[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
__________
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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.
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\5\ P.L. 106-102, 113 Stat. 1338.
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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.
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\6\ See CRS Report R40438, Ongoing Government Assistance for
American International Group (AIG), by Baird Webel.
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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.
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\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.
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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\
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\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.
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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.
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\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.
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\10\ 15 U.S.C. 1011.
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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\
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\11\ See CRS Report RS22506, Surplus Lines Insurance: Background
and Current Legislation, by Baird Webel.
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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\
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\12\ See CRS Report RL32176, The Liability Risk Retention Act:
Background, Issues, and Current Legislation, by Baird Webel.
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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).
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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).
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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.
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\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.
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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\
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\9\ See http://www.insurancecompact.org/. New York, Illinois, and
California do have proposed legislation.
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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).
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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.
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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\
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\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.
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\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.
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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.
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\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.
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\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.
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\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.
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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\
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\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.
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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.
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\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.
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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.
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\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.
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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.
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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.
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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.