The 6th Annual Insurance Reform Summit presented by Networks Financial Institute at Indiana State University in Washington, D.C. on March 4th, assembled a full agenda of academic, policy and industry leaders.
Legislative/Federal Regulatory Perspectives Highlights
Melissa Bean, D-Ill. announced that she and Rep. Ed Royce, R-Calif, will co-sponsor the National Insurance Modernization Act (NIMA) in the next several weeks. Bean made the announcement March 4, in Washington DC at the 2009 Insurance Reform Summit presented by Networks Financial Institute at Indiana State University. Previously referred to as the National Insurance Act in the 109th and 110th Congress, Bean said that the bill is undergoing fine-tuning as sponsors finalize discussion on key elements such as consumer access, uniformity and whether a federal charter would be optional or mandatory for insurers deemed systemically significant.
Bean provided some insight into new measures the bill will contain, including the placement of a physical branch of the Office of National Insurance (ONI) in every state. The bill also would create a systemic risk regulator with the authority to oversee insurance firms defined as “systemically important.” Bean said the scope of the proposed systemic risk regulator’s authority is still under discussion as well as the definition of the term “systemic risk”. During the Summit, many alluded to systemic risk as synonymous with “too big to fail,” although Bean said the definition is still being ferreted out. “As with many issues, the devil is in the details,” she noted. Beyond a systemic risk regulator and an ONI presence in every state, Bean said the NIMA will foster new product innovation and improve the ability for insurance firms to bring new products to market in a timely manner. She said the bill would facilitate and enhance free-market pricing and provide the industry with a national voice to speak on national issues, such as tax policy, international issues, and during times of large-scale crisis such as Hurricane Katrina.
Bean noted that the current insurance regulatory structure has created redundancy and lowered choice for consumers. “I don’t hear people saying we need more regulation; I hear them saying we need better regulation,” she stated. She noted that the current regulatory structure has been lacking in “issues of efficacy” and that the problems currently impacting the greater financial services environment can be attributed in part to a lack of structure that anticipated systemic risk. “We’re really looking for better effectiveness. Consumer protection must be consistent and robust,” Bean said.
Rep. Spencer Bachus, R – Ala, ranking minority member of the House Financial Services Committee advocated an incremental approach to insurance regulatory reform, while acknowledging that the states have done a good job of ensuring that insurance firms are well capitalized and maintain adequate reserves. “In a global economy, it’s very hard to get products out and maintain a sensible, efficient system,” Bachus stated. He mentioned that he will co-sponsor H.R. 1065 - the Non-Admitted and Reinsurance Reform Act - set to be introduced by Reps. Dennis Moore, D-Kan. And Scott Garrett, R-N.J. He described the Act as “a good example of legislation that increases efficiency in the market and doesn’t cost consumers anything.”
Bachus was cautiously supportive of creating an Office of Insurance Information (OII) such as that proposed by Insurance Subcommittee Chairman Paul Kanjorski, D-Pa, in the last Congress. While he expressed concern that the OII needs to be better defined, he said that such an office might have been able to detect early indications of problems at AIG. Regarding AIG’s difficulties, Bachus noted that the recently re-negotiated agreements with the U.S. Treasury and separately, with the Federal Reserve Bank have a much higher probability of success than the original agreements. “The markets have known for some time that the first agreements were not working. There is a much higher probability of stabilizing the company under the new agreement,” Bachus noted.
Industry association and corporate leaders, including those representing the Financial Services Roundtable, National Association of Mutual Insurance Companies, American Council of Life Insurers, Independent Insurance Agents & Brokers of America, Inc; National Organization of Life and Health Insurance Guaranty Associations and National Conference of Guaranty Insurance Funds, as well as Therese Vaughan, CEO of the National Association of Insurance Commissioners spoke at the Insurance Reform Summit and shared their perspectives on regulatory issues critical to the U.S. insurance industry and its competitiveness in an increasingly global and volatile economy.
Research Perspective Highlights
National Association of Insurance Commissioners (NAIC) Chief Executive Officer Therese M. Vaughan, Ph.D., released her paper “The Implications of Solvency II for U.S. Insurance Regulation” as part of the research perspectives during the Summit.
Dr. Vaughn compared and contrasted the U.S. system of determining solvency based primarily on internal models against the Solvency II regulatory capital system being reviewed by European Commission. She also summarized key lessons the insurance industry has learned in the wake of economic turmoil and identified outstanding solvency issues.
As the European Union Commission continues to move toward adaptation of Solvency II, Dr. Vaughan highlighted its three-tiered structure Vaughan noted how Solvency II’s structure differs from the BASEL II approach to calculating capital requirements in its qualitative review, supervisory review, market discipline, supervisory reporting and public disclosure. She also noted the group supervision element, still being developed under Solvency II.
Dr. Vaughan stressed that, in fact, many of the details in Solvency II still remain in discussion. However, she noted some components will include ensuring capital reserve requirements, provisions for investment management, a ladder of intervention involving solvency and minimum capital requirements and a standard formula for setting capital solvency requirements. Dr. Vaughan noted that a key feature of Solvency II is that it encourages firms to use internal models. She noted that internal models can be expected to produce better alignment between firm risk and capital requirements as well as stronger risk management cultures within firms. Firms using internal models expect to see a reduction in required capital relative to the standard formula, but such a model would still be subject to supervisory review and potential intervention.
Dr. Vaughan also discussed the U.S. method of evaluating solvency based on the NAIC’s risk-based capital (RBC) formulas, which include separate factor-based models for life, health, and property-casualty insurance. She elaborated about both the positive features of U.S. supervisory frameworks and the role of multi-state coordination,, both bilaterally and through the NAIC, in supervising the financial reporting, examination and analysis of U.S. insurers.
Amidst the current economic turmoil, Dr. Vaughan noted a transition from rules- to principles-based supervision. She cited three assumptions that lend support to this trend: first, that companies have an incentive to manage risk; second, that regulators can distinguish those companies that are effectively managing risk from those that aren’t; and finally, that companies can trust regulators to take action when risk is not being managed. Since market discipline can erode due to the backstops of guaranty funds and deposit insurance and as well as executive compensation structures that encourage risk-taking, regulators must pay special attention to creating incentives for companies to manage risk.
Dr. Vaughn said that internal models have a role in evaluating, but do not guarantee effective risk management. “Models are by definition a simplification of reality. Regulators must determine what is being left out. The problem of regulatory arbitrage will not go away,” she stated. According to Dr. Vaughan, regulatory forbearance in conjunction with a system of checks and balances will play a key role in creating an effective regulatory structure. . In addressing those gathered at the Insurance Reform Summit, Dr. Vaughan stated that her comments reflected personal insights and were not to be construed as formal statements of position by the NAIC. Click here to download presentation.
Next, Martin F. Grace, Professor of Risk Management and Insurance at Georgia State University, noted that while the topic of insurance regulation has become much more an area of interest in the current financial environment, the role of insurance regulation has been a matter of debate for more than 140 years.
While somewhat despondent over the history of state regulation, Professor Grace said that he is uncomfortable but dimly in favor of moving toward a national regulator. He noted that before moving to a federal regulatory body, questions related to price regulation and compliance costs must be addressed. “The general consensus in the academic community is that price regulation has hurt the insurance market,” he stated.
Professor Grace argued that any discussion of state versus federal regulation must take into account not only who the regulatory agency is, but what should be regulated -- the consequences of risk, especially market failures, rather than the individual company. “The goal of effective regulation is to minimize the costs of market failures and also the cost of the regulation,” he said, adding, “Historically, we have looked at the ‘who’ versus the ‘what’ when regulating. We need to regulate the price of the risk.”
Regarding an optional federal charter, Dr. Grace noted that the concept is not novel but has its roots in the National Banking Act. He added that federal regulation may present economies of scale and reduction in insurers’ compliance costs. While proponents of state regulation have maintained that it fosters competition and innovation, Dr. Grace said he does not accept this argument. He noted concerns that a push toward uniformity would discourage experimentation but said the industry has not typically seen significant innovation resulting from state-based regulation.
Professor Grace suggested that an alternative to the weaknesses inherent in federal and state regulation is the concept of “competitive federalism.” He noted that once an insurance company elects federal regulation, it would become cost prohibitive to revert back to a state mode of regulation, providing the federal regulator with a captive market and an incentive to extract extreme rates. However, under a competitive federalism approach, insurance companies doing business in multiple states could select the state under which they wanted to be chartered and move their regulatory state as needed. He did note the need for legislation requiring states to recognize regulations imposed by other states.
Referencing the National Insurance Modernization Act set to be introduced, Professor Grace expressed concern that the regulation borrowed on consumer protection ideas dating from the 20th century. Noting that legislation should determine what is regulated and how it is regulated while ensuring that the social cost is minimized, Professor Grace said that the new proposal may in actuality increase the cost to society. He said that while all states already have “fair pricing”, the definitions vary.
New proposals may shift risk from low-risk to high-risk individuals, resulting in mispriced risk, according to Professor Grace. He said that all insurance crises in the past 30 years could be attributed to mispriced risk and that the new proposals do not address the issue. Compulsory markets could be potentially affected and guaranty funds could be further stressed.
Summing up his perspective, Professor Grace cited three primary concerns regarding an optional federal charter. First, he noted that while the proposals’ intentions to reduce compliance costs and lower costs for consumers are good, the proposals would could create incentives that could lead to mispriced risk. Secondly, he expressed that the new proposals are old models rewritten, with no thought about the fundamentals of regulation. Finally, he cautioned that the proposals do not account for other costs that might be imposed on society through mispriced risk. Click here to download presentation.
Perspectives on the Financial Protection of Consumers When the Ship Goes Down
The Summit also included an important panel that addressed the consumer impact that occurs when an insurance company fails. Panelists included Scott Harrington, PhD, Alan B. Miller Professor, Wharton School, University of Pennsylvania; Peter Gallanis, President, National Organization of Life and Health Insurance Guaranty Associations; and Roger Schmelzer, President, National Conference of Insurance Guaranty Funds.
Panelists provided their thoughts on consumer protection issues related to insurance company solvency and the kind of safety net there should be if insurance companies are regulated at the federal level.
Peter Gallanis, President of the National Organization of Life and Health Insurance Guaranty Funds, observed that until events in the fall 2008, there was comparatively little thought given to the implication of insurance insolvency. “There was no federal oar in the water when it came to insurance regulatory overview,” Mr. Gallanis noted. He added that the insurance sector has traditionally been a very conservatively operated segment of the financial services industry. “In 2008 many U.S. banks failed but no American consumer lost a penny due to their insurance company failing. The safety net system has done a solid job of protecting American consumers when companies fail,” Mr. Gallanis stated. He supported his point by describing the debacle involving Martin Frankel, who was convicted in 2002 of insurance fraud after a state regulator noted suspicious circumstances and tipped off authorities. Mr. Gallanis noted that policyholders did not lose money in the fraud due to the state guaranty associations immediately stepping in to protect policyholders. “There has really been no squeaky wheel; so insurance regulation has not received a lot of attention,” Mr. Gallanis noted.
According to Mr. Gallanis, the insurance industry addresses two types of solvency concerns: holding companies that own insurance subsidiaries; and the individual policyholders in the insurance companies themselves. He noted that it is critical to distinguish between the holding company and subsidiary firm when considering the need for regulation. “A subsidiary can be financially healthy even when the holding company fails,” he stated, noting that while AIG has experienced significant problems at the holding company level, most of its individual subsidiaries are operating without trouble. Gallanis added that state regulators have done a good job of regulating for solvency by creating receivership statutes that vary from state-to-state. The flexibility of the solvency model allows regulators in each state to place a distressed insurance firm in a category ranging from conservation to rehabilitation to, in the most serious incidents, liquidation. Even if an insurance company enters receivership, Mr. Gallanis noted that the claims of policyholder supersede all other claims and obligations presented by other creditors.
Roger Schmelzer, President, National Conference of Insurance Guaranty Funds, emphasized the inherent differences between the banking system’s FDIC coverage and the states’ insurance guaranty system. Mr. Schmelzer stated that whereas the FDIC is based on the need for immediate liquidity, the insurance guaranty system needs liquidity over time, and, only insofar as claims are made. He noted that the state guaranty funds were developed with the sole purpose of paying claims. “This just-in-time funding solution in the insurance industry is very different from the dollar-for-dollar approach used in banking,” he said. Noting that the system has worked very effectively, Mr. Schmelzer used the example of the nation’s largest insurance failure, Reliance Insurance Company in 2001. He stated that the $2.9 billion has been paid to fulfill policyholder claims, with $1.8 billion of that funding coming from Reliance assets and the balance paid by the state guaranty funds.
Scott Harrington, PhD, Alan B. Miller Professor, Wharton School, University of Pennsylvania, focused on economics, moral hazards and incentives within the insurance regulatory framework. Like Mr. Schmelzer, Dr. Harrington noted that sensible regulation should distinguish between insurance and banking when creating effective regulation.
He stated that government guarantees can create a moral hazard situation because system risk varies across financial institutions. He noted that the BASIL I and II banking structure is intricately linked with moral hazards.
Furthermore, he noted that systemic risk is qualitatively and quantitatively different between banks and insurance companies, especially in the property and casualty arena. Less risk in the insurance industry translates into less need for guarantees, he asserted, adding, “The evidence is overwhelming that there is a lot of market discipline in the insurance industry. Capital requirements can be – and are – more benign in the insurance sector.”
Referencing the paper presented by Therese Vaughan, Chief Executive Officer of the National Association of Insurance Commissioners, titled “Implications of Solvency II for U.S. Insurance Competitiveness and Regulatory Reform,” Dr. Harrington noted that the European Union’s movement toward BASIL II is fundamentally misguided and does not account for the inherent market discipline in the insurance sector.
Dr. Harrington cautioned against relying too heavily on model simulations in creating regulation. He noted that the sub-prime mortgage and foreclosure problems that arose following the housing bubble were not predicted by models and encouraged a heavy gamble that home prices would continue to appreciate. “The models failed. They were totally deficient,” he stated. He added that contributing factors to the collapse included a willingness for investors to gamble with other peoples’ money, the extremely low-cost financing available through Fannie and Freddie, and a deposit structure in the banking system that contributed to risky lending and expansion of subprime loans.
Harrington noted similar problems with the models used by AIG which did not account for collateral calls, the foreclosure crisis and other factors that negatively impacted the holding company. “AIG is not about insurance but about the liquidity crisis resulting from banking and securities events. [AIG] is a bank/security bailout, not an insurance bailout.” Dr. Harrington said.
He also considered the role of incentives, noting that state guaranty funds have demonstrated significant market discipline through their just-in-time funding structure. On the subject of an optional federal charter and systemic risk regulator, Dr. Harrington advocated against an expansion of federal guarantees for insurance company obligations. He noted that if a company is deemed systemically significant, it implicitly expands the definition of too big to fail, interfering with incentives and competition.
Insurance Regulation in the 21st Century: Industry Perspectives, Reactions, and Priorities Highlights
Insurance industry leadership addressed the most critical issues impacting the industry featuring an industry leadership panel comprised of Steve Bartlett, President & CEO, the Financial Services Roundtable; Charles Chamness, President & CEO, National Association of Mutual Insurance Companies; Governor Frank Keating, President & CEO, American Council of Life Insurers, and Robert Rusbuldt, Chief Executive Officer of the Independent Insurance Agents & Brokers of America, Inc.
Panelists at the Summit addressed some of the most critical issues impacting the industry, beginning with the role of state regulation to the pros and cons of a federal role, the need for a systemic risk regulator and consumer protection in a “too big to fail” world.
“The nation’s recovery will begin with the financial services sector,” noted Steve Bartlett, President & CEO of the Financial Services Roundtable. He stated that the immediate challenge is to stimulate lending activity. Mr. Bartlett said that “big” issues such as the TARP and the American Recovery and Reinvestment Act are dominating Congress’s attention at the moment, reducing focus on insurance regulatory policy. Ultimately, Mr. Bartlett said he expects Congress to create federal regulation for the insurance sector. “A federal charter is virtually inevitable. It is not a matter of whether, but of when, how completely and how well,” he stated.
Mr. Bartlett said that systemic risk is the hot issue in the industry. He said that empowering the federal government with statutory power will be a first step in creating a systemic risk regulator. He also expressed the need for a day-to-day information source for insurance at the federal level.
“An island of stability in a sea of financial turmoil,” is how Charles Chamness described the property and casualty insurance industry. Mr. Chamness’ quote expressed the National Association of Mutual Insurance Companies’ position that the insurance industry has succeeded in a state-regulated environment in spite of the turmoil that has impacted other areas of the financial sector. Regarding the role of a systemic risk regulator, Mr. Chamness commented that NAMIC does not see an immediate need for such a position for P&C companies as that sector has very little systemic solvency risk. Mr. Chamness cited the industry’s lack of leverage, strict capital requirements, adequate liquidity and excellent risk management as factors supporting the industry’s low systemic risk. He further noted that in 2008, the nation’s insurance companies received more ratings upgrades than downgrades.
Regarding the role of a dual-structured system providing insurers with the option of a federal charter, Mr. Chamness stated that such a structure would add expenses for both insurance companies and the policyholders they serve. However, Mr. Chamness did see merit in the role of an Office of Insurance Information (OII). “There needs to be a seat at the table for our industry in Washington,” he stated.
Mr. Chamness expressed concern that the problems of AIG have improperly tainted the reputation of the insurance industry. He further commented that while AIG was widely portrayed as an insurance firm, less than 50 percent of its holdings represent insurance companies.
“A federal presence means a federal voice,” is how Governor Frank Keating, President & CEO, American Council of Life Insurers addressed the issue of a systemic regulator. Governor Keating pointed to the significance of the five trillion dollar life insurance industry to the American economy; noting its presence in 75 million American homes and the industry’s role as the largest buyer of bonds. He gave examples of decision makers knowing very little about the role of life insurance and its contribution to the economy. “Today, we are not regulated [at the federal level]. If we had an optional federal charter, we would certainly be okay. Our industry wants to be a part of solving the nation’s problems and let me add, it’s time to buy annuities!” he said.
“A perfect storm from the macroeconomic perspective,” was how Robert Rusbuldt, Chief Executive Officer of the Independent Insurance Agents & Brokers of America, Inc. (IIAB), described the current financial services landscape. Mr. Rusbuldt said that TARP is irrelevant in an industry comprised of small, independent businesses. “We all agree on the need for more uniformity and efficiency; what we don’t agree on are the solutions,” he commented. He noted that IIAB supports an Office of Insurance Information that would facilitate an industry presence at the federal level. However, he does not see a role for Congress to address solvency and rate issues at the federal level.
Supporting IIAB’s stance that insurance companies should remain state regulated, Mr. Rusbuldt pointed to the different solvency rates of banks versus insurance companies. “In 2008 there were 40 bank failures and one insurance failure. For solvency, our state system of regulation has been better,” Mr. Rusbuldt stated. He cautioned that federal regulation would bring anti-redlining and additional underwriting restrictions to independent insurance companies. “Property and casualty is very different from banks in all respects including claims, distributions and customer service,” he noted. He indicated that federal legislation is needed to mandate uniformity at the state level. Mr. Rusbuldt said that Congress will focus on systemic risk regulation, but to guess as to what other topics will dominate Congress’s attention would be merely speculative.
Summit panelists shared their thoughts on what the near future will bring to the insurance industry:
“Adam Smith’s invisible hand is out. That was yesterday’s regulation,” was how Governor Keating indicated he sees the future of insurance regulation. He noted that he expects to see aggressive regulatory reform including regulations that will encourage consumer saving.
“Too big to fail can be a dangerous thing,” stated Charles Chamness. Mr. Chamness said he expects Congress to address flood insurance reform by September. Mr. Chamness noted that he does not believe insurance reform is, or should be, a top priority for Congress at this time.
“The states will not reform themselves,” was how Mr. Barlett expressed his sentiment that in 2010, the industry will see some form of regulatory restructuring that includes an optional federal charter. He also noted that he expects the TARP to be expanded to include life insurance companies.
“The establishment of an Office of Insurance Information could serve as an effective back-up to federal regulation,” noted Robert Rusbuldt.
Panelists were asked how the 2008 elections and the financial meltdown will impact the insurance industry.
“Our industry has been vilified by the [problems in the] broader financial services industry,” noted Mr. Rusbuldt. He cautioned that the industry’s reputation can have a demoralizing effect on financial services leadership. He mentioned the 359 companies that received TARP funds as a means of facilitating lending, noting that many financial service leaders were reluctant to accept the funds for their intended purpose.
“It’s business as usual on the P&C side,” was how Charles Chamness described the P&C industry’s functioning in the current economy. While he noted that 2008 saw some surplus loss, he stated that the fact that the TARP was not extended to property and casualty insurers is a positive sign of the industry’s stability. “Our industry suffers from reputation risk when the financial services sector is held in low esteem,” he stated.
“The President needs to continue to talk up the economy,” was Governor Keating’s recommendation for coming out of an economic slump. He also indicated that a lack of under secretaries at the Treasury is making it difficult to initiate movement. “The Treasury needs a full complement of people,” he stated.
“We have gone from de-regulation to re-regulation,” was the concern expressed by Robert Rusbuldt. Mr. Rusbuldt noted that the Obama Administration’s proposals present concerns to small businesses through tax increases, fewer itemized reductions and increased capital gains taxes. “In the midst of a recession, raising taxes on small business owners simply does not make sense,” he noted. He added that the concept of a systemic risk regulator was a misnomer in his estimation and that a better term might be a systemic risk “overseer” who could occasionally “peer into” the industry without day-to-day involvement.