance Regulation: The 
    Need for Policy Reform, In The Future of Insurance Regulation, 
    edited by M.F. Grace and R.W. Klein. Washington: The Brookings 
    Institution Press.
Grace, Martin F., and Hal S. Scott. 2009. Optional Federal Chartering 
    of Insurance: Rationale and Design of a Regulatory Structure. In 
    The Future of Insurance Regulation, edited by M.F. Grace and R.W. 
    Klein. Washington: The Brookings Institution Press.
Grace, Martin F., Robert W. Klein, and Richard D. Phillips. 2008. 
    Insurance Company Failures: Why Do They Cost So Much? SSRN.
Harrington, Scott E. 2006. Federal Chartering of Insurance Companies: 
    Options and Alternatives for Transforming Insurance Regulation. 
    Networks Financial Institute Policy Brief No. 2006-PB-02. Available 
    at http://www.networksfinancialinstitute.org/Lists/
    Publication%20Library/Attachments/36/2006-pb-02_Harrington.pdf
Insurance Information Institute. 2009. Compulsory auto/uninsured 
    motorists. III 2009 [cited February 20 2009]. Available from http:/
    /www.iii.org/media/hottopics/insurance/compulsory/.
Kaminski, Janet L. 2006. Territorial Rating for Auto Insurance. In OLR 
    Research Report. Hartford: Connecticut General Assembly.
Knowlton, Donald. 1960. Present Status of the Investigation of the 
    Business of and the Regulation of Insurance by the Antitrust 
    Subcommittee of the United States Senate, Insurance Law Journal 
    1960:641-652.
Rothstein, Mark A. 2004. Addressing the Emergent Dilemma of Genetic 
    Discrimination in Underwriting Life Insurance. Cambridge, MA: MIT 
    Press.
Scott, Kenneth E. 1977. The Dual Banking System: A Model of Competition 
    in Regulation. Stanford Law Review 30 (1):1-50.
Skipper Jr., Harold D., and Robert W. Klein. 2000. Insurance Regulation 
    in the Public Interest: The Path Towards Solvent, Competitive 
    Markets. Geneva Papers on Risk & Insurance--Issues & Practice 25 
    (4):482-504.
Tennyson, Sharon L. 2007. Efficiency Consequences of Rate Regulation in 
    Insurance Markets. Networks Financial Institute Policy Brief 2007-
    PB-03. Available at http://www.networksfinancialinstitute.org/
    Lists/Publication%20Library/Attachments/15/2007-PB-03_Tennyson.pdf.
U.S. Department of the Treasury. 2008. Blueprint for a Modernized 
    Financial Regulatory Structure.
U.S. Treasury, Comptroller of the Currency. 2003. National Banks the 
    Dual Banking System. Washington: USGPO.
Willenborg, Michael. 2000. Regulatory Separation as a Mechanism To Curb 
    Capture: A Study of the Decision To Act Against Distressed 
    Insurers. The Journal of Risk and Insurance 67 (4):593-616.

        RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN
                    FROM TRAVIS B. PLUNKETT

Q.1. If Congress were to establish an optional Federal charter, 
how can we be sure that there would be effective consumer 
protections, for the products and services offered and 
stringent regulation of the qualifications of insurance 
professionals?

A.1. The Consumer Federation strongly recommends against 
creating a Federal insurance charter that is optional. Allowing 
insurance companies to chose whether they are regulated at 
either the Federal or State level puts pressure on both sets of 
regulators to reduce consumer protections through regulatory 
arbitrage. Any Federal role in insurance regulation must not be 
optional for insurers. The best way to keep the strengths of 
State insurance regulation, while improving consumer 
protections and uniformity of regulation, would be to establish 
Federal minimum standards. That is the approach the President 
has recommended regarding credit-based insurance in his 
proposal to establish a Consumer Financial Protection Agency.

Q.2. Could the implementation of an optional Federal charter 
for the insurance industry create an environment for regulator 
shopping?

A.2. Yes. That is exactly what has happened with the dual 
charter banking system, and with multiple Federal banking 
charters, which is a model we should seek to avoid with 
insurance regulation.

Q.3. The Administration's proposed Consumer Financial 
Protection Agency (CFPA) would have authority to regulate 
credit insurance, mortgage insurance, and title insurance. 
Should the CFPA also have authority to regulate other insurance 
products and services? What would be the benefits and drawbacks 
of giving the CFPA that authority?

A.3. CFA strongly supports providing the CFPA with authority to 
establish minimum regulatory standards for credit-related 
insurance, such as credit insurance, mortgage insurance and 
title insurance. The sale of these products is obviously 
closely tied to credit transactions over which the CFPA would 
have authority and have been the subject of many abusive 
practices, such as deceptive sales practices and significant 
overpricing. Providing the CFPA with authority to set minimum 
consumer protection standards for other property-casualty 
insurance products and services might well be a very good idea 
and should be studied. The main advantage of such an approach 
would be to require the many States that have not had the will 
or the resources to establish meaningful consumer protection 
requirements regarding insurance rates, forms and claims 
practices, while allowing the States that have been effective 
regulators to continue to establish strong standards. A 
potential disadvantage is that insurance companies could try 
ensure that these standards are weak, as they have successfully 
done in many States, and then federally preempt effective 
regulation in the handful of States that now guarantee strong 
consumer protection standards.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN
                        FROM BAIRD WEBEL

Q.1. If Congress were to establish an optional Federal charter, 
how can we be sure that there would be effective consumer 
protections, for the products and services offered and 
stringent regulation of the qualifications of insurance 
professionals?

A.1. Under an optional Federal charter, the substance of 
protections for insurance consumers and the qualifications for 
insurance professionals would be determined by the Federal 
regulator according to the law enacted by Congress. While some 
optional Federal charter proposals have been criticized as 
containing fewer consumer protections than current State 
regulations, the substance and the locus of regulation are 
issues that can be considered separately. If a particular State 
were considered to have effective consumer protection 
regulation, the Federal system could adopt a similar approach.

Q.2. Could the implementation of an optional Federal charter 
for the insurance industry create an environment for regulator 
shopping?

A.2. Yes. This is a danger in any system where the regulated 
can choose their regulator. One central factor would be the 
ease of changing from one regulator to another, either in a 
legal sense or in a practical sense. It is possible that a 
Federal charter might have specific restrictions on changing 
regulators, such as those contained in H.R. 1880, which 
specifically gives the Federal regulator the power to deny a 
conversion from the Federal to the State system. It is also 
possible that practical factors may limit the attractiveness of 
switching regulators. For an insurer to convert from a Federal 
insurance charter to operating in the current State system 
would require regulatory submissions and approvals in the 
individual States, which could potentially be costly and time 
consuming.

Q.3. The Administration's proposed Consumer Financial 
Protection Agency (CFPA) would have authority to regulate 
credit insurance, mortgage insurance, and title insurance. 
Should the CFPA also have authority to regulate other insurance 
products and services? What would be the benefits and drawbacks 
of giving the CFPA that authority?

A.3. Giving the CFPA the authority to generally regulate 
insurance products and services would be a substantial increase 
in direct Federal authority over insurance. This could make it 
more straightforward for Members of Congress to address 
concerns that might arise over insurance products. Under the 
current system, should a Member of Congress have a specific 
concern over, for example, whether or not auto insurance rates 
should change based on a driver's zip code, the Member may 
consider two questions. First, is the substance of the 
regulatory change desirable, and second, should it be the 
Federal Government, as opposed to the States, regulating 
insurance in this way? If so, it may also be unclear who in the 
Federal Government would enforce the desired regulation. 
Including all forms of insurance under the CFPA would resolve 
many questions about the locus, though not the substance, of 
proposed Federal regulation.
    Currently, insurance regulation at the State level has 
resulted in a patchwork system with somewhat different consumer 
protections across States. CFPA authority over insurance could 
significantly harmonize this system, could leave it essentially 
intact, or could result in even more disparities due to 
overlapping State and Federal regulation. Which outcome might 
occur depends largely on future CFPA regulations and court 
decisions.
    Under the proposed CFPA language, Federal consumer 
protection regulations are essentially a floor--the Federal law 
would not preempt State laws and regulations that provide 
greater consumer protection than the Federal regulation. The 
CFPA itself decides what constitutes greater consumer 
protection, subject to court review. Federal banking regulators 
have historically interpreted broadly their preemption powers 
over State regulations; however, whether this would continue 
under the CFPA is unclear. What the substance of the CFPA 
regulations might be with regard to insurance is especially 
hard to predict as there is little existing Federal law dealing 
with insurance consumer protection.
    One particular flashpoint could be a CFPA decision as to 
whether rate regulation in insurance constituted greater or 
lesser consumer protection, and thus whether it might be 
subject to Federal preemptions. Many States have forms of 
direct control over insurance rates. Such controls have largely 
been removed from Federal banking and securities regulation. 
Some argue that rate regulation should be considered a 
fundamental form of consumer protection, while others argue 
that it harms consumers through market distortions.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
                        FROM BAIRD WEBEL

Q.1. What would be the effect of an optional Federal charter on 
State guarantee funds and State budgets? How are these issues 
addressed in legislation in Congress or proposed by the 
Administration?

A.1. State budgets receive significant revenues from the 
insurance industry. State taxes on insurance premiums amounted 
to more than $15 billion in 2008 and assessments, fines, and 
fees added approximately $3.3 billion to this. Federal 
chartering legislation typically has included language (e.g., 
Section 321 of H.R. 1880) giving States the authority to 
continue taxing the premiums of national insurers. Assuming 
such language, an optional Federal charter should have little 
impact on State premium tax revenues. The money received by 
States in assessments, fines, and fees, however, may be 
affected. The extent of the impact would depend on precisely 
how many insurance companies and producers left the State 
system for a Federal charter or license. This is very difficult 
to predict, as it would largely depend on the specific details 
of Federal regulation and possible responses by the States to 
make the State system more attractive.
    How State guarantee (or guaranty) funds might be addressed 
under a Federal charter is less straightforward than the 
premium tax issue, since guaranty funds are typically connected 
in some way to the safety and soundness regulation designed to 
prevent failure in the first place. CRS Report RL32175, 
Insurance Guaranty Funds, addresses guaranty funds in detail, 
and I will summarize some of the issues here. State guaranty 
funds are largely integrated into the State insurance 
regulatory system, so that those who oversee the insurers day-
to-day are also essentially responsible for dealing with 
insurer failures if they occur. In nearly every State, the 
funds needed to pay for insurer insolvencies are raised by 
after-the-fact assessments on insurers licensed in the State. 
Thus, the regulatory incentives and power are relatively 
closely aligned and focused on avoiding insurer insolvency. 
Creating a dual regulatory system could change these incentives 
in that the day-to-day insurance regulators may no longer be 
the primary actors responsible for addressing insurer failures, 
or the funding to pay for an insurer failure may come from 
insurers outside the purview of the entity overseeing the 
insolvency. Some fear that this could weaken the focus on 
preventing insurer insolvency.
    The treatment of guaranty funds has differed in past 
Federal chartering legislation. The current National Insurance 
Consumer Protection Act (H.R. 1880) would create a Federal 
guaranty fund to handle insolvencies of national insurers, 
while also requiring national insurers to participate in the 
State guarantee fund system. In the 110th Congress, the 
National Insurance Act of 2007 (S. 40/H.R. 3200) would have 
required all federally licensed insurers to participate in 
State guaranty funds, with the possibility of a Federal 
guaranty fund if the State guaranty funds do not treat national 
insurers in the same manner as State insurers. Versions of the 
National Insurance Act (S. 2509/H.R. 6225) were also introduced 
in the 109th Congress. In the 108th Congress, the Insurance 
Consumer Protection Act of 2003 (S. 1373) would have 
established a prefunded national insurance guaranty association 
and required all interstate insurers to pay into the fund. In 
the 107th Congress, the Insurance Industry Modernization and 
Consumer Protection Act (H.R. 3766) would have required all 
insurers electing Federal regulation to participate in State 
guaranty associations.
    Guaranty funds, along with the vast majority of insurance 
regulation, are not addressed in the financial regulatory 
reform proposals recently advanced by the Administration.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN
                       FROM HAL S. SCOTT

Q.1. If Congress were to establish an optional Federal charter, 
how can we be sure that there would be effective consumer 
protections, for the products and services offered and 
stringent regulation of the qualifications of insurance 
professionals?

A.1. This could be done by creating a new consumer financial 
protection agency that had jurisdiction over these matters. 
Perhaps preferable would be to lodge this function in a 
division of a new consolidated supervisor and regulator, a U.S. 
Financial Services Authority. These options are discussed in 
the May 2009 Report of the Committee on Capital Markets, The 
Global Financial Crisis: A Plan for Regulatory Reform.

Q.2. Could the implementation of an optional Federal charter 
for the insurance industry create an environment for regulator 
shopping?

A.2. Clearly the option of a Federal or State charter does 
provide this opportunity. This issue could be addressed by 
having a mandatory Federal charter for the largest or most 
interstate insurance companies.

Q.3. The Administration's proposed Consumer Financial 
Protection Agency (CFPA) would have authority to regulate 
credit insurance, mortgage insurance, and title insurance. 
Should the CFPA also have authority to regulate other insurance 
products and services? What would be the benefits and drawbacks 
of giving the CFPA that authority?

A.3. It is problematic to have Federal consumer regulation of 
any services provided by State regulated insurance companies. 
This concern would become even more serious if the scope of 
CFPA regulation of insurance products were expanded. In 
general, Federal regulation of consumer protection for 
insurance products would create the situation in which Federal 
regulation could make insurance providers less financially 
sound, with the potential consequence that State guaranty funds 
would bear the costs. While excluding consumer regulation of 
banking products from the purview of the banking agencies also 
raises the conflict between consumer protection and safety and 
soundness, that conflict is entirely at the Federal level and 
thus is more easily resolved. The same could be said for 
federally regulated insurance companies (as a result of either 
optional or mandatory Federal charters), assuming there were 
also Federal guaranty funds.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN
                      FROM MARTIN F. GRACE

Q.1. If Congress were to establish an optional Federal charter, 
how can we be sure that there would be effective consumer 
protections, for the products and services offered and 
stringent regulation of the qualifications of insurance 
professionals?

A.1. Answer not received by time of publication.

Q.2. Could the implementation of an optional Federal charter 
for the insurance industry create an environment for regulator 
shopping?

A.2. Answer not received by time of publication.

Q.3. The Administration's proposed Consumer Financial 
Protection Agency (CFPA) would have authority to regulate 
credit insurance, mortgage insurance, and title insurance. 
Should the CFPA also have authority to regulate other insurance 
products and services? What would be the benefits and drawbacks 
of giving the CFPA that authority?

A.3. Answer not received by time of publication.
