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The Future of Insurance Regulation in the United States
Brookings Institution Press
Copyright © 2009 Brookings Institution Press
All right reserved.
ISBN: 978-0-8157-0286-3
Chapter One
The Future of Insurance Regulation: An Introduction Martin F. Grace and Robert W. Klein
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 court decisions until the Southeastern Underwriters case in 1944. In that case, 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, since the passage of the MFA the bulk of insurance is now 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 and 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 that would allow them to choose to be federally regulated and exempt from state regulation. However, there is fierce opposition to an OFC among the states and state-oriented segments of the industry.
Since the Gramm-Leach-Bliley Act (GLBA) was enacted in 1999, there has been increasing interest in Congress and significant sectors of the insurance industry to establish some form of federal insurance regulation. The GLBA provided the opportunity for banks, insurance companies, and other types of financial intermediaries to be owned by the same holding company. In addition, each type of firm was still subject to regulation by the particular intermediary's regulator. Although the GLBA was a significant step forward, a number of experts have criticized the division of regulation among various agencies and levels of government. In this sense, insurance is marked as the area most out of line with a modern, integrated system of financial regulation.
The demand for federal regulation arises from not only the high cost of state regulation but also other problems associated with it. The high cost of state regulation derives from the fact that insurers must comply with the specific regulations in each state in which they do business. Insurers are burdened by duplicative yet often inconsistent regulation of many aspects of their operations, including solvency, products, prices, and market conduct. While solvency regulation is relatively uniform (albeit enforced by each state), the regulation of insurers' other activities (that is, market regulation) varies greatly among the states. Many insurers are concerned about the hurdles they must overcome in getting prices and products approved and the constraints and mandates imposed on various aspects of their market activities, which they view as excessive and unnecessary. These concerns have grown as the industry has becoming increasingly national and international in its scope of operations and as financial convergence has spurred competition between insurance companies and other institutions in the sale of certain financial products with similar attributes. The U.S. system of state insurance regulation is viewed as substantially undermining insurers' efficiency and ability to compete in national and international markets.
At the same time, any move to federal insurance regulation is strongly opposed by certain stakeholder groups, including state officials, state and regional insurance companies, and many insurance agents. Opponents of federal regulation raise concerns about the possibility of weakened regulation, reduced consumer protection, and lack of proper attention to local issues. State regulators, understandably, also may fear significant erosion of their authority if large segments of the industry become subject to federal regulation. Additionally, state-oriented insurance companies and agents may be concerned about the competitive advantages that would be gained by national insurers and agents that opt for federal regulation. Hence proposals to establish some form of federal insurance regulation, principally an OFC, have been mired in a fierce debate that has thwarted decisive legislative action.
Still the push for federal insurance regulation shows no signs of abating and may very well intensify in the context of the current problems in financial markets and efforts to restructure the regulatory framework for all financial institutions. The U.S. Department of the Treasury issued its blueprint for financial services regulation reform in March 2008, before conditions in financial markets reached crisis proportions and contributed to cascading problems in the overall economy. The Treasury blueprint acknowledged an important federal role for insurance regulation and advocates an insurance OFC similar to that conceived in pending federal legislation. The 2008 Treasury plan will likely be revisited by the new administration and Congress that took office in January 2009, but many of its components, including an insurance OFC, may be incorporated into the reform measures advocated by this administration.
With the financial crisis of September 2008, the significant financial failure of a noninsurance subsidiary of the American International Group (one of the largest insurers in the world), and the resulting federal bailout of the financial services industry, the interconnections among various financial institutions and markets became apparent, increasing the pressure for overhauling the regulatory structure. Insurance will likely be a subject of considerable discussion as reform efforts move forward, but how and when it might be incorporated into a federal regulatory framework remains uncertain. Views differ as to how recent events will affect the prospects for federal insurance regulation. However, the issues underlying the need for examining the structure of insurance regulation have remained largely unchanged even as market conditions have changed.
This brings us to the purpose of this book. In July 2008 Georgia State University, the American Enterprise Institute, and the Brookings Institution sponsored a conference on the future of insurance regulation in Washington, underwritten by the Risk Foundation. The following chapters are based on papers presented at the conference and address a number of issues surrounding the structure of insurance regulation and its policies. Although the papers were presented in July 2008, in the chapters that follow the authors reflect on subsequent events and their significance for the future of insurance regulation.
The conference addressed a number of important issues surrounding the future of insurance regulation and the different paths it might take, primarily the question of state versus federal regulation, specifically the merits of an OFC and how it might be designed. Beyond the questions involved with the institutional framework for insurance regulation, the conference also considered how insurance should be regulated from a policy perspective and the implications of financial convergence and the internationalization of insurance markets for an optimal regulatory structure. Arguably, current OFC proposals leave a number of unanswered questions, and other reform scenarios are possible. Hence, the purpose of the conference was to look beyond the merits of an OFC and to ask broader questions, such as
-What is the right administrative apparatus for insurance regulation?
-What areas should be regulated and how?
-How does deregulation affect markets and consumers?
-How does financial convergence interact with changes in regulation?
-How does regulation affect insurance markets internationally?
This is an appropriate time to examine these questions. Recent events have exposed further vulnerabilities in financial markets and cracks in the regulatory structure for financial institutions. Policymakers must tackle a host of issues in charting a future course for financial regulation generally and insurance regulation specifically. The following chapters put the OFC proposal in context and examine various aspects of its design and implementation as well as a broader set of questions associated with insurance regulation. This book provides policymakers and academics with insights into the implications of a number of the policy choices that are likely to be considered.
An Overview of the Insurance Industry and Its Regulation
In chapter 2 Robert Klein provides an overview of the insurance industry and its current regulatory structure that establishes a context for the following chapters. He reviews the considerable growth and evolution of the U.S. insurance industry and its principal sectors: life insurance and annuities, accident and health insurance, and property-casualty insurance. Since the enactment of the MFA, the industry has grown substantially in size, scope, and complexity. Most of the insurance in a given state is sold by insurers that are domiciled in other states. Insurers also now underwrite a wide variety of exposures, and their financial structure and risks have become much more complex. The states have been challenged in keeping pace with the industry and its growing scope and complexity.
State insurance regulators have responded to these challenges by substantially increasing their resources and improving their methods in overseeing the industry. They have made substantial changes in many areas and have embarked on various initiatives to harmonize their regulatory requirements, eliminate unnecessary constraints, and ease the compliance burdens of insurers. Still these efforts have fallen far short of what national insurers would consider satisfactory, and it is questionable whether a state-based system could ever achieve the efficiencies of a federal regulator. Nonetheless, the vision of federal regulation may not be realized any time soon, which makes reforms at the state level all the more relevant.
Klein also outlines alternative frameworks for insurance regulation. An OFC has received the greatest attention and support, but other structures have been proposed. Other proposals include federal standards for state regulation and the creation of a single-state regulatory system in which an insurer would be subject solely to the oversight of its domiciliary jurisdiction regardless of where it did business. While these other proposals have not attracted strong constituencies, their relative merits may surface as the debate over insurance regulation progresses. Indeed, if history is any guide, the pattern of incremental changes in federal and state roles may continue for some time before a more fundamental restructuring of insurance regulation occurs.
The Pros and Cons of Federal Insurance Regulation
In chapter 3 Martin Grace and Hal Scott examine the legal structure of regulation proposed in OFC legislation and compare it to current state practice and current federal regulatory practice. The chapter starts with an overview of the economic argument for an optional federal charter approach to insurance regulation. In the last few years a number of researchers have attempted to document the costs of the state system of regulation. Evidence exists that the insurance industry is an interstate business. Thus duplicative regulation is costly, and the states themselves are not necessarily efficient regulators. The average property liability company has sixteen state licenses, and the average life company has twenty-five licenses. Grace and Scott pose several questions. Is there any social value in having sixteen or twenty-five different regulators looking at each company? Is there any value in duplicative regulation or inconsistent regulation? Does each state have the proper incentives to regulate when it knows there are other states looking at the firm? Evidence suggests that small states might free ride on bigger states' regulatory apparatus. A federal regulator might be able to reduce these types of costs to the benefit of the insurance consumer.
Grace and Scott also look at the response of the National Association of Insurance Commissioners (NAIC) to the issue of duplicative regulation by examining the commonality of regulatory approaches for a number of model acts promulgated by the NAIC. Few of the model laws in their (admittedly nonrandom) sample were uniformly adopted by the states: there not only seems to be a natural limit to the number of states that might adopt a model act but, in addition, some large states have adopted their own version of the model.
Grace and Scott also find that there are significant questions left unaddressed by the current proposal. For example, it is still feasible for firms in a group to expose the market to significant systemic risk and be outside the scope of systemic risk review. In addition, because of the competitive nature of various markets and the various sophistication levels of consumers of these products, what gets regulated needs to be examined. Further, how state solvency funds interact with an OFC warrants more thought. Finally, in a point that is often overlooked, the authors stress that a national and international industry needs the regulation that will allow it to thrive in its chosen markets.
In chapter 4 Robert Detlefsen takes a critical look at an optional federal charter style of regulation. He summarizes several criticisms of an OFC, including the likelihood that a dual system would create inequities among firms competing within the same markets; the potential that an OFC would confuse consumers as to who is responsible for regulating their insurer; and the possibility that an OFC would require the establishment of a new federal bureaucracy on top of the bureaucracies that exist in each state. Detlefsen also takes on the question of whether federal regulators would be more competent than their state counterparts, given the recent performance of federal regulators responsible for overseeing financial institutions and markets.
Detlefsen also points out that the demand for an OFC style of regulation is different for each sector of the industry. While both are concerned about uniformity of licensing and the speed to market for new products, property-casualty companies are interested in reducing distortions caused by rate regulation and underwriting restrictions. In contrast, life companies are more interested in avoiding the costs of duplicative and inconsistent regulations, which hamper their ability to get new and innovative products introduced in the market.
Detlefsen examines the dual-charter option in the banking industry in a practical light. He asserts that an OFC is not really optional, as competition between state and federal regulators is illusory. First, companies may choose a federal regulator, but the costs of reversing such a decision would likely be high. Second, there will not really be regulatory competition between the states and the federal government due in part to the high costs of switching as well as the possibility of significant federal preemption of state regulatory authority. Restricting state authority to what the federal government decides is proper takes away the states' ability to compete. This is important in Detlefsen's view because Congress could take an interventionist approach to insurance with the goal of fairness in mind. However, fairness is likely to socialize private risk sharing by prohibiting the use of risk-related underwriting criteria. While this could happen in the states, the comparison between markets can provide evidence to other states regarding the desirability of such policies.
Regulatory Policy Reform
In chapter 5 Martin Grace and Robert Klein tackle the issue of policy reform. They believe that proponents of a federal charter approach envision that federal regulators will diverge significantly from the restrictive policies enforced in a number of areas by the states. Thus even if an OFC could achieve significant structural efficiencies, its ultimate effect on insurers and insurance markets will greatly depend on the policies adopted by federal regulators. Also, to the extent that the states continue to be the predominant regulators, their policies will have significant implications for how insurance markets function. Hence Grace and Klein outline a set of principles and discuss needed reforms in key areas of insurance regulation that are relevant in either a state or a federal framework.
(Continues...)
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