[Senate Hearing 109-1067]
[From the U.S. Government Publishing Office]
S. Hrg. 109-1067
PERSPECTIVES ON INSURANCE REGULATION
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
ON
EXAMINING THE INSURANCE MARKET AND MODERNIZING
INSURANCE REGULATION
__________
JULY 18, 2006
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html
----------
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Washington, DC 20402-0001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Andrew Olmem, Counsel
Jim Johnson, Counsel
Stephen R. Kroll, Democratic Special Counsel
Dean V. Shahinian, Democratic Counsel
Lynsey Graham Rea, Democratic Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
C O N T E N T S
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TUESDAY, JULY 18, 2006
Page
Opening statement of Senator Allard.............................. 1
Opening statements, comments, or prepared statements of:
Senator Johnson.............................................. 7
WITNESSES
Randal K. Quarles, Under Secretary for Domestic Finance,
Department of the Treasury..................................... 2
Prepared statement........................................... 31
Scott E. Harrington, Ph.D., Alan B. Miller Professor, The Wharton
School, University of Pennsylvania............................. 16
Prepared statement........................................... 37
Robert W. Klein, Ph.D., Director of the Center for Risk
Management and Insurance Research, Georgia State University.... 18
Prepared statement........................................... 43
(iii)
PERSPECTIVES ON INSURANCE REGULATION
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TUESDAY, JULY 18, 2006
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 2:05 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Wayne Allard, presiding.
OPENING STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. The Committee will come to order.
Today, the Committee will examine perspectives on insurance
regulation, a topic which will likely be one of our biggest
issues for the coming year. Insurance has helps millions of
people during some of the most vulnerable times in their lives.
Insurance has served many people well. Even for those who do
not personally own an insurance policy, every American has a
vested interest in a robust, well-regulated insurance market.
Well-regulated insurance markets help families and
businesses manage risk. If private insurance were to fail in
this function it would likely fall to the Government to provide
assistance. Because insurance is so important, it is critical
to maintain healthy insurance markets through good regulation.
Therefore, we cannot take reform of insurance regulation
lightly. It is important that we understand the implications
for States, and especially for consumers.
Before coming to Washington, D.C., I served in the Colorado
State Senate. My service as a State legislator gave me a
particular appreciation for States' rights. However, I
understand the insurance markets have evolved, and so market
regulation must also evolve to keep pace.
Before we can make decisions about the future of the
insurance industry we must understand the present state of the
industry. Quite simply, we need to understand and define the
problem to be solved before we start discussing solutions. This
hearing will be an important step in that effort.
Today, the Committee will continue its examination of
insurance regulation by hearing the perspectives of three
experts on financial regulation.
I would like to welcome back to the Committee Under
Secretary Quarles, who has a unique background in financial
regulation having served in a variety of positions with
responsibilities for financial regulation at the Treasury
Department during the current and prior Bush Administrations.
In addition, he served as co-head of the financial institutions
group at the law firm of Davis, Polk and Wardwell.
I am also pleased to welcome to the Committee Dr. Scott
Harrington and Dr. Robert Klein, two of the country's leading
experts on insurance regulation.
Before we enact any insurance regulation reforms,
especially any of the comprehensive reforms that have been
proposed, it is crucial that all of the economic and legal
consequences of such reform be fully understood. Accordingly, I
look forward to hearing the experts' insights of our
distinguished witnesses. I want to thank all of the witnesses
for being here today. Their testimony will be very helpful.
At this time I would like to submit an opening statement by
Chairman Shelby for the record. If the Chairman shows up this
afternoon--he might--then we will give him an opportunity to
make some comments.
Senator Sununu. I do not have an opening statement, Mr.
Chairman. I am ready to go right to the witness.
Senator Allard. Very good.
Then as other members show up that may have statements, we
will give them an opportunity to present those statements.
We will start with the first panel. Secretary Quarles,
welcome to the Committee, Under Secretary of Domestic Finance,
Department of the Treasury. We look forward to hearing your
comments.
STATEMENT OF RANDAL K. QUARLES, UNDER SECRETARY FOR DOMESTIC
FINANCE, DEPARTMENT OF THE TREASURY
Mr. Quarles. Thank you. Thank you, Mr. Chairman, members of
the Committee. It is a very welcome opportunity to appear here
today to discuss both the role of insurance in our economy and
the need to modernize the regulation of insurance.
As you noted in your opening comments, in the first
instance, the issues surrounding insurance regulation are
significant because the insurance industry is a significant
part of the U.S. financial sector. It has assets of over $5.6
trillion at the end of 2005.
But even more importantly, insurance, like other financial
services, has significant ripple effects through our entire
economy. The ability of individuals and businesses to insure
against risk adds certainty to their planning. That contributes
to greater economic activity, enhanced economic growth. And
insurance is also, like other financial services, in that its
cost and its safety and its ability to innovate and compete are
heavily affected by both the substance and the structure of its
system of regulation.
So, as a result, not only of the industry's importance
considered simply as a separate line of economic activity, but
even more as a result of its consequences for commerce and
economic growth more broadly, we should seek to ensure that the
regulatory system for the insurance industry is consistent with
the efficient and cost-effective delivery of its services, and
with continuing innovation in the design of its products.
Now in that regard there seems to be virtually no
disagreement that the current insurance regulatory system is in
need of modernization. As you know, unlike the banking and
securities sectors, insurance is solely regulated at the State
level. While this multiplicity of regulators can provide
certain benefits in the form of local expertise and control, it
does raise a number of issues that deserve further
consideration. In our view, those issues fall into three main
categories.
One, potential economic inefficiency. That results both
from the substance of regulation, especially, and form control,
but also from the structure of regulation, the inevitable
duplication in cost that is associated with multiple, non-
uniform regulatory regimes.
Second, our international impediments.
Both questions of comity, facilitating international firms'
operations in the United States which benefits U.S. consumers,
and competitiveness, facilitating U.S. firms' operations
abroad, which provides growth opportunities for those firms,
helps diversify their risk exposures.
And third, systemic blind spots. The inability of the
official sector to understand and respond to the insurance
industry's evolving contribution to risk that affect the
financial system as a whole.
So, at the most fundamental level, the question in each of
these areas is whether the benefits from regulatory competition
that are fostered by our existing multiple regulatory structure
or could be fostered by other multiple regulatory structures,
are outweighed by the costs of regulatory fragmentation, which
are significant in a 50-State system. And in light of that
consideration, where needed, what can be done to address those
issues.
Now, I discuss each of those three categories of issues in
detail in my written testimony, but let me just provide a brief
overview of them here.
First, with respect to economic inefficiency. One aspect of
modernization has been a focus on the lack of uniformity in
State regulation. While the NAIC has achieved some success over
the past 135 years in fostering more uniformity among the
States, many of its model laws and regulations have not been
enacted, and differing State insurance regulatory treatment can
lead to inefficiencies and to undue regulatory burden. In turn,
that can directly limit the ability of insurers to compete
across State boundaries, and reduced competition can diminish
the quality of services, it diminishes consumer choice, and
ultimately leads to higher prices.
Now among the areas of potential inefficiency from non-
uniform regulation are licensing, and form approval
requirements. I describe those in some detail, again, in my
written testimony. But perhaps the greatest potential for
inefficiency in the current system is with price controls.
Insurance is maybe the last major market in the United States
with direct price controls. And the term price controls is
frequently used to describe the State regulation of rates that
are used by property and casualty insurers that are licensed or
admitted in a State.
One of the fundamental principles that we are all familiar
with is that price controls result in inefficient outcomes. If
the mandated price is set above the market clearing price, the
result will be surpluses. If the mandated price is set below
the market-clearing price, the result will be shortages.
The latter outcome is what we generally observe in
insurance markets with strict price controls. When insurers are
not able to charge what they feel is an adequate rate for their
product, they generally tighten their underwriting standards in
order to limit their writings to preferred risks that are less
likely to suffer an insured loss. This obviously leads to
shortages in the voluntary market and increases demand on what
is referred to as the residual markets, which are State-
sponsored mechanisms that provide consumers with another way to
obtain automobile, property, or workers' compensation insurance
coverage.
Insurers that operate in a State and provide insurance in
the voluntary market in the State are generally required to
participate in these residual markets. But as the size of the
residual market grows, in light of the price control, it is
likely that fewer and fewer insurers would be willing to do
business in that line of insurance in the State in question.
That puts further pressure on the residual market
mechanism. States usually respond by adjusting prices to
preserve the viability of that particular market. As a result,
States with a less restrictive regulatory environment are
generally characterized by lower and less volatile loss ratios,
smaller residual markets, and insurance expenditures that are
below the national average.
Next, let us turn to the international impediments. U.S.
firms and firms from abroad in insurance and in banking and in
the securities sector compete around the globe, around the
clock. Clearly, foreign sources of capital are important if we
are going to have a robust U.S. insurance market.
But as noted above, the lack of uniformity in our State-
based insurance system has the potential to lead to
inefficiency, undue regulatory burden. And while that burden
and inefficiency affects all insurance companies that are
licensed to operate in the United States, foreign firms are
likely to find adapting to such standards more difficult.
In my prior role as the Assistant Secretary for
International Affairs at the Treasury I led our financial
regulatory dialogue with the European Union and with other of
our bilateral partners. Among the issues that were stressed,
again, both in our E.U. dialogue and in others of our financial
regulatory discussions with foreign officials were rate and
form approvals, capital adequacy standards, guaranty fund
membership, and most fundamentally, that our insurance market
has at least 50 different regulators, and the insurance
companies have no single regulator to coordinate with on
insurance matters.
Navigating the existing regulatory structure is daunting
for a new foreign company that is seeking to do business in the
United States. And it has certainly impeded the flow of capital
into the United States to some degree.
Finally, there is the question of systemic blind spots. As
previously noted, the insurance sector is a critical part of
the broader U.S. economy, and in terms of size alone is a key
participant in the U.S. financial sector. In comparison to
other financial institutions, it could be argued that financial
problems at an insurer pose less potential to generate broad
economic problems as opposed to systemic risk to the financial
system.
But nonetheless, there remains some potential for
disruptions in the insurance market to affect economic activity
in financial markets. And most importantly, these potential
risks, whatever the degree of them may be, may not be well
understood at the State or the Federal level in our current
structure.
For example, there has been a considerable amount attention
paid to the expanding credit derivatives market. While in that
area there are a number of issues that might warrant attention,
as with many other derivative contracts, a credit derivative is
very similar to an insurance policy that pays off when certain
credit events occur. So given the close correlation to
insurance, insurance companies appear to be taking a more
active role in this market.
From an overall perspective of market stability, do we
fully understand what risk insurance companies are undertaking,
or how their activity could affect the credit derivatives in
other financial markets?
While the State-based system has made improvements in
solvency and holding company regulation, under a structure with
over 50 different regulators it may be somewhat difficult for
individual State regulators to get a firm handle on the risks
that large, complex insurance companies pose to our Nation's
insurance system. Add into that mix that the Federal Government
has little to no role in the current regulatory system and we
are left with what could be a large blind spot in evaluating
risks that are posed to the general economy and to financial
markets.
So, to sum up, it is clear to us, we think it is to most
observers, that our current system of insurance regulation
requires modernization to meet our current challenges. The
existing system of regulation has the potential to lead to
inefficient economic outcomes. That raises the costs and
reduces the supply of insurance products to consumers. It
deters international participation in our domestic markets.
Again, that raises costs and limits consumer choice. It creates
obstacles to our own insurance firms' international expansion,
and it limits the ability of any one regulator to have an
overview of risk in the insurance sector and its contribution
to risk in the financial system more broadly.
These are issues of importance not just to the insurance
industry or even to the larger financial services industry, but
to the economy as a whole because of the essential role that
the mitigation of risk through insurance has in promoting
commercial activity and enhancing economic growth.
We have been monitoring the developments with respect to
insurance regulation closely, and while we are still evaluating
what approach we believe to be the most appropriate, it is
clear that all of the approaches that are on the table should
be assessed in light of the fundamental principles we have
discussed today, and we are looking forward to continuing this
discussion.
Thank you, Mr. Chairman.
Senator Allard. Thank you very much for your testimony.
We will now proceed to the first round of questions. We
will set aside 5 minutes for each member to ask questions.
I would like to start this off by asking a few questions.
First of all, while the role of insurance at the Federal level
has been rather limited, there has been a Federal role, and it
has been dispersed among several agencies. Should an optional
Federal charter be created? Do you believe that the new
regulator should be independent or should they be part of an
existing agency? What are your thoughts about that?
Mr. Quarles. Well, that is an issue that I think requires
further consideration. We at the Treasury Department would not
have a final view on that. Both regulatory structures exist
currently and are shown to work. The banking regulatory bureaus
that are part of the Department of the Treasury, the OCC, and
the OTS, the depository insurance regulatory bureaus, obviously
work well and have for a long time. So that is a model that
certainly can work.
The independent regulatory model is also one that has been
shown to work over time. In the very near term it would be the
case that if the choice were made to stand up a new Federal
regulator, in the transition period that would be easier to do
within an existing bureaucracy and with the support of an
existing bureaucracy than to immediately stand up a new
regulator. That could ease the time to implementation.
But for a final view, we do not have a final view at this
time.
Senator Allard. And if we were to go to an independent
regulator, would you think that would need to be supported by
fees provided by the insurance industry?
Mr. Quarles. That has, in general, become a principle of an
independent regulator, is that its administrative expenses are
generally provided by fees on the regulated industry. But
again, I think that is an issue that needs to be considered in
light of all of the full range of issues that are relevant to
both the type of regulator that would be put in place and to
the best structure of regulation that would ultimately address
the issues that I outlined in my testimony.
Senator Allard. Now, if it went into an agency, would you
expect that agency to absorb those costs, or do you expect the
industry to pay for it?
Mr. Quarles. Again, that is not a question on which we have
a final view. But again, the usual structure of an independent
regulatory agency is that it assesses fees in order to cover
its costs.
Senator Allard. Now, Mr. Secretary, in your written
testimony you noted that the European Union has undertaken
reforms to forge one insurance market for all 25 of its member
states in the E.U. If the Europeans are successful in
establishing a unified insurance market do you visualize any
adverse consequences for the U.S. insurance market and/or the
competitiveness of U.S. insurance companies?
Mr. Quarles. Well, I do think that the structure of
regulation, particularly for financial services companies has a
significant impact on the competitiveness of the regulated
industry. So as the regulation of an industry in another
jurisdiction becomes more streamlined and efficient, one would
expect that to result in increased competitiveness for the
affected industry, and at the margin result in a competitive
advantage for that industry versus the United States.
Senator Allard. Now, we have a decentralized regulatory
regime right now basically right now with the States. Is there
an adverse impact, from your point of view, on the global
market and how the insurance companies can compete?
Mr. Quarles. The existing issues largely result from
questions of reciprocity when a domestic insurer wants to
operate abroad, and frequently the regulatory structure abroad
requires the jurisdiction in which they want to operate to have
a point of contact, to have confidence in a single, regulatory
interlocutor in the home jurisdiction of the financial services
company, in this case an insurance company that would be
operating abroad. So, that is a current issue.
More broadly, I think there is a concern that if, over
time, insurance companies that become used to operating under
more streamlined regulatory jurisdictions abroad come to view
our current regulatory structure as too much of a barrier to
trade, that further barriers could be imposed on our financial
services companies wanting to operate in their jurisdictions.
Senator Allard. OK. My time is expired.
First individual in on the opposite side is Senator
Johnson.
STATEMENT OF SENATOR TIM JOHNSON
Senator Johnson. Well, thank you, Mr. Chairman. I regret
that I was delayed. As you know, this hearing is overlapping
caucuses and it complicated some things, but I appreciate--what
I thought I would do is, I want to make a statement and then I
want to ask Under Secretary Quarles a question at the
conclusion of that.
I do appreciate holding this hearing on a continuing effort
to examine the issue of insurance regulatory reform. Last week
we heard from 10 witnesses representing various segments of the
insurance industry, and the general sentiment expressed was
that it is time for the Federal Government to act. And I agree.
Senator Sununu and I have done just that. We have crafted a
comprehensive legislative proposal that would give insurers a
choice of charter.
Insurance is the last sector of the financial services
industry for which there is no concurrent State and Federal
regulation, but it appears that the climate is changing. With
the proliferation of the Internet, the world is becoming
smaller and smaller while the national and global marketplaces
are becoming larger. Consumers today have more information
available to them than ever before. Virtually instant access to
information, allowing them to comparison shop for products and
services all over the world.
Businesses have to be able to meet consumer needs and
expectations. Insurance is no exception. It is a large, complex
and diverse industry and its growth should not be hindered by a
regulatory structure that has failed to adequately adapt to the
evolving business environment and consumer demands. This
process is about reforming a system of regulation that has
failed to keep pace.
What was once a sector of the economy that was marked by a
local geographic focus, the financial services industry has
taken on a national, and even a global focus. And as a part of
that industry, insurance cannot and should not be left behind.
Not everyone is convinced that we need to create a dual system
of regulation like we have for the securities industry or the
banking industry. Some argue that consumers will be confused by
having to deal with more than one regulator.
I have to echo the sentiments expressed by my colleague,
Senator Sununu, last week. Consumers are not dumb. And quite
frankly, many consumers right now hold policies that are
governed by more than one regulator, as do many Members of
Congress who maintain residences in different States.
Under an optional Federal charter, my local agent in South
Dakota, who wrote the policy on the home my wife, Barbara, and
I own, could obtain a national license and also be able to take
care of my insurance needs here in Washington.
As a consumer, it has never occurred to me that I have
insurance policies that are governed by the laws of different
States, and I have never had a reason to call Merle Scheiber,
South Dakota's Director of Insurance because of an issue that
my agent or insurance company could not assist me with.
What has occurred to me is that because I own property in
different States, I have to do business with different agents
licensed in those different States. And for that I have no
choice.
However, S. 2509, the National Insurance Act, would give me
that choice as a consumer, and would give my agent a choice, as
well.
I am also disappointed that opponents of Federal
legislation have suggested that the Federal Government is
incapable of protecting the interests of consumers, and that
Washington is full of inexperienced, insensitive and
unresponsive bureaucrats who would make a mess of insurance
regulation and consumer protection. I just could not disagree
more.
We have created systems of Federal regulation here in
Washington that are widely referred to as world class. A
Federal insurance regulator would be no less. I expect the
commissioner of national insurance to be an expert on the
issues facing the industry and develop strong consumer
protections and regulations that are applied and enforced in a
fair and impartial manner.
I want to be clear. A Federal regulatory agency should not
be expected to be a close friend of the industry, nor should
the industry or agents expect to have its ear. That would be a
recipe for disaster.
Mr. Chairman, I look forward to hearing from our witnesses
today. I have appreciated the testimony of Under Secretary
Quarles. These witnesses are highly credentialed experts, and I
appreciate their willingness to appear before us today.
To Under Secretary Quarles, some people believe that the
Federal Government does a pretty bad job of protecting
consumers or responding to their needs. How would you respond
to the contention that a Federal regulator would be distant and
that a State-based regulation of insurance assures a level of
responsiveness that simply cannot be matched at the Federal
level?
Mr. Quarles. Well, I think that whether a regulator is
going to be responsive or not is not a function of the level of
our governmental structure that we place that regulator at, but
the charge that we give that regulator and resources and
attitude of that regulator.
We have certainly seen that the Federal Government can do a
very good job of consumer protection. So I do not think that it
is inherent in the nature of the Federal/State dichotomy that
the Federal Government cannot do a good job of consumer
protection.
Senator Johnson. Do you believe the presence of a Federal
insurance regulator would threaten the survival or
effectiveness of the State system?
Mr. Quarles. I do not think that would be a necessary
consequence. In answering this question, I do want to
underscore that as we look at the various proposals on the
table at the Treasury Department we have not yet come to a view
as to what we think is the right approach. But it is definitely
not an inevitable consequence of creating a Federal option that
saps the vitality of the State system.
I mean, that is the attractiveness of one regulatory system
versus another, is going to be a function, again, of the
attitudes of the State regulators and their approach to their
regulatory responsibilities.
Senator Johnson. I realize my time is about expired. Let me
ask just one last point here.
Do you see evidence of competitive inequities between
banks, security firms, and insurance companies because of their
differences of regulation?
Mr. Quarles. As bank securities firms and insurance
companies do increasingly become competitors in areas of--in
offering certain financial products, I think that it is the
case that the current fragmented regulatory system does create
some obstacles for insurance companies in the time to market of
new products. And it is in the new products area that this
competition would largely be occurring.
So while I do not want to overstate the importance of that
differential for the insurance industry, the burden that that
places, I think that it is undeniable that there is a greater
time to market for a new product in the insurance industry than
in banking and securities.
Senator Johnson. Thank you, Mr. Secretary, and I yield
back.
Senator Allard. Let me now call on the Senator from New
Hampshire.
Senator Sununu. Thank you, Mr. Chairman.
Mr. Secretary, you talked a little bit about price controls
in your testimony and I think you indicated that you felt that
was perhaps the greatest factor or contributor to inefficiency
in the current State-based system.
Roughly how many States still have some form of rate
regulation or price controls?
Mr. Quarles. It is a very significant majority. I think it
is about 43.
Senator Sununu. Do you believe that consumers fare better
in States or under a system that does not regulate rates?
And if so, how so?
Mr. Quarles. No. I think that the, you begin with the fact
that--just look at average insurance expenditures in the States
that have less regulation. The States with less price
regulation do not have insurance expenditures that are any
higher than the States with more price regulation. In fact, the
States with the least price regulation actually have insurance
expenditures that are below the national average.
So, what would the reasons----
Senator Sununu. And that is something that has been
correlated?
Mr. Quarles. Yes. Absolutely. And when you look at what
would be the reasons for that, a State like Illinois, that has
relatively little rate regulation would, in fact, have
relatively low insurance expenditures.
And that is because of the operation of these residual
markets and the effect of price controls on the availability of
insurance that I described in my testimony.
When there is a price control that sets the price below
what would be the clearing price, then the insurer is going to
withdraw the supply of that product in that State. As it
withdraws the supply, the residual market mechanism would
require all insurers who were offering that line of insurance
in the State to participate in the residual market.
Senator Sununu. I want you to explain that in a little bit
more detailed fashion, how those residual markets work and why
it is problematic for price controls, why it is problematic for
their usage to be increased in the price control situation you
described.
Mr. Quarles. Sure. Absolutely. So, given the recognition of
the fact that if you require an insurance company to provide
its product at a certain price, it will choose not to provide
that to certain customers because it will judge the risk too
great for the price that it is allowed to charge.
Most States that have these price controls then have a
residual market in which the insurers are required to
participate for individuals who would seek automobile insurance
or worker's comp insurance that they would otherwise be unable
to obtain in the admitted market or in the voluntary market.
And if you offer a particular line of insurance in the
voluntary market, you are generally required to participate in
this residual market.
But while, in theory, you could come to the same effect by
pricing the residual market appropriately, in order to
compensate the participants in the residual market for the
extra risk they are taking for insuring these greater risks,
that is very, very difficult to do as a matter of practice.
So what you will almost, therefore, always see is that the
residual market risk is underpriced. And if it is significantly
enough underpriced, you will have insurers saying well, if I
offer this line of insurance at all in this State, even in the
voluntary market, I am going to have to lose money in the
residual market. And so I need to withdraw from that line
entirely in that State.
In order to prevent that from happening, the rate
regulators will then seek to adjust the price that is allowed
in these two markets, increase the price in order to make this
a continuing attractive economic proposition for the insurance
companies. But the effect of that is to result in average
prices that are either higher because of the inefficiency of
trying to set prices this way, or certainly no lower than would
be created simply by allowing the market to operate.
Senator Sununu. You suggest that the residual markets are,
more often than not, they are not self-sufficient. So where
does the money come from required to cover their operating
costs?
Mr. Quarles. Insurance companies are assessed to cover the
deficiencies of the residual market, which is another reason
that there is an economic disincentive for them to continue in
the activity that requires them to participate in that residual
market.
Senator Sununu. What is the long-term effect on price
controls on volatility, price volatility?
Mr. Quarles. Well, as I mentioned, when a rate regulator
sees that this effect is happening, it will attempt to adjust
the rates in order to make the market attractive. But because
this is not being set by the market because it is being set in
a centrally planned environment, those rate changes, when they
happen, are likely to be significant swings.
And therefore, the volatility of rates, it is not just the
level of rates that is lower in the less regulated States, but
the volatility is significantly lower in the less regulated
States.
Senator Sununu. One more question about price controls, and
then I will come back, because my time is up.
I read a description of--I think it was referred to as
price trapping in the market that suggests that another
unintended consequence of a price control is it makes insurers
less likely to lower their rate, even if their costs go down,
because of the fear--and I guess it is a natural fear, human
behavior--that they would not be able to raise them because
they are in a regulated environment. That for political
reasons, although it is hard to imagine any regulator ever
operating in a political way--and we have had some very good
ones testify in front of this Committee. But maybe for
political reasons people would be reluctant to approve a later
rate increase.
And so they would therefore not want to lower the prices
even if their own cost profile showed that they could do that
and still make money.
Is that real or did I just make it up?
Mr. Quarles. I do not have statistics for you today as to
how common an effect that is, but inevitably that disincentive
is there because rate regulation, in any environment, whether
we are talking about insurance or financial services more
broadly, or other areas where there is rate regulation, rate
regulation is also often very sticky on the upside.
Senator Sununu. Thank you very much. Thank you, Mr.
Chairman.
Senator Allard. I will now call on the Senator from Rhode
Island.
Senator Reed. Thank you very much, Mr. Chairman. Thank you,
Mr. Secretary.
Let me follow up on the line of questions Senator Sununu
raised about residual markets. Looking ahead, if there was a
Federal charter, then a company could go in under their Federal
charter into a State and not participate in the residual
market, which is mandated in the State law. Is that a fair
assumption?
Mr. Quarles. Well, it would depend on the specific
structure that was created, but in general that would likely be
the case with the Federal charter.
Senator Reed. And there could be then either an unintended
incentive to get out of the residual market, which you
described, some complications or problems with the Federal
charter, leaving the residual market diminished consistently,
causing those that stayed to pay increasingly higher prices to
cover the risk.
And the point of the residual market is to provide
protections to consumers that cannot get it in the voluntary
market. Is that correct?
Mr. Quarles. Yes. That is right. That would be a logical
consequence.
Senator Reed. But that would be, in some respects, a very
unfortunate consequence because you would diminish
opportunities to purchase insurance or you would shift the
burden onto those companies for one reason or another who
cannot get out of the State regime; is that correct?
Mr. Quarles. I think that--I mean, the issues that you are
describing are definitely issues that would need to be
considered, the incentives that would be created for movement
between regulatory regimes. I do not think that movement
between regulatory regimes, whatever the incentives that were
created, would be particularly rapid because of just the legal
and technological obstacles there are to move between
regulatory regimes.
But the issues that you are describing would definitely
have to be considered.
Senator Reed. This raises a general question. I wonder if
Treasury has looked ahead at some modeling or projecting the
dynamics of what would take place with these two charters. Have
you done that, Mr. Secretary?
Mr. Quarles. No. We have not.
Senator Reed. Would you consider that to be a useful
exercise?
Mr. Quarles. Absolutely. I mean, as this dialogue
continues, it is the sort of thing that we would need to look
at.
Senator Reed. One of the areas for concern, and I think you
addressed this in the context of the European experience versus
the United States is they are trying to streamline their
procedures, streamline costs, become more efficient. Some of
those costs, though, go to consumer protections.
And there is a fear, I think again, if we look ahead, that
if you have a very stripped down Federal approach, without some
of the protections that you have at the State level, that it is
inherently more attractive from a profit and loss standpoint,
you will get people moving over there and you will have
consumer protections that are weakened.
Is that a concern we should have?
Mr. Quarles. I think that should be less of a concern when
you are considering the options of a Federal charter or not.
Again, without wanting to take a view here at all, because we
think that all of the various structures that have been
proposed approach these issues in different ways and merit
consideration.
But I do not think that there would be, in any--I neither
think that it is inherently necessary nor likely that a Federal
regulator, even if it was streamlining the costs of consumer
protection, would do a worse job of consumer protection.
Senator Reed. Well, one would hope that you are right. And
it is our responsibility to make sure of that if we go down
this path.
Again your comment, it would seem to me then that if we
assume that consumer protections will be adequate and similar
to the States, we still have the issue of the residual market.
But the great attractiveness of this approach is avoiding the
registration costs and the--supervisory costs, rather, in 50-
plus jurisdictions versus one. Is that the biggest?
Mr. Quarles. The registration costs, as well as form
approval burdens. I mean, the general multiple administrative
burden. On the economic inefficiency, regulatory burden side, I
think that is important, although I do not think that the
regulatory burden on the industry is the most important reason
for considering the modernization of our current regulatory
structure.
I think issues like the international impediments and the
systemic blind spots that I have described are at least as
important as the regulatory burden.
Senator Reed. Thank you. Thank you, Mr. Chairman.
Senator Allard. OK, we have finished the first round of
questioning.
Senator Sununu. Can I just ask a couple of more questions
of the Secretary?
Senator Allard. That is what I am going to propose to the
Committee. I think we have got time to do a second round if we
limit it to 3 minutes. Is that satisfactory to the members? OK,
we will go to the second round and we will limit it to 3
minutes per person.
On regulating financial entities, it requires a great deal
of resources and expertise. And a successful regulator must be
able to attract and retain top caliber employees. And, in some
situations, it has been difficult for Federal financial
regulators to get adequate human capital.
In fact, nearly all Federal regulators are able to pay
above the general Government pay scale because of the demand
out there in the labor market.
Do you believe that States have the resources and experts
necessary to carry out the necessary level of oversight of
these large and highly complex entities?
Mr. Quarles. Well, I certainly do not want to characterize
all States or any particular State, but it would obviously be
true that there is significant variation in the resources that
States devote, and are able to devote, to insurance regulation.
Some States, obviously, devote a lot of resources and
relatively sophisticated resources to it. They are able to do
that. But others are not. And I think that is an issue, the
significant variability of the resources.
Senator Allard. In insurance, we have companies that may
specialize in certain areas. You may have casualty and property
companies. You may have life insurance companies. You may have
automobile insurance, title insurance, medical liability,
medical insurance.
What area do you think most necessitates a Federal
regulator?
Mr. Quarles. As we look at the issues, I do not think that
I would prioritize across lines at this moment. I mean, the
broad categories of issues that I described at the outset of my
testimony, whether it is regulatory burden, international
impediments, systemic overview, are applicable really across
each of those lines to one degree or another.
So as we think about the issues right now, we have not
prioritized which are most in need of regulatory reform. We
think that it is applicable, really, across them all.
Senator Allard. In my State of Colorado, in some insurance,
we get put into a regional pool. So the insurance company just
does not look at the State, but also looks at other States that
might be part of this pool. For example, in some, we are a part
of California, which we accuse that of creating a high-premium
rate for people in Colorado.
Do you think that a Federal regulator would have an impact
on these regional pools?
Mr. Quarles. I think it is certainly easier for a Federal
regulator to consider issues across State boundaries. Issues
that effect State-to-State relationships.
Senator Allard. My time is expired. I might want to pursue
that a little further later on.
The Senator from South Dakota.
Senator Johnson. Mr. Secretary, is there anything
especially unique about the business of insurance, of the
insurance industry, that would make an optional Federal charter
or concurrent State and Federal regulation inappropriate or
inoperable?
Mr. Quarles. No. I do not think so. I think that, while
there are, obviously, a number of unique aspects of the
insurance industry versus other elements of the financial
services industry. I do not think that any of them relate as to
whether a Federal regulator would affect the question--whether
a Federal regulator is appropriate.
I think whether or not one concludes that that is the right
way to address the issues we have described here will depend on
other considerations and not on the special nature of
insurance.
Senator Johnson. Given the fact that Congress has been
confronted with a number of insurance issues over the past few
years that have been national in scope, such as TRIA, and large
scale devastation, such as we experienced with Hurricane
Katrina, do you believe that a Federal regulatory presence of
some sort on some insurance matters is needed?
Mr. Quarles. I think that has been a weakness in the
overall Federal Government regulatory structure. And again,
without wanting to describe how one should address it, we do
find that there is a weakness in our ability to analyze and
address insurance issues, generally.
Senator Johnson. I yield back.
Senator Allard. Senator from New Hampshire.
Senator Sununu. You indicated, in your testimony, that
foreign capital is important to the insurance market, and that,
to some degree, perhaps the State regulatory structure can
impede that flow. Could you describe a little bit the role that
the foreign capital plays in our domestic insurance markets?
And in what ways in particular could the regulatory system be
improved to help sustain a better flow of foreign capital?
Mr. Quarles. Well, the role that foreign capital plays in
our insurance markets--which is beneficial--is the role that it
plays in our economy generally, but particularly in financial
services.
There are very sophisticated foreign financial services
firms that are capable of providing useful competition in the
industry as a whole, which is always beneficial to consumers.
They can provide additional product innovation. There are a
number of ways in which foreign financial firms, particularly
from other developed countries--I am thinking particularly of
Europe--can bring benefits to our financial services sector
through participation.
But it is not nearly anecdotal. I mean, we hear a lot of
anecdotes from foreign insurance firms that they find our
insurance regulatory system enough of a barrier that, at the
margin, they are less likely to make investments in our
insurance industry and to operate in our direct insurance
industry in the United States, which is the most heavily
regulated.
And you can see that simply by looking at just the general
level in foreign participation in different financial services.
In the banking area, for example, over a very long period,
foreign participation in the banking industry has been 20 to 25
percent of the industry as a whole. In direct insurance in the
United States, it is significantly less, maybe about 15 percent
of premiums for direct insurance in 2005 were written by
foreign-controlled firms.
Senator Sununu. Assuming for the sake of discussion that
Senator Johnson and I have persuaded 98 of our colleagues to
support our legislation, and 435 members of the House of
Representatives and it is on the verge of becoming law because
the President is prepared to sign the legislation, having
received that recommendation from his top policy advisors at
Treasury, would you suggest or prefer that a regulatory agency
for life and property and casualty be independent with Treasury
or an entity that stood by itself outside of Treasury?
Mr. Quarles. That is interesting. So, the question that you
are asking is it better for a regulatory agency to be
independent within Treasury, as opposed to just within
Treasury.
Senator Sununu. Yes. I think we can assume that is going to
be an independent thinking regulatory body, but should it be
within Treasury or outside?
Mr. Quarles. Well, that is an interesting question. I do
not want to give you a final view on the specific question with
respect to insurance today, because it is not one that we have
completely formulated?
Senator Sununu. So you are refusing to answer my question?
[Laughter.]
Senator Sununu. It has happened before.
Mr. Quarles. I promised that I would never do that. But, as
a general rule, I do think that, just as a general matter of
organizational behavior, if you will, it is something of an
issue when an entity is within an organization that, in fact,
has no control over it, but then is expected to have some
responsibility for it.
And I do not know, again, that that structure is, in fact,
is necessary for the efficient operation of a regulator. But
those would be, I think, some of the principles that we would
have in mind as we looked at that proposal.
Senator Sununu. Thank you.
Senator Allard. Thank you, Senator Sununu. I did not
realize that you were such an idealist that first question
implied.
Senator Sununu. Well, it is all hypothetical.
Senator Allard. Well, we have completed the first round. I
would just remind the members of the Committee that the
Committee asked for questions to be submitted within the week,
and then we ask the participants on the panel to respond back
in 10 days. I hope that, Mr. Secretary, you would be willing to
do that. And thank you for coming and testifying before the
Committee.
Mr. Quarles. Thank you, sir.
Senator Allard. We will now go to our second panel. And on
our second panel, we have Dr. Scott Harrington, who is the Alan
B. Miller professor at the Wharton School, University of
Pennsylvania.
He is joined by Dr. Robert Klein, Director of the Center
for Risk Management and Insurance Research at Georgia State
University.
And when you gentlemen get settled, we will start off with
testimony first from Dr. Harrington, and then we will go to
you, Dr. Klein. And you are familiar with the rules, I think,
that ask for 5-minute testimony. We will not be real strict on
that enforcement, but at least reasonably close, if you would,
please.
STATEMENT OF SCOTT HARRINGTON, Ph.D., ALAN B. MILLER PROFESSOR,
THE WHARTON SCHOOL, UNIVERSITY OF
PENNSYLVANIA
Mr. Harrington. Good afternoon, Mr. Chairman, and members
of the Committee.
Much of my research over the past 30 years, for better or
for worse, has focused on the economics of insurance markets
and insurance regulation.
A number of my publications have dealt specifically with
whether problems in insurance markets and insurance regulation
justified some form of optional Federal chartering. And, at the
time, given my assessment, I concluded ``no.''
In February of this year, I prepared an issues paper on
possible Federal chartering of insurance companies and other
Federal intervention for the Networks Financial Institute.
Despite some reforms, I highlighted that regulations of
rate classification and policy forms remain dysfunctional in
many States. With no end in sight, and with burdens on
interstate commerce, cross-sector competition, and cross-
national competition, I concluded that some form of Federal
intervention was necessary to modernize insurance regulation.
When not impeded by misguided regulation, most modern
insurance markets are highly competitive. Regulations should
focus on reducing the extent to which some insurers might
misrepresent or fail to keep their promises. It should do this
through appropriate monitoring of insurance solvency and some
oversight of sales and claims practices.
The main features of State regulation and solvency are
entirely sensible. The system of limited ex post assessment of
solvent insurers to pay a portion of failed insurers'
obligations is appropriate economically, and it works
reasonably well, especially under some circumstances. Limits on
State-guaranteed protection reduce their adverse effects on
policyholders incentives to deal with safe insurers.
Compared with pre-funding, such as occurs under deposit
insurance, ex post assessment likely increases financially
strong insurers' incentives to be vigilant in pressing for
effective solvency regulation.
But other aspects of State regulation fail to pass a cost
benefit test. Lack of uniformity, unnecessary or excessively
burdensome processes for form approval represent a major
problem. They disadvantage insurers compared with federally
regulated financial institutions and something really needs to
be done to help speed to market.
Price controls are truly problematic. State requirements
that regulators approve rates before use for many types of
insurance are unnecessary and counterproductive.
Prior approval regulation of insurance rates produces
significant administration and compliance costs borne by
consumers.
It cannot and does not affect insurance company profits in
the long run. It impedes timely adjustments of rates to new
information. It produces fewer but larger rate changes, greater
swings in coverage availability in residual market size, and it
increases insurers' risk.
Quite a bit of my research over the years has documented
these effects. In addition, some States significantly restrict
underwriting and rate classification, including caps on
residual market rates.
Some of these policies provide some benefit. But, in
general, they create cross-subsidies from lower-risk buyers of
insurance to higher-risk buyers. They push up average premium
rates in a State to a more high-risk insurer and fewer to low-
risk insurers, or they buy less coverage.
And these types of subsidies to high risk reduce higher-
risk buyers' incentives to take action to mitigate risk.
In some cases they require costly State re-insurance or
risk adjustment mechanisms to insure stable markets with all
sorts of distorting influences.
Appropriately designed, optional Federal chartering and
regulation of insurance has the potential to achieve the
essential goals of regulatory modernization, to increase
uniformity, to provide national certification or approval of
policy forms, to have rates and rate classes determined by
competition, rather than rate regulation, and streamline or
lower the cost of monitoring market conduct.
And it can do this all, with luck, while preserving or even
enhancing private market incentives for safe and sound
insurance markets. It will motivate States to further modernize
and it could promote beneficial regulatory competition over the
long run.
Requiring federally charted insurers to participate in the
State guarantee fund system, perhaps with minimum standards, is
a sensible approach in any optional Federal chartering.
It should be recognized, however, the guarantees of
insurers' obligations under Federal chartering could evolve
toward nationalization over time, with uniform coverage. And
with some Federal oversight of State-chartered insurer's
insolvency, as is true in the dual banking system.
Any optional Federal chartering system will entail some
risk that the scope of Government guarantees of insurers'
obligations will ultimately increase, including being backed by
the full faith and credit of the United States, reducing
private incentives for safety and soundness.
A fundamental goal should be to avoid expanding guaranteed
fund protection under any optional Federal chartering system,
and impossible to intelligently narrow the scope of guarantees
to encourage private incentives for safety.
A pre-funded Federal guarantee system should likewise be
avoided. Federal-chartered insurers' rates should not be
subject to prior approval regulation. In turn, that would help
discipline regulation of State-chartered insurers' rates. There
are, again, inherent uncertainties, both about the specifics in
any legislation that could ultimately be adopted, and whether
any initial exemptions for freedom for price controls would
persist over time.
With regard to residual markets, it is not part of any
unnecessary optional Federal chartering plan that Federal-
chartered insurers' would not have to participate in residual
market.
But what is important is that if they participate in
residual markets that there are some sort of safeguards, at
least written safeguards, that would discourage extensive cost
subsidies at the State level through the residual market
mechanism.
Optional Federal chartering could be an effective engine
for modernization. There are risks, and it would involve the
cost of creating a new Federal regulator. Unintended
consequences or mistaken policies would have national
repercussions.
There are other approaches. One would be narrow and
carefully targeted preemption of certain State regulations that
do not meet minimum standards.
And a second would authorize insurers to choose a primary
State for regulation and operate nationwide, in large part,
under the rules of that State. I think both of those types of
approaches are also worthy of serious consideration.
Thank you.
Senator Allard. Dr. Klein.
STATEMENT OF ROBERT W. KLEIN, Ph.D., DIRECTOR OF THE CENTER FOR
RISK MANAGEMENT AND INSURANCE
RESEARCH, GEORGIA STATE UNIVERSITY
Mr. Klein. Good afternoon, members of the Committee that
are left, or will be here. I appreciate the opportunity to
speak to you today about insurance regulation.
I am going to try to keep my comments relatively short, but
obviously, I am going to be open to questions. My views on the
issue of what kind of regulatory reforms are needed are
probably pretty close to Scott Harrington's. My views on the
institutional route to those reforms lie somewhere between the
optional Federal chartering proponents and the optional
chartering opponents.
So, at the end of my testimony, I am likely to have made
more enemies and less friends, and probably just about
everybody will hate me. But that is not untypical for me to do.
Senator Allard. Welcome to the academic world.
Mr. Klein. I am sorry?
Senator Allard. Welcome to the academic world.
Mr. Klein. Right. I will just briefly mention, in 30 years
I have been an insurance regulator, and I have worked for
insurance regulators. And, during the last 10 years, I have
been an academic studying insurance regulators. So, that is
what I have been doing.
I am going to quote a bit from my written testimony, and
then I am going to do a little ad hoc summarization.
In my opinion, the States have come a long way in improving
their regulation of insurance, but further reforms are needed,
both in terms of the States' structures and processes, as well
as their policies.
I think the preferred institutional route to this goal is
strong Federal standards for and oversight of States'
regulation of insurance that will move their structures and
policies to where they need to be.
In essence, the States need to appropriately and
efficiently regulate things that need to be regulated, and not
regulate things that do not need to be regulated.
However, if this cannot be achieved under the institutional
arrangement that I would prefer, then an optional Federal
charter approach may be necessary to achieve the objectives the
States would be either unwilling or unable to achieve.
The specific reforms that I propose reflect four basic
themes or characteristics.
One, the elimination of regulation where it is not needed.
Two, uniform and appropriate and efficient regulation where
it is needed, to the extent that uniformity is possible, given
differences in State laws that cannot be changed.
Three, singular institutions and processes for insurers'
filings and applications that would be approved for all States.
And four, full rationalization and coordination of all
State enforcement and compliance activities.
In the regulatory system that I envision, the States would
efficiently enforce a uniform set of regulations, to the extent
that uniformity is legally feasible in their respective
jurisdictions and the inefficiencies and costs of unnecessary
State differences and redundant regulatory processes would be
minimized.
I have prepared a list of 11 reforms which I will list or
summarize.
First of all, there should be a uniform set of requirements
for insurance products sold to persons, small businesses, and
for mandated insurance coverages, to the extent that the
uniformity is legally feasible.
So, we would have requirements, but they would be uniform
among all States.
Regulatory restrictions or mandates on insurance products
sold to medium and large businesses should be eliminated,
except where Government requirements or significant
externalities compel such regulation.
Prospective price regulation should be eliminated in all
lines of insurance except those lines where market failures and
abuses have been demonstrated, such as title insurance and
credit insurance.
Some residual authority to intervene in pricing should be
retained should competition and market forces fail to ensure
fair and competitive rates.
A process should be established that would allow an insurer
to make one product filing that could be approved for sale in
multiple States, as well as one licensing application that
could apply to multiple States.
A rigorous set of uniform financial standards should be
established, maintained and properly enforced. We are almost
there but we have more ground to cover.
Also, the laws and process for administering insurance
company receiverships need to be further rationalized and made
uniform among the States.
There should be streamlined and appropriate State
enforcement of all insurance regulations that are retained or
instituted, including single, national, financial and market
conduct examinations that would serve all States.
Efforts to streamline and nationalize the licensing and
regulation of insurance producers should continue to their
maximum possible fulfillment.
I will just briefly summarize the rest of my points.
We do need to look at systems for the reporting of various
insurers' data, beyond that which you would call financial
data. That is an area we need to look at.
I would basically do away with elected insurance
commissioners. I would have them all appointed.
I do think that there should be a further strengthened
program of consumer public education and information. I think
that, despite all of the efforts that we have to get consumers
more informed, there is a huge amount of ignorance out there,
which is a problem. So we need to be more aggressive and
proactive in that area.
And finally, if we establish the type of institutional
framework that I described, we are going to need some kind of
comprehensive and continuing evaluation of that structure. So
that, basically, we have a certain amount of Federal monitoring
and oversight to make sure that the States are doing what they
are supposed to be doing, and that the system that has been
established and designed functions as it is supposed to
function.
So, those are essentially my recommendations, and I will
leave it at that. And I will be happy to answer any of the
questions that you may have.
Senator Allard. Let me start off a question for the panel.
I would like to have your view on insurance that operates in
smaller States--I am talking population-wise--as opposed to
larger States.
And insurance companies face certain compliance and market-
entry costs in order to do business in a State. And does this
leave the smaller States, potentially, at a disadvantage? I
would like to have your comment on that.
Mr. Klein. That is a good question. I think that probably
smaller States, perhaps, do present a little more of a
challenge for insurers in terms of entry. I mean, basically, if
you were to look at the number of insurers operating in a small
market versus a large market, a small market is going to have
fewer insurers. They are going to be less likely to make the
expenditures necessary in order to operate within that State.
So, I think a small State, to a certain extent, probably
does suffer a bit in terms of entry costs or compliance
requirements relative to the volume of business that a company
could do in that State.
Senator Allard. So, if they sign off on agreement that they
are going to have a certain regulatory agreement, it might work
out fine for the larger State, but on the smaller State, it
would not work out so well because you have such a small
market.
Yes. Dr. Harrington.
Mr. Harrington. I would say that if the regulatory
environment is conducive to making insurance companies feel
that they can market their products at rates that will cover
their costs, it is really not a material issue on our modern
markets.
As an example, in South Carolina, where I lived for 16
years, when they relaxed some pernicious automobile insurance
regulation, the number of auto insurance writers went from 100
to up to the high 100's within 12 months.
So, at some point, smallness is a problem, but I do not
think it is really an issue in our modern world unless the
State does things to make it hard for companies to operate.
Senator Allard. Yes.
Yes. Dr. Klein.
Mr. Klein. Yes. I would tend to agree with Scott. I think
that if we had a system that worked the way that I would
conceive of, and I think that the way that Scott would conceive
of, where essentially, whether it is through an optional
charter or it is through uniform requirements in all States,
entry barriers in small States would not be significant. So,
basically, an insurer creates one product and is able to sell
it in all States, then you basically remove that cost and entry
barrier.
So, they can sell it in South Dakota. They can sell it in
New York. A State's market size does not matter too much, other
than maybe some issues relative to distribution.
Senator Allard. If you had, with the insurance company,
when we talk about the optional charter, you can either go
Federal or State, are you thinking in your mind, that an
insurer might select several States that he might get licensed
in to sell insurance? And a Federal charter that would
encompass that would encompass all, or are you thinking in
terms of just one State, which might be his headquarters, and
he insures in there, or he goes to a Federal charter?
See what I am trying to get at? Some insurance companies
may be able to cherry pick the market if they can pick the best
States that have the best markets and go with those, as opposed
to a Federal charter. And that might be 10 States as opposed to
a Federal charter. I would like to have your comment on that
option that might be available.
Mr. Harrington. I would presume that an optional Federal
chartering system would require an entity to pick. You either
have a Federal charter and you operate nationally subject to
that charter, or you maintain the current requirements to get
licenses in every State where you write business.
Now, I certainly think that companies will make that
decision strategically and in the interest of their owners. And
that is one of the possible advantages of moving in that
direction. And that it will then encourage regulatory
environments that could help to lead to entry in robust
insurance markets.
Senator Allard. It seems to me, maybe, more of a
competitive market, where it would at least, as far as the
Federal charter is concerned, might be a force that would hold
down, you know, Federal charter rate costs. You know, what the
insurance company would get charged for a Federal charter. Mr.
Harrington. I think, in general, that there are advantages that
could reduce costs associated with regulatory competition.
Senator Allard. Yes.
Mr. Harrington. To be sure, we do not know, yet, what might
happen in insurance if we have optional Federal chartering. I
am not sure that it will be that easy for insurers that choose
the Federal charter, for example, to switch later on if they
had to go back and get licensed in 46 States or 49 States.
So, that could detract a little bit from the competitive
results.
Senator Allard. Yes.
Dr. Klein, do you have any comment on that?
Mr. Klein. Yes. A little bit. I think I tend to agree with
Scott. I think that my sense would be that most of the national
companies that operate in a large number of States would
basically opt for the Federal charter, and that really should
be the regulatory regime if we are going to have that kind of
system.
And presumably they will stay with that as long as the
regulator and the Republicans are in the majority. But there
could be a time--I do not necessarily want to show any
disrespect--we could have a Democratic President and a
Democratic regulator appointed and Federal regulation, at that
point in time, might not look so good to certain companies. And
so there would be a question if they would switch or could
switch. And that could be an issue.
But my sense is that, basically, if we went to this
optional system, we would have a large number of national
companies that would, basically, go for the Federal charter and
keep their fingers crossed that the regulatory regime would
stay reasonable.
And you would have a withering of State insurers and you
would have a few insurers that would just specialize in certain
State or certain niches. And that is probably a market
segmentation that would result.
Senator Allard. Personally, I like to hold down the
regulatory environment, but sometimes I do not know how much
company I have on that effort.
Senator Johnson.
Senator Johnson. Well, thank you. I would only observe that
our friends in the banking industry do not seem to be going
back and forth between Federal and State charters depending on
which party is in the White House. I think that the regulatory
balance has been fairly stable there.
Let me just ask a couple questions to each of you. One of
the early on debates that we have had relative to a Federal
regulator is whether that regulator is more appropriate for
life insurance than it is for property and casualty, or whether
we ought to stick to a more comprehensive approach, and that
there is no necessary advantage or disadvantage either way.
Would either of you care to comment? Is there one element
of the insurance industry that is significantly where a Federal
regulator more justifiable than another?
Mr. Harrington. That is a very interesting question. I have
not reached a final conclusion.
But seriously, at times I think that the speed to market
issue and the competition of life insurance companies with
other financial institutional and the accumulation of
management business creates an additional edge which makes it
very, very important for them to get more uniformity and more
rapid speed to market.
But when I go down that route, I start thinking about prior
approval rate regulation or property casualty insurance,
residual market rate caps, and all of those things, as well as
the fact that in the modern world, many of the larger entities,
of course, have life insurance and property casualty insurance.
So, things really are not that simple across product lines.
Mr. Klein. And my response would be that to a certain
extent, I think you have got a point. I think for life
insurance and annuity products we would not expect there to be
significant differences between States in terms of what people
need, other than income levels might be different. So that does
kind of lend itself, perhaps, to greater uniformity and that is
probably one of the reasons why the NAIC has adopted uniform
standards in that area more readily.
But the other side of this is that I do feel, and I agree
with Scott, that there does need to be a lot of reform on the
property-casualty side. There is a lot of regulation there that
simply, in my view, is not necessary, or potentially harmful.
And the States need to make further, major moves in that area.
And if they would be willing to do that with the type of
institutional structure I described, that would be terrific. If
not, then I think maybe optional chartering would have to be
the alternative. But, one way or another, I think those changes
need to occur, and so we have got to get there somehow.
Senator Johnson. And Dr. Harrington, some of your
publications in the early 1990s, you concluded that Federal
regulation of insurance and the possible optional Federal
charter would not have been an appropriate response and not
justified at that time. But since then, you have concluded that
States' regulation of rates, rate classification and policy
forms remain dysfunctional in many States and with no obvious
end in sight.
Can you elaborate just a bit on what has led you to decide
that now is the time to start considering Federal regulation or
possibly an optional Federal charter? Were there situations and
specific organizations and States that led you to the
conclusion that States can no longer do an adequate job of
insurance regulation.
Mr. Harrington. Senator Johnson, that is an excellent
question. I have had to really think long and hard about that
issue.
I think in the past 3 or 4 years I became even more
distressed by what I observed in terms of the politics of State
regulation. And I also became more knowledgeable and aware and
concerned about international insurance, international
insurance competition, and the competition between insurance
companies and other financial institutional than I had been
previously.
My earlier writings, to some extent, more focused on
insolvency problems that had arisen and arguments for Federal
chartering that related to alleged defects in State oversight
of insolvency. And I felt that the States had taken actions and
done some things that had redressed those problems.
But it is really an evolution of the modern economy, as
well as seeing State regulation in action, in some cases, up
close and personal, and I found it to be very distressing.
Senator Johnson. Let me close with just one last question
to Dr. Klein.
In your testimony, you stated that you had a concern that
you had with adequacy of State regulation of agents and brokers
and noted some instances of fraud.
Is this a symptom of the patchwork of State laws and
regulations in this area, or do you think a Federal regulator
would be more effective in educating and regulating agents and
brokers in enforcing stringent standards of conduct?
Mr. Klein. That is an interesting question. I think it does
have something to do with a patchwork. I mean, there is a lot
of variation and some States, I think, do a much better job of
regulating and ensuring the competency of agents than others.
It is possible that a Federal regulator, if it really
focused on it properly, could do a better job of making sure
that agents were competent and did not commit fraud or abuses.
But, on the other hand, a good State regulator that is very
focused, that has very good standards, is very hands-on, can be
effective; but there is a potential for problems in States that
have not handled that well.
And I am sure there are a lot of instances like that.
Senator Johnson. There is a great deal of variability. So,
that is where the recommendation that I would make is that I
would have uniform standards, but I would make them rigorous.
Mr. Klein. Yes. There is a great deal of variability.
Some of this has to do with incompetence and some of it has
to do with outright fraud. The fraud is a problem that deserves
a different type of enforcement approach. But the incompetence
thing is also an issue and that really is a matter of not only
having high competency requirements, but making sure that the
agents continue to maintain that level of competence.
Senator Johnson. Having some kind of Federal standard or
Federal regulator may, in fact, be on the side of consumer
protection.
Mr. Klein. In that respect, it could be. Yes.
Senator Allard. Senator from New Hampshire.
Senator Sununu. Thank you.
Dr. Harrington, Under Secretary Quarles spoke about what he
perceived to be the problems with rate and price controls. I
take it that you generally agree with his assessment.
Is there a particular aspect of price controls, or a
particular effect that price controls have on insurance markets
that your research has shown to be particularly problematic?
Mr. Harrington. The two most problematic aspects are the
tendency for some States, occasionally, not to allow rates to
go up on average commensurate with the growth and claim costs.
It creates availability problems and increases residual
markets. It also tends to lead to changes that bump around more
than what they probably need to.
Senator Sununu. Greater volatility.
Mr. Harrington. Right.
And then the other thing is very State specific, it is when
there are decisions made, really, to hold down rates for
certain segments of the population in ways that produce
substantial deficits in residual markets.
And, over time, they require greater rates for the
voluntary market. So you end up in those mechanisms by trying
to lower rates to some, you end up raising rates to others. I
think that is negative sum.
Senator Sununu. He noted that over 40 States still have
some kind of rate and price regulation. What is the
international experience? Do our counterparts in Europe, for
example, still regulate prices in insurance?
Mr. Harrington. I do not have detailed information in all
countries, but in Europe, in general, the movement has been in
the past 15 years, away from price regulation and toward
reliance on competition, with some very narrow exceptions
related to public health insurance programs.
Senator Sununu. How would residual markets operate in an
environment without price controls? How can Government, broadly
speaking, a Federal regulator in this particular case, ensure
that the main objective of residual markets continues to be met
in a world where we do not have price limits, price caps, price
controls?
Mr. Harrington. Senator Sununu, that is an important
question and a difficult one. In principle, I think that it is
easy to say that with Federal chartering, federally chartered
insurers should participate in State residual markets, but
those markets must be designed so that the rates that are
charged are self-sustaining.
The question is, how do you actually get to that result and
practice?
For the types of insurance that we are generally concerned
with, and ignoring catastrophe coverage, which can be
troublesome, it is possible for reasonable----
Senator Sununu. I am sorry. When you say catastrophe
coverage, what are you talking about.
Mr. Harrington. I think certain types of--the hurricane
risk----
Senator Sununu. You are talking about specialty insurance,
not general property casualty, auto insurance.
Mr. Harrington. For Worker's Compensation insurance,
automobile insurance, it is quite possible to get a handle on
what rate adequacy should be for the market of last resort.
Many States have done this for decades and, as you know,
their residual markets for automobile insurance have been very
tiny, because the rates for the residual market do not crowd
out the private sector.
Senator Sununu. Are there any residual markets for
hurricane insurance or earthquake insurance?
Mr. Harrington. Yes. There are. We have the special State
systems in some States. I do not know if they would fall under
the rubric specifically of residual market.
And we also have beach and windstorm plans in a number of
the coastal States.
Senator Sununu. But you are suggesting that there are some
markets where insurers are forced to offer and sell hurricane
insurance?
Mr. Harrington. In a number of the States for many years,
there have been regions on the coast that have been designated
as eligible for coverage through a beach State--beach and
windstorm plan--which is, in essence, a residual market.
When those plants have performed well, the rates have
helped affordability, but they have not produced large cross-
subsidies and assessments.
Senator Sununu. But is insurers participation in those
plans compulsory?
Mr. Harrington. I believe it is in some States. I cannot be
certain on all the States.
Senator Sununu. Excellent. Thank you. You talk about it
being ideal to narrow the scope of the guarantee funds.
What does that mean?
Mr. Harrington. Let me give an example. In some of the
States, have no guarantee firm protection for large commercial
insurance buyers that have net worth in excess of some
threshold.
Large entities with resources do not need to be protected
against the consequence of their insurers' default. They can
manage that risk and they have the wherewithal to identify safe
insurers to keep that from happening.
So, there is not a strong public policy reason to rope in
large corporations as an example and give them protection. It
is similar to banking, where you have uninsured depositors.
Senator Sununu. Thank you.
Thank you, Mr. Chairman.
Senator Allard. I would like to follow up on the guarantee
fund question that Senator Sununu was pursuing. On an optional
Federal charter system, should the guarantee funds be
administered at the national or the State level? And what are
the implications of each type of administration?
Mr. Harrington. I have not thought through what should
happen. My thinking has been more on what I guess is likely to
happen. I think once you have Federal-chartered insurers and
State-chartered insurers, I think it makes perfect sense to
have the beginning of the system be participation in the State
guarantees by Federal-chartered insurers.
I think there will be pressures over time that would tend
to move toward having some nationalization of that system.
In terms of the specific administration of a national
system, I have not thought about it.
Mr. Klein. Yes. I would just add to that. I agree with
Scott about the short-term. I think over the long term there is
a problem when the administrator of the guaranty fund, so to
speak, or you have a situation where States regulation of
insurers that come under its purview for financial purposes
could potentially draw or impose costs on insurers that are,
say, nationally regulated.
When you get, basically, a disconnect between a regulation
and the payers, or the guarantors, you have got a problem. Now,
you actually have that problem right now, under the State
system. And that could be potentially worsened with federally
chartered insurers still contributing to State guaranty funds.
So, I think over time that kind of conflict would need to
be resolved. Actually, what exists, I think, in banking right
now seems to me to make a lot of sense.
Because, as I understand it, the FDIC guarantees both the
Federal banks and some of the State banks. And, basically,
their rules ultimately determine the financial standards, to a
great degree, for those institutions.
So, whoever the guarantor is, their standards and their
rules ought to apply over the entities that are being covered
so that you do not have this disconnect between the
responsibility of guarantees and the control over financial
risk.
Senator Allard. And another question along the same lines,
what are the implications of the funding guarantee funds
through assessments after insolvency, as is currently done by
States other than New York, as compared to a system that
collects annual assessments regardless of insolvency, such as
under the FDIC.
Mr. Harrington. I like the way ex post assessment has
worked in general in insurance markets, because, with some
exceptions, insolvency assessments have been very minor.
The historical risk associated with those assessments is
the type of thing that can readily borne on an ex post basis.
And there are mechanisms when assessments increase and they may
hit limits for making sure that the claims get paid.
Ex post assessments for many companies, but not all
companies, create, I believe, additional incentives for them to
pay attention to what regulators are doing and how effective
solvency regulation is and how effective liquidation of
insolvent companies is.
It gives them, I believe, possibly, more skin in the game,
than if they put money into a pot that accumulates over time
which they view as gone once it leaves their coffers. And I
think that is another useful reason to have ex post
assessments.
And another thing, the major advantage of charging
insurance companies in advance would be, if you could, in
principle, have risk-tailored premium for guaranteed
protections, so that an insurer would have more insolvency risk
would face a higher ex ante premium, which, in turn, would give
them an incentive to reduce their insolvency risk.
But I doubt that, in practice, we will ever get to the
point where we have reasonably accurate risk-based premiums for
guarantees for insurers. And my reason for that is
understanding some of the politics and having observed bank
regulation.
Senator Allard. Do you agree, Dr. Klein?
Mr. Klein. Pretty much. I mean, I also would like to see
risk-based assessments, whether post or pre, and I think
actually, you could have a risk-based post assessment, as well
as a risk-based pre-assessment.
But I also agree that it would be a highly politically
charged process. Even though, theoretically, if Scott and I
were running the system, we could probably develop good risk-
based charges, but the people that would be actually in that
situation would be under a lot of pressure.
So, I am not sure that you would get the result that you
would, ideally, like to have.
Senator Allard. Let me get back to what I was trying to get
at in an earlier question. I am going to put this in a little
different format.
Let me direct this to you, Dr. Klein. Someone suggested
that life insurance and property casualty insurance are
fundamentally different products. Life insurance is a more
national product, and therefore creating an optional Federal
charter for life insurance companies is more appropriate than
for property and casualty insurance companies.
What is your view, and does an optional Federal charter
make more sense for life insurers than for property casualty
insurers?
Mr. Klein. Well, as I indicated before, perhaps to an
extent, there is more commonality among life insurance products
and less of a State variation issue there.
So, one could make that argument, but I would not take that
too far because the argument that the conditions for property-
casualty insurance in the various States vary so much that
uniform requirements, whether done through an interstate
compact or done through optional chartering, or whatever, would
not work because States are so different in terms of their
situations is not valid in my view.
I put in my written testimony, that I do not really buy
that. There are some differences, but, basically, if you look
at the property-casualty insurance products that are typically
sold in various States, other than needing to meet different
State laws, they are pretty similar.
And so, I do not see variations among States being an
argument against uniformity in product regulation in the
property-casualty arena. And, in fact, I would advocate it for
both, both life and property-casualty. Understanding that maybe
in life insurance, there would be a little less of an issue or
concern about State variation.
Senator Allard. Dr. Harrington, do you have a comment?
Mr. Harrington. Yes. I do. The local nature of torte
liability law and Worker's Compensation law, I believe, at the
margin, makes the property casualty insurance business more
local than the life insurance business.
But on the other hand, some of the inefficiencies
associated with misguided regulation are particularly
pronounced for property casualty insurance and, in particular,
what we have been discussing in terms of rate regulation and
residual markets.
So, I do not have a strong opinion that one deserves more
than the other. I think that in property casualty insurance,
there are things that State regulators do that can have
spillover effects on insurance buyers on other States. And at
the margin that justifies some sort of national response.
Senator Allard. Some have said that the reason we have put
in place rate regulation is to prevent a race to the cheapest
policy. And then, by doing that, they under-price their
policies based on competition of the market. Is rate regulation
still justified to prevent a race to the bottom as some
suggest? And could solvency regulation take the place of rate
regulation in making sure insurance companies maintain adequate
reserves to pay future claims?
Mr. Klein. OK. I will answer that first, and let Scott give
his opinion. It is an interesting question that a lot of people
have asked me. And, based on my research, rarely, if ever, have
I seen a regulator disapprove a rate cut, no matter how severe.
And a good case in point, I guess, is what Reliance was
doing in Pennsylvania, or the other States in which it was
operating. I mean, I am not aware of any regulators who said
Reliance, you should not cut rates so far and keep spending so
much money.
I mean, for political reasons, and this basically happens
in commercial lines, a regulator is not going to oppose a rate
decrease. So, the only kind of situation that probably one
could contemplate, although I do not know that this has ever
really occurred is that if an insurer got to a point where its
rate cuts were so severe relative to its expected losses that
it did threaten its solvency--and admittedly, I think Reliance
was such a case--one could make an argument that there should
have been some earlier intervention by regulators. But for
whatever reason, reasons I would like to know myself, that did
not occur.
Basically, my response is that I do not think that rate
regulation can deal with the under-pricing phenomenon. I think
experience has shown that.
Potentially, a more active or proactive solvency type of
approach could deal with the companies that cut prices so far
that their solvency is threatened, which tends to have a
depressing effect on the rest of the market.
Senator Allard. Any comments, Dr. Harrington, on that
question.
Mr. Harrington. I agree with Dr. Klein and I think
regulators can pay more attention to companies that they think
might be under-pricing in the sense of taking a closer look at
their solvency.
But I just agree with Dr. Klein.
Senator Allard. Let me go to something more local, as far
as my State is concerned. Now, I understand that the NAIC is
attempting to address one of the industry's most pressing
concerns, and that is slow product approval through the use of
an interstate compact.
In Colorado, they brag about the fact that they are the
first State to adopt the compact. Now, what are your thoughts
on this initiative--and it seems to be moving ahead
successively. So, is it necessary for Congress to consider an
optional Federal charter? And, if so, why is an interstate
compact insufficient, and what are the problems with it?
Mr. Klein. Well, I have done a little bit of reading about
this, but I have to admit I have not really had an opportunity
yet to really thoroughly access how well it is working and what
the companies think about it.
It sounds promising, but I, at least, have a couple of
issues. One is, will other States join this? And two, I would
be interested in knowing what the companies who go through this
process, what their assessment of it is, and whether they feel
that it does satisfy their need for streamlined and uniform
approval of products.
So, it sounds like it is a good idea and it may be
accomplishing quite a bit of progress, but I have not really
been able to assess it.
Senator Allard. As I understand it, this compact just has
four general areas, life, annuity, disability, and long-term
care insurance.
Mr. Klein. Right.
Senator Allard. Yes.
Dr. Harrington, did you have a comment?
Mr. Harrington. I regard it as a very positive development
in general, but it will forever be incomplete and it is a slow
process.
Senator Allard. OK. I am going to draw the Committee
hearing to a close.
Again, I would remind this panel as well as the other panel
that Committee members have a week with which to submit
questions, and then we would ask that when you receive the
questions, you get it back to the Committee within 10 days, if
you would, please.
I would like to thank Under Secretary Quarles, Dr.
Harrington, and Dr. Klein for their testimony before the
Banking Committee. Insurance regulation is a highly complex
topic, and their testimony has aided our understanding of the
issue. In particular, their responses during the question and
answer period will be invaluable as we continue to explore the
appropriate regulatory reforms.
Just like Chairman Shelby, there are many members with
other commitments this afternoon, and I am sure that many of
them would like to take advantage of our witnesses' expertise
by submitting those questions for the record. Therefore, we
will hold the record open until the end of the week, should
they wish to submit any questions.
Witnesses, this is an important topic for the Committee, so
we would appreciate your prompt response to the questions.
Thank you all for being here today. This hearing is
adjourned.
[Whereupon, at 3:42 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF RANDAL K. QUARLES
Under Secretary for Domestic Finance
Department of the Treasury
July 18, 2006
Good afternoon Chairman Shelby, Ranking Member Sarbanes and Members
of the Committee. Thank you for the opportunity to appear before you
today to discuss the role of insurance in our economy and the need to
modernize the regulation of insurance. This is an important topic, one
that affects not only the efficiency and competitiveness of a
significant U.S. industry and a central function of the U.S. financial
system, but one that has broad consequences as well for the ability of
our economy as a whole to innovate and to grow.
INTRODUCTION
In the first instance, the issues surrounding insurance regulation
are significant because the U.S. financial services industry is one of
our country's most important areas of economic activity, and the
insurance industry is a large part of the U.S. financial sector.
According to the Federal Reserve, at the end of 2005, total assets held
by U.S. insurance companies totaled $5.6 trillion, as compared with
$11.82 trillion for the banking sector, and $10.5 trillion for the
securities sector.
In addition to the size and importance of the insurance industry
considered solely in itself, however, insurance--like other financial
services--has substantial ripple effects through the economy as a
whole. Insurance performs an essential function in our overall economy
by providing a mechanism for businesses and the general population to
safeguard their assets from a wide variety of risks. The ability of
businesses to insure against risk adds a degree of certainty to their
planning and thus contributes to greater economic activity and enhanced
economic growth. The general population also benefits from being able
to purchase protection for various types of losses that would be
difficult for individuals to absorb on their own. Insurance companies
are in the business of managing these risks. They specialize in
evaluating the potential for losses and perform an important function
by spreading that risk widely across various segments of our economy
and population.
Insurance is also like other financial services in that its cost,
safety and ability to innovate and compete are heavily affected by both
the substance and the structure of its system of regulation. As a
result, then, both of the industry's importance considered simply as a
separate line of economic activity as well as its consequences for
commerce and economic growth more broadly, we should seek to ensure
that the regulatory system for the insurance industry is consistent
with the efficient and cost-effective provision of its services and
with continuing evolution and innovation in the design and distribution
of its products.
In that regard, there appears to be virtually no disagreement that
the current State-based insurance regulatory system could benefit from
further modernization. There have been a variety of approaches that
have been considered: State-driven efforts at reform, total Federal
preemption of the State-based system, the setting of Federal standards
for States to administer, and the creation of a dual chartering
structure that would allow insurers to opt for either State or Federal
regulation.
Unlike the banking and securities sectors, insurance is solely
regulated at the State level, and while this multiplicity of regulators
can provide certain benefits in the form of local expertise and
control, it does raise a number of issues that deserve further
consideration. In our view, those issues fall into three main
categories:
Potential inefficiency, resulting both from the substance
of regulation (especially price and form control) but also from
its structure (the inevitable duplication and cost associated
with multiple non-uniform regulatory regimes);
International impediments, both questions of comity
(facilitating international firms' operations in the United
States, which benefits U.S. consumers) and competitiveness
(facilitating U.S. firms' operations abroad, which provides
growth opportunities for U.S. industry and helps diversify
their risk exposures);
Systemic ``blind spots'', the inability of the official
sector to understand and respond to the insurance sector's
evolving contribution to risks affecting the financial system
as a whole.
At the most fundamental level, the question posed in each of these
areas is whether our current system of insurance regulation is up to
the task of meeting the challenges of insurance regulation in today's
evolving and increasingly global insurance market. More broadly, we
should evaluate whether the benefits of regulatory competition (which
are fostered by our existing structure or other multiple-regulator
structures) are outweighed by the costs of regulatory fragmentation
(which are significant in a 50-State system).
BACKGROUND
The current structure of insurance regulation in the United States
is the result of a long history. In 1868, the U.S. Supreme Court
concluded that the issuance of an insurance policy was not interstate
commerce, and therefore outside the constitutionally permitted scope of
the Federal Government's legislative and regulatory authority (Paul v.
Virginia). In 1944, some 76 years later, the Court reversed itself
holding that insurance was indeed subject to Federal regulation and
Federal antitrust law (United States v. South-Eastern Underwriters
Association). In 1945, before any assumption of Federal regulatory
authority over insurance, Congress passed the McCarran-Ferguson Act,
which ``returned'' the regulatory jurisdiction over the business of
insurance back to the States, and generally exempted the business of
insurance from most Federal laws provided such activities were
regulated by State law.
Under the current State-based regulatory system, each State has a
chief insurance regulator, generally referred to as ``commissioner,''
who is charged with administering State insurance laws, promulgating
regulations, and other duties pertaining to the supervision of the
business of insurance. In most States the insurance commissioner is
appointed by the Governor. In 11 States, including California, the
commissioner is elected. Each State commissioner is a member of the
National Association of Insurance Commissioners (NAIC) that was founded
in 1871. The NAIC is the primary vehicle through which State insurance
regulators exchange information and coordinate activities to enhance
the effectiveness of insurance regulation.
State insurance regulation can be divided into two broad
categories:
Solvency or financial regulation aimed at preventing
insurer insolvencies and mitigating consumer losses should
insolvencies occur; and
Consumer protection and market regulation focused on
potential anti-consumer practices.
Each State enacts State-specific insurance laws. The NAIC has
developed model laws and regulations covering various aspects of the
insurance business in an effort to achieve greater uniformity. In the
solvency and financial regulation area these range from accounting and
investments to solvency/market examinations, holding companies, insider
trading and proxies, and reinsurance. In the consumer protection area
these model rules cover matters ranging from privacy protection,
deceptive advertising, unfair policy terms, and discriminatory or
unfair treatment of policyholders. Many model laws must be approved by
State legislatures before they can be implemented, while some States
may have the authority to adopt model regulations in certain areas
without legislative action. The adoption of model laws and regulations
has been spotty at best. It is a cumbersome process that, in many
cases, can take a number of years. It also allows for variation in
implementation across States.
The State-based insurance regulatory system was subject to
significant criticism in the 1980s after several major insurance
companies became financially impaired. At that time, there were calls
for regulatory reform, including a proposal for a preemptive Federal
regulator. State insurance regulators, sensing that the State-based
system was in jeopardy, made some impressive strides in undertaking
initiatives to reform State solvency regulation. They established an
NAIC Accreditation Program requiring the adoption of designated model
laws and regulations, and a review of the insurance regulatory agency
of each State by an independent review team to assess compliance with
the required standards. As a result, today there is a relatively
uniform solvency regime that has been implemented across the States.
However, in other areas of regulation, the States appear to be much
more reluctant to adopt uniform standards.
Another important aspect of the State-based insurance regulatory
system is its system of guaranty funds. Unlike the system that is in
place for federally insured depository institutions, there is not a
Federal guarantee ensuring that policyholder claims are paid. Each
State operates its own guaranty fund, and typically separate funds are
maintained for property/casualty insurance (mostly personal lines) and
life/health insurance. If an insurer becomes insolvent, the State
insurance regulator typically is appointed as the liquidator. As
liquidator, the regulator appoints a receiver to manage the
liquidation. The guaranty fund then works with the receiver and assumes
responsibility for the payment of a specified portion of the claims
that would otherwise have been paid by the insurer. The State-based
guarantee system is funded primarily on a post-assessment basis, with
all insurers that write particular types of business being subject to
an assessment to fund losses.
KEY ISSUES IN CONSIDERING INSURANCE REGULATORY MODERNIZATION
An important part of this debate is what should be the role, if
any, of the Federal Government in insurance regulation. While the
State-based system has a number of potential merits--such as local
knowledge of insurance market conditions and preserving local
decisionmaking over key aspects of activity within a particular State--
it does raise a number of issues that need to be considered as
financial markets evolve in this country and abroad. The key issues I
will focus on today are: potential inefficiencies associated with the
State-based system--most prominently undue regulatory burden and price
controls; international implications for free markets and
competitiveness; and fully understanding the impact of the insurance
sector on financial sector soundness.
Potential Inefficiencies of the State-based System
As I indicated, there is virtually no dispute over the fact that
there is a general need for modernization of the current State-based
system. One aspect of modernization has been a focus on the lack of
uniformity in State regulation. Even though the NAIC has achieved some
success over the past 135 years in fostering more uniformity among the
States, many of its model laws and regulations have not been enacted by
the States. States interpret these model laws differently, and craft
individualized exceptions to them. This should not be a surprise given
that the general nature of State legislatures and regulators to
preserve authority in areas where it is perceived to be warranted.
Nonetheless, differing State insurance regulatory treatment can
lead to inefficiencies and undue regulatory burden. This can directly
limit the ability of insurers to compete across State boundaries.
Reduced competition can diminish the quality of services, consumer
choice, and ultimately lead to higher prices.
At the most basic level, States have individual requirements that
insurers and producers (i.e., agents and brokers) must meet to operate
in each State. For example, all insurers must receive a license from
each State in which they plan to do business. While the NAIC has tried
to simplify this procedure, the filing requirements for licenses can
vary significantly from State to State and companies must still
ascertain and comply with those requirements.
All States also require a license from those who wish to sell
insurance, and the licensing process also varies from State to State.
The multi-State licensing of insurance producers has been somewhat
streamlined in recent years thanks to the provisions of the Gramm-
Leach-Bliley Act, which provided for a Federal preemptive producer
licensing system (the National Association of Registered Agents and
Brokers) that served as a threat to the States to develop a more
unified system. The States responded and established a system that
established the required reciprocity arrangements. Reciprocity
arrangements have somewhat streamlined the process; however, agents
must still obtain a license in each State in which they do business.
Another area of potential inefficiency is form approval regulation.
Form approval is the system or process by which State insurance
regulators review and approve (or disapprove) policy forms insurers
wish to use in a State. There are at least seven categories of State
policy form approval systems, including the use of State required
forms, strict prior approval of forms, ``file and use,'' ``use and
file''--to no form filing required. State form approvals can be based
on any number of factors. For example, some States require certain
disclosures and descriptions of coverage, some even specify the proper
typeface sizes and the color of ink, as well as specifying that the
disclosure has to be on the first page of the policy--a requirement
that can make an insurer have to have State-specific cover pages for
their policies. Some States also require special disclosures for
particular products such as small face amount life insurance policies,
or special ``buyer's guides'' or policy endorsements for certain
products. Requirements for descriptions of coverage can also vary from
State to State, with some States requiring the language text itself to
be based on specific readability standards, such as a minimum score of
40 on the Flesch reading ease test or compliance with some other test
approved by the commissioner.
The NAIC made efforts to achieve a higher degree of uniformity in
product approvals by launching such programs as CARFRA (Coordinated
Advertising, Rate and Form Review Authority) and SERFF (System for
Electronic Rate and Form Filing). In addition, just last month some 27
States entered into an Interstate Insurance Product Regulation Compact
that would provide for uniform national product standards for the
products sold by life insurers (life insurance, annuities, disability
income insurance, and long-term care insurance). While these efforts
may lead to some degree of greater uniformity, it is still up to each
State to interpret and enforce such standards.
States justify form approval as a necessary tool for consumer
protection. However, there should be a careful analysis of the cost and
benefits of these requirements at the individual State level. In
addition, having multiple technical State requirements makes it very
difficult, and very costly, for an insurer to roll-out a new product on
a nation-wide basis.
Perhaps the greatest potential for inefficiency in the current
State-based system is with price controls. Insurance is perhaps the
last major market in the United States with direct price controls. The
term ``price controls'' is frequently used to describe State regulation
of rates used by property/casualty insurers licensed or admitted in a
State (referred to as the ``licensed/admitted market''). This market
includes such personal lines of insurance as automobile and homeowners,
as well as a substantial portion of the commercial lines of insurance
such as fire, burglary, theft, workers compensation, and commercial
automobile. The basic legal standard for rates in all States is that
they not be ``inadequate, excessive, or unfairly discriminatory.'' In
the early years of State insurance regulation, the emphasis was more on
whether rates were adequate, and thus would prevent solvency problems.
However, more recently it seems as though most of the controversy over
price controls has concerned efforts of State regulators to hold down
prices for their constituents by denying rate increases on grounds that
they are excessive.
States address rate regulation in a number of different ways. For
example, as to rates on most lines of commercial property/casualty
insurance; 5 States have no filing requirements (No File); 2 require
informational rate filings only (Information Only); 9 allow rates to be
used without pre-filing, but they must be subsequently filed (Use and
File); 13 require filing before they are used (File and Use); and 19
require rates to be filed and approved before they are used (Prior
Approval). Of the 43 States with some degree of rate control, many also
provide for the exemption of rate approval requirements on certain
large commercial property/casualty policies based on the amount of the
premium charge or size of the policyholder.
One of the fundamental principles of economics is that price
controls result in inefficient outcomes. If the mandated price is set
above the market clearing price, the result will be surpluses; if the
mandated price is set below the market clearing price, the result will
be shortages. The latter outcome is what we generally observe in
insurance markets with strict price controls. When insurers are unable
to charge what they feel is an adequate rate for their product, they
generally tighten their underwriting standards in order to limit their
writings to ``preferred'' risks that are less likely to suffer an
insured loss. Not being able to charge an adequate rate also limits
insurers' abilities to price on the basis of measurable differences. To
the extent that prices do not accurately reflect differences in risk,
low-risk consumers are effectively forced to subsidize high-risk
consumers. This obviously leads to shortages in the voluntary market,
or a ``tightening market,'' and increases demand on what is referred to
as the residual markets. Residual markets, known also as ``shared'' or
``involuntary'' markets or ``markets of last resort,'' are State-
sponsored mechanisms that provide consumers with another way to obtain
automobile, property, or workers compensation insurance coverage.
For example, where a driver with a history of multiple accidents
applies for insurance, an insurer might be willing to write the
coverage if it could charge a rate commensurate with the risk. However,
if that rate was more than the State regulator allowed it to charge,
then the insurer would likely refuse to write the policy. If no other
insurer in the voluntary market were willing to issue coverage at an
approved rate, then the driver could apply to the State's residual
market (sometimes referred to as the ``assigned risk pool.'')
All licensed insurers in a State are generally required to
participate in that State's residual markets, typically by assuming a
fair share of the residual market's operating results. Residual market
programs are rarely self-sufficient, and where the premiums received
are insufficient to support the program's operation, insurers are
generally assessed to cover the resulting deficits.
The residual market mechanism is the way that States address the
shortages that are caused by price controls. While it is theoretically
possible for the price control/residual market mechanism structure to
duplicate the result that would occur in the absence of price controls,
that outcome seems highly unlikely. At the most basic level, given that
the residual market mechanism structure requires all insurers to share
in the fortunes of the residual market mechanism, as the size of the
residual market grows, it would be likely that fewer and fewer insurers
would be willing to do business in that line of insurance. As insurers
pull back from that line of insurance, further pressure is placed upon
the residual market mechanism. So in a broad sense, one potential
outcome of the price control/residual market mechanism structure is
that it artificially restricts the number of insurance suppliers in a
particular market. States typically respond to this outcome by
adjusting prices to preserve the viability of that particular market.
Most evidence indicates that there is a strong correlation between
the size of residual markets and price controls: the larger the
residual market you find in a State, you will also generally find a
tighter market and a higher degree of rate inadequacy--often the result
of price controls. In other words, price controls generally result in
elevated residual market populations when the permitted rates are lower
than indicated by market forces.
Automobile insurance is often cited as an example of problems with
State price controls. In 2004, the average nationwide percentage of
private passenger cars insured through residual market mechanisms was
1.5 percent. However, in States with more restrictive price controls,
such as North Carolina and Massachusetts, the percentage of private
passenger cars insured through the residual market was, respectively,
24.2 percent and 6.5 percent. In general, States with a less
restrictive regulatory environment (e.g., Illinois and South Carolina)
are generally characterized by lower and less volatile loss ratios,
smaller residual markets, and insurance expenditures below the national
average.
Another example is workers' compensation insurance, which is often
pointed to as the line of insurance with the greatest degree of rate
regulation. In the last few years, the percentage of workers'
compensation premiums in residual markets has been on the increase.
Among those States that report through the National Council on
Compensation Insurance (25) the residual markets' share has increased
from 3.2 percent in 1999 to 11.5 percent in 2005, and was even as high
as 12.7 percent in 2004. There is also wide variation among individual
States, with 2005 market shares ranging from 1.1 percent in Idaho to
highs of 22.7 percent in New Jersey and 20.5 percent in Massachusetts.
International Issues
U.S. firms and firms from abroad in insurance, banking, and
securities compete across the globe and around the clock. Clearly
foreign sources of insurance capital are important for a robust U.S.
insurance market.
As noted above, the lack of uniformity in our State-based insurance
system has the potential to lead to inefficiency and undue regulatory
burden. While all insurance companies that are licensed to operate in
the United States are subject to same regulatory standards, foreign
firms likely find adapting to such standards more difficult. From the
international perspective, issues that have been raised in bilateral
financial regulatory discussions with foreign officials are that our
insurance market has at least 50 different regulators, and they or
their insurance companies have no single regulator to coordinate with
on insurance matters. Navigating the State-based insurance regulatory
structure is likely a challenge for a new foreign company seeking to do
business in the United States and has likely impeded the flow of
capital into the United States to some degree. Issues that have been
brought to our attention include: rate and form approvals; capital
adequacy standards; and guarantee fund membership.
The U.S. insurance market, in particular the global nature of
insurance, is vastly different than it was six decades ago when
McCarran-Ferguson was enacted. To give an example of the sort of
efforts underway internationally, the European Union (EU) is continuing
its work on its Solvency II project focused on insolvency risk for
insurers in preparation for its scheduled introduction on an EU-wide
basis in 2010. Solvency II is an important undertaking for it
encompasses quantitative capital requirements, a supervisory review
process expected to harmonize the procedure in Europe, and it will
conform to disclosure requirements with those of the international
accounting standard-setters. This is all part of the effort to forge
one insurance market for the twenty-five member States in the EU.
Reflecting the growing international nature of the markets, the NAIC is
working closely with international regulators on a number of projects,
such as Solvency II in the EU, on international accounting standards,
and others. The NAIC itself is not a regulator but facilitates
communications among the States on international regulatory issues. To
that end, it engages in regulatory cooperation with international
insurance regulators and through Memoranda of Understanding (MOUs), and
supports individual members by providing technical assistance to
regulatory agencies. The NAIC also coordinates closely with Office of
the U.S. Trade Representative in international financial services
negotiations, and it participates in Treasury's financial markets
regulatory dialogues with various countries, including China, Japan,
and the EU.
To sum up, there is significant work underway in international
insurance regulation to reflect the changes taking place in the United
States and global insurance markets. In evaluating proposals to
modernize our system of insurance regulation, we, too, need to consider
what will best serve us in maintaining an insurance marketplace that
attracts capital and does not set up artificial and costly barriers. A
number of countries are pushing forward with regulatory systems seeking
more uniform, efficient and stronger insurance sectors, in order to
underpin more and better products for their consumers with less risk to
the financial system.
Lack of Federal Understanding of Risk in the Insurance Market
As previously noted, the insurance sector is a critical part of the
broader U.S. economy and in terms of size alone a key participant in
the U.S. financial sector. In comparison to other financial
institutions, it could be argued that financial problems at an insurer
or reinsurer pose less potential to generate broad economic problems or
pose systemic risk in the financial system. The immediate financial
problems from the failure of a large insurer or reinsurer could be
limited given the nature of insurance contracts (e.g., delayed
payments, dispersed risks, and timing of in force coverage) and the
general funding strategies of many insurers (e.g., a focus on meeting
potential near term liquidity needs to pay claims). Nonetheless, there
remains some potential for disruptions in the insurance market to
impact economic activity and financial markets. And importantly, these
potential risks may not be well understood at either the State or
Federal level.
At the most basic level, the failure of a large insurer or
reinsurer could place stress on State guarantee funds and to
policyholders that do not have guarantee fund protection (mostly large
commercial organizations). This could in turn have a negative impact on
the broader economy, which could also impact other financial
institutions. While market participants should perform their own due
diligence when they enter into insurance contracts, given the magnitude
of potential consequences of a large insurer insolvency the Federal
Government should have a better understanding of the nature and
potential for such an event.
Given that the insurance sector is also a direct participant in a
number of financial markets, either through direct credit exposures or
through derivative counterparty relationships, financial problems at
insurers could be transmitted throughout the broader economy. For
example, there has been a considerable amount of attention paid to the
expanding credit derivatives market. While there are a number of issues
that might warrant attention, as with many other derivative contracts,
a credit derivative is very similar to an insurance policy that pays
off when certain credit events occur. Given the close correlation to
insurance, insurance companies appear to be taking a more active role
in this market. From an overall perspective of market stability, do we
fully understand what risks insurance companies are undertaking, or how
their activity could impact the credit derivatives and other financial
markets?
In addition to broad areas of financial sector stability, there has
been a convergence across some product lines that are offered by
banking, securities, and insurance firms. This is particularly true in
regard to wealth management products. Many wealth management products
serve a similar purpose (e.g., variable rate annuities and mutual
funds), but are offered by firms with different charters and underlying
regulatory structures. Any underlying economic reason for treating like
products differently for regulatory purposes has blurred over time.
Much like the State-based insurance system, differing regulatory
treatment for like products adds complexity and creates potential
problems for the free flow of capital. Given the general efficiency of
capital markets, differences in regulation (whether through capital
standards, product approval standards, or otherwise) and differences in
tax treatment can direct capital flows away from their most efficient
uses. These are all areas where the Federal Government should have a
better understanding of potential implications.
What should be apparent is that the insurance industry is extremely
complex. While the State-based system has made improvements in solvency
and holding company regulation, under a structure with over 50
different regulators it may even be somewhat difficult for individual
State regulators to get a firm handle on the risks that large complex
insurance companies pose to our Nation's insurance system. Add into
that mix that the Federal Government has little to no role in the
State-based insurance regulatory system, and we are left with what
could be a large blind spot in evaluating risks that are posed to the
general economy and financial markets.
CONCLUSION
To sum up, it is clear to us--as we think it is to most observers--
that our current system of insurance regulation requires modernization
to meet the challenges facing the insurance industry, and financial
services, generally, in the 21st century. Our existing system of
regulation has the potential to lead to inefficient economic outcomes
(raising the cost and reducing the supply of many insurance products),
deters international participation in our domestic markets (again
raising costs and limiting consumer choice), creates obstacles to our
own insurance firms' international expansion, and limits the ability of
any one regulator to have an overview of risk in the insurance sector
and its contribution to risk in the financial system more broadly.
These are issues of importance not just to the insurance industry, or
even the larger financial services industry, but to the economy as a
whole, because of the essential role that the mitigation of risk
through insurance has in promoting commercial activity and enhancing
economic growth.
Treasury has been closely monitoring the developments of the
various approaches to modernizing insurance regulation--ranging from
the self-initiated approaches of the State regulators, and establishing
Federal standards for the harmonization of State insurance rules, to
the concept of an optional Federal charter now being considered by this
Committee. While we are still evaluating what approach we believe to be
the most appropriate, what is clear is that each of them should be
evaluated in light of the fundamental issues we have discussed today.
Again, thank you for addressing the issue of insurance regulatory
modernization and for giving me the opportunity to express the
Treasury's views. We look forward to continuing this dialogue.
______
STATEMENT OF SCOTT E. HARRINGTON, Ph.D.
Alan B. Miller Professor, The Wharton School
University of Pennsylvania
July 18, 2006
Good afternoon Mr. Chairman and members of the Committee. My name
is Scott Harrington, and I am pleased to provide my perspectives on
insurance regulation. During my 28-year career in academia, much of my
research has focused on the economics of insurance markets and
insurance regulation. Many of my publications have dealt specifically
with insurance rate regulation, with solvency regulation, with the
performance of State regulation, and with possible Federal intervention
in insurance regulation.
In the early 1990s I published two papers dealing, respectively,
with insolvency problems in the property/casualty and life/health
insurance sectors. I concluded that Federal regulation of insurance
would not be an appropriate response to those problems. In 2002 I wrote
a monograph for the Alliance of American Insurers on possible optional
Federal chartering and regulation of property/casualty insurance
companies. I concluded that optional Federal chartering was not
justified at that time.
Earlier this year, I prepared an issues paper on possible Federal
intervention in insurance regulation for the Networks Financial
Institute, on which much of this statement is based. Despite a number
of positive and incremental reforms in State insurance regulation
during the past decade, I highlighted that several key aspects of State
insurance regulation, including regulation of rates, rate
classification, and policy forms, remain substantially dysfunctional in
many States--with no end in sight and with significant burdens on
interstate commerce. I concluded that a transformation of insurance
regulation was necessary to promote healthy price and product
competition and to eliminate regulatory micromanagement of price and
product decisions, and that such transformation could not be achieved
without Federal intervention.
In the remainder of my statement I will first elaborate on the key
shortcomings in State insurance regulation. I will then turn to
potential benefits, risks, and design issues for optional Federal
chartering. I will also briefly discuss alternative modes of Federal
intervention that might redress State regulation's problems without
creating a Federal regulator.
State Regulation's Performance
The economic rationale for government regulation of business
activity is to protect the public interest by efficiently mitigating
market failures. Regulation should only be undertaken if there is a
demonstrable market failure compared to the standard of a reasonably
competitive market and there is substantial evidence that the benefits
of regulation will exceed its direct and indirect costs. Economically
efficient regulation also requires matching the appropriate regulatory
tool to the specific market failure.
Given the competitive structure of most modern insurance markets,
the main economic rationale for regulation of the insurance business is
to cost-effectively reduce the extent to which insurance companies or
intermediaries misrepresent what is being promised at the time of sale,
or fail to keep their promises through insolvency or deficient claims
settlement. Achieving that objective requires regulatory oversight of
insurance company solvency. It also favors some regulatory oversight of
sales and claim practices to supplement competitive market discipline
and contractual and tort liability remedies for fraud,
misrepresentation, and breach of contract.
In contrast to the early 1970s and early 1990s, the current debate
over insurance regulation has relatively little to do with solvency
regulation. The main characteristics of State solvency regulation--
regulatory monitoring, controls on insurer risk taking, risk-based
capital requirements, and limited guaranty fund protection--are
sensible given the economic rationales for regulating solvency and for
partially protecting consumers against the consequences of insurer
default. Having regulators in an insurer's State of domicile play a
lead role in solvency regulation reduces duplication in effort and
cost. A significant degree of coordination and uniformity among the
States has been achieved through the National Association of Insurance
Commissioners (NAIC), including through its promulgation of financial
reporting requirements and its solvency regulation certification
program.
The State guaranty system of limited, ex post assessments to pay a
portion of insolvent insurers' obligations is appropriate and has
worked reasonably well, despite a large increase in required
assessments this decade. Systemic risk (the possibility that failure of
one insurer or rumors of trouble could produce a run that would
adversely affect otherwise solvent insurers) is significantly smaller
for insurers, especially property/casualty insurers, than for
commercial banks, thus reducing the need for comprehensive guarantees.
Limited guaranty protection helps reduce the moral hazard problem,
whereby guarantees reduce policyholders' incentives to buy coverage
from safe insurers. Ex post assessments avoid the accumulation of funds
that could be appropriated by legislatures for non-insurance purposes.
Compared with pre-funding, the responsibility for assessments also
could increase incentives for financially strong insurers to press for
effective solvency surveillance and efficient liquidation of insolvent
insurers.
There are two broad problems, however, with other aspects of State
insurance regulation. First, too much time and money are wasted on
administering and complying with diverse regulations across the States,
which often are either unnecessary or deal with activities that are
amenable to less oversight, less bureaucracy, and much more uniformity
across jurisdictions. Second, insurance regulation is often used for
political ends to redistribute income among insurance buyers. These
redistributive activities generally are economically inefficient, and
they typically are opaque to the public.
There are four specific issues with State regulation's performance:
1. Costs and delays associated with regulatory approval of policy
forms in 51 different jurisdictions.
2. Costs, delays, and possible short-run suppression of rates below
costs associated with regulatory approval of insurers' rate
changes.
3. Restrictions on insurers' underwriting (risk selection) decisions
and risk classification systems.
4. State mandates that insurance policies provide coverage for
certain types of benefits or losses.
The saliency of these issues varies across States and types of
insurance.
Prior Approval of Forms
The NAIC and many State regulators and legislatures have taken some
steps to streamline and homogenize the form approval process for life
insurance and annuities, including creation of an interstate compact
for approval of some forms. However, the continued patchwork process by
which life insurers have to obtain approval for their products under
State regulation and the associated costs, delays, and refusals place
life insurers at a competitive disadvantage with federally regulated
competitors in the asset accumulation and management business. The form
approval issue is also important for property/casualty insurers and to
a lesser extent (apart from the mandated benefits issue) for health
insurers. Except for States that have substantially eliminated prior
approval of policy forms for ``large'' commercial risks, property/
casualty insurance policy forms are subject to regulatory approval in
all States, with associated direct costs, compliance costs, and delays.
Prior regulatory approval of policy forms is unnecessary and counter-
productive for commercial lines of property/casualty insurance, except
perhaps for very small businesses.
Prior Approval of Rate Changes
Market structure and entry conditions are highly conducive to
competition in most types of insurance. Modern insurance markets that
are relatively free from regulatory constraints on prices and risk
classification generally exhibit strong evidence of competitive conduct
and performance. Insurers vary substantially in terms of price,
underwriting, and service.
Competition creates strong incentives for insurers to forecast
costs accurately and to price and underwrite so as to avoid adverse
selection, thus producing highly and increasingly refined systems of
rate classification. Prices vary across insurers in relation to rate
classification systems and underwriting standards. Substantial
evidence, including small ``residual markets'' in States with little or
no regulatory intervention in pricing, indicates that competition in
pricing and risk selection promotes the availability of coverage if
rates are sufficient to cover expected costs and provide insurers with
a reasonable expected profit.
Prior approval rate regulation cannot be justified as a response to
monopoly or oligopoly pricing in insurance markets, nor can it be
justified as necessary to prevent collusion, or to protect consumers
from inadvertently purchasing coverage from high price insurers. Prior
approval regulation produces significant administration and compliance
costs, which are ultimately borne by consumers. The rate approval
process has sometimes been contentious and biased toward rate
suppression that distorts the supply of coverage.
Prior approval regulation generally cannot be expected to affect
insurer profits in the long run. Insurers must expect a reasonable
profit over time in order to continue to supply coverage. Even when
prior approval rate regulation allows adequate rates on average, the
rate filing and approval process impedes timely adjustments of rates to
new information about expected costs. This regulatory lag tends to
produce fewer but larger rate changes and greater swings in
availability of coverage and insurer profitability. Uncertainty about
approval of proposed rate changes increases insurers' risk, with
possible adverse effects on insurance buyers in other States.
Regulatory suppression of rates in some States during some time periods
reduces voluntary market sales by current insurers, increases residual
market size, reduces entry by new insurers, and reduces incentives for
insurers to provide valuable services and to invest in product
distribution and service.
Progress has been made among the States in reducing the scope of
prior approval regulation. It is virtually certain, however, that a
significant number of States, including some of the largest, will
retain such policies unless motivated to change through Federal action.
The reasons are basically political. State legislators and regulators
benefit when they claim to save consumers money. Some consumers are
deeply suspicious of insurers and resent having to pay significant
amounts of their income for insurance. Some consumer organizations,
with ready access to major media, continue to press for rate regulation
and to condemn ``deregulation,'' claiming that ``true'' competition
does not exist. Perhaps more important, the regulatory staffs in some
States appear wedded to the mistaken notion that price controls protect
consumers and serve a useful social purpose.
Classification and Issue Restrictions
Some States directly and significantly restrict insurance
underwriting and rate classification for health insurance (e.g.,
``community rating'') and/or some types of property/casualty insurance
(e.g., restrictions on rate variation across geographic regions within
a State). These restrictions generally lower premium rates for high-
risk buyers and raise rates for low-risk buyers. In order to ensure
that high-risk buyers can obtain coverage at rates that insurers
recognize as lower than expected costs, insurers are required to offer
coverage to virtually all applicants under ``guaranteed issue'' or
``take-all-comers'' requirements.
Guaranteed issue and rating restrictions may allow some high-risk
buyers to purchase coverage who otherwise might find it difficult to
locate a willing health or property/casualty insurer. But their
predominant motivation and function is to lower premium rates for
buyers with relatively high expected claim costs by charging above-
market premium rates for buyers with relatively low expected claim
costs. In the case of health insurance, in principle this might help
higher-risk persons afford coverage, receive the types and quality of
medical care that flow to insured persons, and cut down on both costly
emergency care and bad debts for hospitals and providers. In the case
of auto liability insurance, it may encourage more drivers to comply
with compulsory insurance requirements, thus reducing the number of
uninsured motorists and costs borne by other parties.
However, significant restrictions on rating and risk selection and
guaranteed issue requirements have serious drawbacks, including:
1. Average premium rates tend to go up as more high risks insure and
some low risks reduce or drop coverage.
2. Competitive rating and risk classification provide some incentive
for higher-risk buyers to take actions to control losses and
thus qualify for lower premiums and/or have lower uninsured
losses (e.g., by forgoing construction or employing damage
resistant construction in disaster prone areas, by purchasing
crash-resistant vehicles, by installing security systems in
homes or businesses, and so on). Restrictions on classification
dull those incentives, increasing losses and premiums over time
for the insured population.
3. When insurers are forced to accept applicants at regulated rates
that are below expected costs for some buyers and above
expected costs for others, it is very likely that the relative
proportions of under- and over-priced buyers will vary across
insurers. Some State reinsurance or risk-adjustment mechanism
generally is needed to ensure a stable market. Such mechanisms
involve significant administrative and compliance costs, and
they can distort insurers' incentives for cost-effective
monitoring and settlement of claims.
These problems help explain why many States have eschewed such
policies. In the case of automobile insurance, the bulk of the States
use residual market mechanisms (mostly assigned risk plans) to narrowly
target intervention to ensure availability of coverage to the
relatively few buyers who might find it hard to locate a willing
insurer. On the other hand, some States have used voluntary market rate
caps and residual markets as an alternative method of holding down
rates for high-risk buyers in automobile or workers' compensation
insurance. The result has been large residual market deficits and the
need for voluntary market insureds to pay higher rates to subsidize
those deficits. In the case of health insurance, over 30 States have
established high-risk pools to guaranty coverage to persons with
chronic health conditions at subsidized rates, including all
jurisdictions without any other guaranteed issue requirements. The
pools generally are designed to provide subsidized coverage to a
relatively narrow, high-cost segment of the public.
Mandated Benefits
A complex web of ``mandated benefit'' requirements, which require
that if a certain type of insurance is purchased, then it must cover
specified losses, characterizes the State-based system of insurance
legislation and regulation. Benefit mandates are most prevalent and
debated for health insurance. Many observers argue that health
insurance mandates produce significant increases in the cost of health
coverage in some States, and significant reductions in the number of
people covered by private health insurance.
Mandates for other types of insurance in many States include
requirements that homeowners and/or auto insurance policies cover tort
liability claims brought by one family member for injuries caused by
another; requirements that auto insurance buyers buy coverage for
losses caused by uninsured motorists, including pain and suffering; and
mandates (mooted by the Terrorism Risk and Insurance Act and its
extension) that property insurance policies cover fire losses caused by
terrorism and in some States prohibit any terrorism exclusions. Many
States also significantly limit allowable deductibles and co-payments,
which can significantly drive up the cost of coverage.
Many mandates are argued to serve some consumer protection
function. In reality, and when they are not simply redundant (i.e.,
mandating what a large majority of buyers would willingly insure),
mandates often simply force people or businesses to purchase and pay
for insurance coverage of losses they would not willingly insure. In
contrast to the cases of compulsory liability insurance laws and
compulsory workers' compensation insurance laws, there would be little
or no spillover on other parties without such mandates.
Optional Federal Chartering
The American Bankers Insurance Association, the American Council of
Life Insurers, and the American Insurance Association agree on a number
of principles for optional Federal chartering to encompass life and
property/casualty insurers:
1. Creation of a Federal regulator to license insurers choosing a
Federal charter and regulate solvency, market conduct, and
accounting of federally chartered entities.
2. Exemption of federally chartered insurers from prior approval
rate regulation and burdensome form approval requirements.
3. Preemption of State rules to help ensure a single set of Federal
rules for federally chartered insurers.
4. Participation of federally chartered insurers in the State
guaranty fund system, subject to Federal minimum standards.
5. Repeal of the McCarran-Ferguson limited antitrust exemption for
federally chartered insurers.
6. Payment of State premium taxes by federally chartered insurers.
The National Insurance Act of 2006 (S. 2509), introduced by Senators
Sununu and Johnson, incorporates most, if not all, of these principles.
Optional Federal chartering along these basic lines would
streamline, modernize, and homogenize regulatory requirements for
federally chartered insurers. It would almost certainly achieve
efficiencies in oversight and regulation of policy forms. The results
would include helping to level the playing field between insurers and
federally regulated financial institutions. Very importantly, federally
chartered insurers would be substantially freed from antiquated and
counter-productive prior approval rate regulation.
Participation in State Residual Markets and Guaranty Funds
If federally chartered property/casualty insurers could be exempted
from participation in State residual markets, residual market rate
regulation could not be used to produce sustainable cross-subsidies
among insurance buyers. States that wanted to cap rates for higher-risk
buyers would have to finance rate subsidies some other way. Exemption,
however, seems unlikely in view of legitimate State interests in
ensuring the availability of mandatory coverages. In order to reduce
the ability of States to use residual markets to cap property/casualty
insurance rates (e.g., in automobile and workers' compensation
insurance), the best approach (incorporated in S. 2509) is probably to
make participation of federally chartered insurers in property/casualty
residual markets contingent on rates being set at self-sustaining
levels. To be sure, disputes as to whether that type of criterion is
being met in some States are likely inevitable.
A Federal guaranty system for federally chartered insurers would
destabilize and eventually completely crowd out the State system.
Requiring federally chartered insurers to participate in the State
guaranty fund system, perhaps subject to some minimum standards, is
sensible. S. 2509 would require federally chartered insurers to
participate in ``qualified'' State guaranty associations and establish
a national guaranty fund, with ex post assessments, for obligations of
insurers doing business in any non-qualified States.
The guaranty system under Federal chartering, however, would likely
evolve toward nationalization or quasi-nationalization with uniform
coverage. Insolvency of a multistate federally chartered insurer with
different coverage limits in different States would very likely create
strong pressure for uniform, national coverage. Insolvency of a number
of State-chartered insurers would likely create similar pressure. Such
an evolution very likely would be accompanied by some Federal oversight
of the insolvency risk of State-chartered insurers (as is true for
State-chartered banks with Federal deposit insurance).
As I have emphasized in a number of my publications, any move
toward optional Federal chartering involves a risk that the scope of
government guarantees of insurers' obligations will ultimately
increase, thus increasing moral hazard and producing pressure for
stricter solvency standards. A fundamental goal of the guaranty system
with optional Federal chartering should be to maintain reasonable
coverage limits overall and to include significant restrictions on
coverage for commercial insurance, at least for buyers with substantial
net worth. The creation of a pre-funded, Federal system for all
insurers should be avoided. It is highly unlikely that meaningfully
risk-based charges for guaranty fund coverage would accompany pre-
funding, and pre-funding could dull some insurers' incentives to press
for effective solvency regulation and standards.
Regulatory Competition
Optional Federal chartering would presumably provide additional and
immediate motivation for State regulators to modernize their systems.
More generally, it could promote beneficial regulatory competition over
time if insurers are able to switch charters and regulators at
relatively low cost. Dual chartering of banks appears to have resulted
in a certain degree of beneficial regulatory competition. However, the
cost to multistate, federally chartered insurers to switch back to a
State charter and return to State regulation in multiple States might
be larger than in banking. If so, there is a greater risk that Federal
chartering could become dominant and entrenched for larger, multistate
insurers, reducing the scope of regulatory competition.
Substantial Elimination of Rate Regulation
The substantial elimination of prior approval rate regulation
should be the sine qua non for optional Federal chartering of property/
casualty insurers. Elimination of prior approval rate regulation for
federally chartered property/casualty insurers would be very likely to
constrain substantially prior approval of rates for State-chartered
insurers as well. Again, however, there are inherent uncertainties,
including the scope of federally chartered insurers' exemption from
rate regulation that will be included in any bill that might be passed,
and regarding whether any exemptions will persist. It is also uncertain
whether Federal regulation would persistently resist temptation to
redistribute wealth through restrictions on rate classification,
guaranteed issue, and mandates. State regulation is largely unable to
achieve cross-subsidies between States (or between lines of business
within a State). While Federal regulators may be more resistant to
local pressures that produce within-State cross subsidies, they may
face similar pressures on a national level and significant pressure
over time for adopting or endorsing policies that promote cross-
subsidies within and between States.
Other Approaches to Spurring Regulatory Modernization
The case for insurance regulatory modernization through increased
uniformity and substantial deregulation of rates and forms is
overwhelming. Optional Federal chartering might go a long way toward
achieving this result. But there are risks, and it would require
substantial investment and costs in creating and maintaining a Federal
regulatory agency. Potential unintended consequences, or mistaken
policies in response to political pressure, would have national
effects. Two alternatives to improve insurance regulation without
creating a Federal regulator and which might entail less risk are: (1)
Federal preemption of State regulations that do not meet minimum
standards, and (2) allowing insurers to choose a State for primary
regulation with authorization to operate nationwide primarily under the
rules of that State.
Minimum Standards and Preemption
The enactment of minimum Federal standards for and preemption of
certain forms of regulation could help modernize insurance regulation
without creating a true Federal regulator and associated bureaucracy.
The potential effectiveness of this approach as a means to remedy the
key problems of rate and form regulation is not clear. Prohibiting
prior approval rate regulation, for example, by itself would not
prevent regulators in some States from challenging rates based on
allegations that they are excessive or unfairly discriminatory. The
threat of such actions could contribute to a de facto prior approval
environment. More generally, any ``minimum standards'' approach faces
the difficulty of monitoring compliance. States that did not wish to
comply would attempt to circumvent or evade the requirements.
A draft proposal, The State Modernization and Regulatory
Transparency Act (SMART), released by Representatives Oxley and Baker,
would establish minimum and uniform Federal standards for numerous
activities of State regulation, with Federal preemption of State laws
and rules failing to meet such standards after specified periods. The
complex proposal deals with regulation of insurer and producer
licensing, market conduct, policy forms, rates, surplus lines,
reinsurance, fraud, solvency oversight, receivership of insolvent
insurers, and the viatical market. A ``State-National Insurance
Coordination Partnership'' would be created to oversee rules, changes,
and compliance.
The proposal contains provisions designed to promote uniformity and
provide for one-stop approval of policy forms, and to eliminate prior
approval rate regulation for commercial property/casualty insurance
(excepting medical malpractice insurance). The proposal's breadth and
complexity increases the difficulty of enforcement and the likelihood
of unintended consequences. A narrower and simpler standards/preemption
approach would focus on policy forms, rates, and possibly mandates.
Primary State Regulation
Another approach to spurring modernization without Federal
regulation would be for the Congress to enact legislation that would
allow insurers to choose a ``primary State'' for the purpose of rate,
form, and possibly a number of other types of regulation and allow them
to operate in all other States where they are licensed (``secondary
States'') without having to meet the corresponding requirements in
those States. The general concept has its roots in corporate law, where
corporations choose a State in which to be chartered, with that State's
laws governing the rights of management and shareholders throughout the
country. The concept is to some extent reflected in Federal
authorization of risk retention groups for certain types of property/
casualty insurance.
The Health Care Choice Act, proposed by Representative Shadegg and
Senator DeMint, adopts this approach for individual health insurance.
Insurers would be subject primarily to regulation by the primary State,
but they could operate in secondary States subject to primary State
rules. The proposal includes a number of safeguards and minimum
standards for primary State regulation regarding, for example, solvency
regulation, guaranteed renewability of contracts, and independent
review of disputed claims. The bill requires clear disclosure and
warning to consumers that primary State regulation applies and that
various secondary State regulations do not. The main purpose is to
allow consumers in States with mandated benefits, guaranteed issue,
and/or community rating rules that drive up the cost of individual
health insurance coverage to have the opportunity to buy coverage not
subject to those constraints. Many consumers would likely be able to
obtain less costly coverage that is more closely related to their needs
and ability to pay.
More generally, the primary regulator approach could be an
effective means of achieving substantial homogenization and
streamlining of policy form regulation for all types of insurance--and
of significantly constraining prior approval rate regulation--with
relatively little Federal involvement. A common argument against this
general approach is that it could lead to a ``race to the bottom.''
That risk is reduced significantly by would-be primary States' concerns
with their own citizens' welfare and by buyers (and agents/brokers)
concerns with their own welfare. I believe that this risk could be
managed with well-designed minimum standards and clear disclosure. It
also, for example, would not be necessary to rely mainly on the primary
State for solvency oversight and/or market conduct regulation.
Conclusion
Despite the existence of economically appropriate regulatory
regimes in many States, certain aspects of State regulation--in
particular the regulation of rates, rate classification, and policy
forms in many States--appear beyond repair at the State level. Some
form of Federal intervention is necessary for fundamental change.
The central goals of regulatory modernization should be to provide
one-stop approval or certification of policy forms, to have virtually
all rates, rate classes, and covered benefits determined by competition
rather than regulation, and to preserve and enhance private market
incentives for safe and sound insurance. The key policy question is
what form of Federal intervention has the best potential for achieving
these goals given short- and long-run political dynamics and the risks
of unintended consequences.
Optional Federal chartering and regulation of insurers offers the
potential to achieve more streamlined, less duplicative, and pro-
competitive regulation. A well-designed optional Federal chartering
system would have a number of potential advantages. It would also
entail the creation of a new Federal bureaucracy and inherent risks.
The alternative of allowing insurers to designate a ``primary State''
and to operate nationwide subject in large part to the regulations of
that State might have the potential to improve significantly the
performance of insurance regulation with relative simplicity, less
risk, and without creating a Federal regulator. A narrowly targeted
program of minimum Federal standards that would preempt non-conforming
State regulation also has the potential to improve insurance regulation
without creating a Federal regulator, and perhaps also with less risk
than Federal chartering.
______
PREPARED STATEMENT OF ROBERT W. KLEIN, Ph.D.
Director of the Center for Risk Management and Insurance Research
Georgia State University
July 18, 2006
Introduction and Summary
Chairman Shelby and Members of the Committee, good afternoon and
thank you for the opportunity to testify before the Committee on the
topic of insurance regulation.
My name is Robert Klein. I am currently the Director of the Center
for Risk Management and Insurance and an Associate Professor of Risk
Management and Insurance at Georgia State University. In my 30-year
career I have been both an insurance regulator and an economist who has
studied insurance regulation. From 1979 to 1988, I served as an
economist for the Michigan Insurance Bureau and the Michigan Senate.
From 1988 to 1996, I was the Chief Economist and Director of Research
for the National Association of Insurance Commissioners. I joined the
faculty and assumed my current positions at Georgia State University in
1996. I have performed a number of studies and written numerous
publications on topics in insurance regulation--a list of some of these
publications appear as ``Selected References'' at the end of my written
testimony.
In my opinion, the States have come a long way in improving their
regulation of insurance but further reforms are needed, both in terms
of the States' structures/processes as well as their policies. I think
the preferred institutional route to this goal is strong Federal
standards for and oversight of the States' regulation of insurance that
will move their structures and policies to where they need to be. In
essence, the States need to appropriately and efficiently regulate
things that need to be regulated and not regulate things that do not
need to be regulated. If this cannot be achieved under the
institutional arrangement I favor, then an optional Federal charter
approach may be necessary to achieve the objectives that the States
would be unwilling or unable to achieve.
The specific reforms that I propose reflect four basic themes or
characteristics:
1. The elimination of regulation where it is not needed;
2. uniform, appropriate and efficient regulation where it is needed
to the extent uniformity is possible given differences in State
laws that cannot be changed;
3. singular institutions and processes for insurer filings and
applications that would be approved for all States; and
4. full ``rationalization'' and coordination of all State
enforcement and compliance activities.
The urgency and need for insurance regulatory reform is increasing
for several reasons. One, risk and choice regarding health insurance
and retirement funding is increasingly being shifted from employers to
employees. Two, as the baby boom generation moves into retirement,
their purchase of or choices regarding health insurance and retirement
funding vehicles will affect a large segment of the population.
Privatization of some portion of social security accounts could further
increase the importance of this area. Third, environmental and
political changes appear to be increasing the risk of natural and man-
made ``disasters'' so it is important that individuals and firms
purchase sufficient insurance coverage at risk-based prices. Fourth,
insurance companies continue to improve their financial risk management
but this remains a continuing challenge because of mega or catastrophe
risks, macroeconomic volatility, and the use of more complex and novel
risk hedging/diversification instruments. Fifth, international trade in
insurance is increasing and this has implications for the regulation of
insurers entering U.S. markets as well as U.S. insurers that are
seeking to enter foreign markets. Regulators need to keep pace with
these developments and update their standards and enforcement
activities accordingly. Regulators' resources will be stressed so they
need to use their resources efficiently and shift their efforts to
areas where regulation is most needed and away from areas where it is
not needed.
A key factor underlying my recommendations is the highly
competitive nature of most insurance markets, despite widespread
consumer ignorance about insurance. Enough consumers shop for the best
price and pay some attention to quality of service that most insurers
in most markets behave as if every consumer was well informed and
shopped intensively. The main problem that arises and requires
regulatory attention is the ability of insurers with ``improper
intentions'' to take advantage of many consumers' ignorance or
inability to understand what they are buying and to correctly determine
the solidity and integrity of the insurers they are buying from. There
is also a problem with certain specific lines of insurance, such as
title insurance and credit insurance, where the nature of the sales
process and relationships between lenders and insurers lead to
``reverse'' competition problems. Hence, these specific lines require
greater regulatory supervision than lines such as auto, home and life
insurance.
Further, in disputes between insurers and insureds over claims and
benefits, insurers tend to have more bargaining power because of their
substantial legal resources and ability to outlast an insured who is
facing a financial crunch and has small reserves to draw from. Even
nationally prominent insurers with strong brand names may seek to
``push the envelope'' in certain situations or have particular
employees who fail to act correctly. Hence, regulators can improve
market performance in these areas by preventing insurers and personnel
with bad intentions from taking unfair advantage of consumers either in
the sale of insurance or in the payment of claims. Some of my
colleagues may take issue with this opinion but there are literally
thousands if not millions of examples of where market forces have
failed to prevent abuses.\1\ Moreover, by going after the ``bad
actors'', regulators make it easier for the ``good actors'' to do the
right things and maintain a higher quality of service.
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\1\ The admitted misbehavior of several prominent life insurers and
their agents in the 1980s involving the sale of universal life
insurance products is just one of many of these examples.
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In the regulatory system I envision, the States would efficiently
enforce a uniform set of regulations (to the extent uniformity is
legally feasible) in their respective jurisdictions and the
inefficiencies and costs of unnecessary State differences and redundant
regulatory processes would be minimized. I recognize that the design
and implementation of such a system would require substantial analysis
and discussion to resolve a number of issues associated with combining
collective and individual State enforcement of uniform regulations in
the context of our Federal system of government in which the States
retain certain prerogatives. Some form of Interstate Compact would
probably be needed as one of the vehicles to create and implement the
system as well as some sort of arrangement to monitor and audit States'
enforcement activities. Such a system would also require a ``Plan B''
for States which chose not to join such a system. In the remainder of
my testimony, I explain the nature and rationale for my proposed system
and reforms in greater detail and address certain issues that might be
raised and criticisms that might be made with respect to what I
propose.
I have one last partially self-serving observation to offer in this
introduction. The ability of academics like me (at institutions that
are not overwhelmed with donations and endowments from wealthy people
and firms) to offer informed opinions on topics involving public policy
and other matters dealing with risk and insurance is directly affected
by public and private funding for ``basic'' research on the industry
and its regulation. Unfortunately, both public and private funding of
such research is almost non-existent and there are indications that it
may totally evaporate. Further, academics' access to data and
information resources, beyond publicly filed financial statement data,
is becoming increasingly restricted and/or costly. The Congress and
Administration could be of great help in taking steps to help with the
funding problem and possibly with the data and information problem--
there would a relatively high return on the investment of a relatively
small amount of funds (e.g., less than $1 million per year).
Summary of Proposed Reforms
Among the specific reforms I would advocate are:
1. A uniform set of requirements should be adopted for insurance
products sold to persons, small businesses and for government-
mandated insurance coverages (e.g., workers' compensation) to
the extent that uniformity is legally feasible.
2. Regulatory restrictions or mandates on the insurance products
sold to medium and large businesses should be eliminated except
where government requirements or significant externalities
compel such regulation.
3. Prospective price regulation should be eliminated in all lines of
insurance, except those lines where market failures and abuses
have been demonstrated such as in title insurance and credit
insurance. Some residual regulatory authority to intervene in
pricing should be retained should competition and market forces
fail to ensure fair and competitive rates.
4. A process should be established that would allow an insurer to
make one product filing that could be approved for sale in
multiple States as well as one licensing application that could
apply to multiple States.
5. A rigorous set of uniform financial standards should be
established, maintained and properly enforced--we are almost
there but have more ground to cover. Also, the laws and process
for administering insurance company receiverships should be
further rationalized and made uniform among the States.
6. There should be streamlined and appropriate State enforcement of
all insurance regulations that are retained or instituted,
including single, national financial and market conduct
examinations that would serve all States.
7. Efforts to streamline and nationalize the licensing and
regulation of insurance producers should continue to their
maximum possible fulfillment.
8. A comprehensive effort should be made to develop common and
uniform systems for reporting of various insurers data that
would minimize the cost of such reporting and maximize the
value of and access to the information reported with
appropriate protection of information that would be considered
unsuitable for public access.
9. Competent and qualified State insurance commissioners should be
appointed--not elected. No one would propose that Federal bank
regulators be elected and the same principles should apply to
State regulatory officials.
10. There should be a comprehensive and strengthened program of
consumer and public education and information regarding the
risks they must manage and related insurance products and
coverages--the high level of consumer and public ignorance and
misconceptions regarding insurance frustrates efforts to
improve insurance regulation.
11. There should be a comprehensive and continuing evaluation of
regulatory attention to chronic and emerging problems and the
effectiveness and efficiency of regulatory monitoring and
enforcement activities. An independent, national Insurance
Regulation Oversight Commission could be established to perform
this function and advise the Congress, working cooperatively
with the National Association of Insurance Commissioners and
other national organizations of State officials and
legislators.
This is a long list of ideas but it is not exhaustive nor is it
uncontroversial. There may be legitimate differences of opinion about
their merits and feasibility. The list is intended to promote the kind
of thought and discussion that will be needed to ultimately develop an
optimal and feasible program of reforms. It is relatively easy to
propose reforms; crafting a workable system within the web of States'
rights and laws is another matter. Achieving sufficient political
consensus and support and overcoming antagonistic special interests
presents an additional challenge.
I also recognize that the NAIC has initiatives in many of the areas
of reform I have identified above. In some areas, these initiatives may
eventually come close to achieving certain of the objectives I have
advocated. However, for reasons I will explain below, in many areas the
NAIC is not going as far as I would advocate or can only encourage but
not force the States to make the necessary changes.
Alternative Institutional Structures: Federal and State Roles
This leads me to comment further on the Federal versus State
institutional debate since this is an issue that weighs heavily in
peoples' minds even if this hearing is intended to address a broader
set of issues. Further, the institutional structure that is employed
has implications for the nature of the reforms that can be instituted.
I prefer to discuss and dispense with this issue here so that I can
move on to detailed discussion of the reforms I advocate.
I will acknowledge that sweeping reforms could be accomplished
through the complete takeover of insurance regulation by the Federal
Government if it were to establish efficient processes and the
``right'' policies, but there is no assurance that this would occur
under Federal insurance regulation or that such processes and policies
would be sustained over time. Hence, while Federal regulation might
exploit certain inherent structural efficiencies and reforms would be
easier to achieve from a legal standpoint, I am not convinced that it
would necessarily result in better regulation and there is the danger
that it could result in worse regulation.
I also have some reservations about the optional Federal charter
proposal, although it does have some merits and may ultimately be the
only feasible way to achieve the reforms I advocate. I understand that
it is viewed as having certain desirable properties--most notably, it
is voluntary in the sense that insurers could choose to be federally or
State regulated and consumers could choose to buy insurance from
federally or State regulated insurers. Further, it would increase the
efficiency and reduce the cost of regulatory compliance for insurers
with national operations. Some of my colleagues may also favor the idea
because they perceive that it would promote ``regulatory competition''
and they tend to view competition as a good force. However, in my view,
competition between individuals and firms in markets for goods and
services may yield efficiencies and benefits that do not always carry
over to competition between governments.
The crux of the problem is that the ultimate arbiters of what
governments do and the companies that insurance is purchased from--
voters and consumers--are woefully ignorant about insurance and its
regulation. I am concerned that many consumers would not understand or
be able to evaluate the differences between and the implications of
Federal versus State-regulated insurers or differences between the
policies of the two regimes. Hence, more of the power and benefits of
choosing the regulatory venue could tend to accrue to the regulated not
to the intended beneficiaries of regulation. It could weaken the
oversight of State-regulated insurers and encourage States to ease
regulations in ways that would be desirable to insurers ``on the
fence'' but not in the best interest of consumers.
Further, it would probably lead to increased market concentration
as federally chartered insurers would able to increase their
competitive advantage over State-regulated insurers and State
regulation would not be able to impose the entry barriers and high
compliance costs that they currently do on national insurers. Increased
concentration is generally viewed as a bad thing but this would not
necessarily be the case if it derives from the increased efficiency of
federally chartered insurers and the benefits of these efficiencies are
passed to consumers. I would expect that concentration would not
increase to a level that would impair competition and reduced entry and
exit barriers would contribute to competition. Hence, I do not view the
likely market restructuring results of Federal chartering to be a
reason to oppose this approach. State and regional insurers would
probably diminish and focus their operations to ``niche markets'' that
would not be served by national insurers.
There is the risk of fraudulent insurers slipping through the gaps
between Federal and State regulation, taking advantage of the confusion
and gullibility of many consumers and small business owners. These
problems have been demonstrated in the Federal carve-out of ERISA-
qualified health insurance plans and the problems that have occurred
with some risk retention and purchasing groups. One can imagine the
frustrations and problems that would occur for a consumer with
legitimate complaints about an insurer who contacts one regulator and
is told that the insurer is regulated by another entity or perhaps not
regulated at all.
All of this said, the alternative institutional approach I favor
may not prove to be workable in the process of designing it and
negotiating its features between the Federal and State governments. If
that proves to be the case, then the optional Federal charter approach
may be the next best solution. It does have a number of attributes and
it would enable consumers to choose to buy insurance from insurers that
are not hobbled by inappropriate or unnecessary State regulatory
restrictions and mandates.
The approach that I would prefer arises from my belief that the
high tension between the Federal and State governments over insurance
regulation has had very positive effects. Vesting insurance regulatory
authority unequivocally in one entity or the other potentially reduces
its incentives to implement needed reforms and could decrease the
transparency of its policies and practices. At various times in
history, the States have made great strides in improving their
regulation of insurance when Federal intervention or takeover is
threatened. In this struggle, the Federal Government has a big hammer
and the greatest power that also has increased over time as it has
gained more allies. The States, with their remaining allies, have less
countervailing power but enough to force a good and transparent debate.
For reasons that I do not yet fully understand, the debates and
legislative threats that occur during these periods seem to promote a
healthy and transparent examination of insurance regulatory systems and
policies and the States feel compelled to institute reforms that are
generally good ones.
However, there is a legitimate question as to whether the States
would have the ability and desire to fully achieve the kinds of
ultimate reforms that I and others advocate. Many States, if not all,
believe that they should retain some prerogative to regulate their own
markets as they see fit--``market regulation'' pertains to things such
as prices, policy forms and market practices. For example, if public
officials in a State believe that it should still regulate prices for
personal lines insurance, then they may strongly resist any pressures
to do otherwise. The NAIC can and has strongly encouraged States to
reform and standardize their regulation of insurance markets, but it
has no authority and generally little leverage to compel States to do
so. The NAIC has also created systems to facilitate single portals for
insurer/intermediary filings and applications, but the requirements for
approval of what is filed and applied for still vary among States with
exception of life and annuity products.
In contrast, the NAIC is able to compel much greater uniformity and
quality with respect to the financial or solvency regulation of
insurance companies (which I distinguish from market regulation)
because of the greater inter-connections between State polices and
practices in this area.
Only the threat of Federal intervention, either full takeover or
optional chartering, can potentially induce all the States to move
further toward uniformity and reform than they would otherwise choose
to do so. Even then, certain States may draw a line in the sand, beyond
which they are unwilling to go unless forced to by some higher
authority. Hence, the issues of regulatory reforms and the question of
the institutional structure that would be established by Congress are
intertwined and not yet resolved. Congress would be wise to hold its
cards until these issues and questions are resolved.
Detailed Discussion of Specific Reforms
Below I attempt to explain and support my recommendations in
greater detail. Unfortunately, given the short notice I received, time
did not permit me to fully explain all of my recommendations so I have
focused on those that I believe are the most important and likely to
encounter the greatest controversy. I can further explain my ideas and
respond to other questions in additional testimony submitted after
today's hearing.
Regulation of Insurance Products
The regulation of insurance products refers primarily to the policy
forms that insurers must file for approval with State insurance
departments before the policies can be used in the market. The term
``product'' may be more appropriate because insurers may be required to
file and receive approval for related materials such as marketing
plans. Insurers are typically required to file for approval both new
products and changes to existing products. Typically, the States
require prior approval of products sold to persons and small business
(e.g., auto insurance, home insurance, life insurance, business owners
polices, etc.) or that are subject to State governmental mandates, such
as workers' compensation insurance. The level or degree of regulation
of products sold to medium size and larger firms tends to be less,
especially in States that have embraced NAIC templates for the
``reengineering'' of commercial lines regulation. These firms, with the
assistance of informed risk managers and brokers, should be able to
protect their own interests in assessing products and insurers and
negotiating contract terms.
For most property-casualty products that are more intensively
regulated, State requirements and mandates for approval vary both
formally (State laws and regulations) and informally (regulators'
preferences with respect to policy language, policy form formats,
etc.). Understandably, this greatly frustrates insurers seeking to sell
similar products in multiple States and increases the cost of delays in
the introduction of new products or product changes. I would be more
sympathetic to the States' view on this if I accepted their argument
that differences in State conditions justify differences in product
requirements. However, with the exception of differences in the cost of
living (it probably costs more to get a car repaired in New York than
in Mississippi), I do not believe that differences in State needs
justify the degree of variation in State requirements. Most of the
variation, in my opinion, results from different political environments
or philosophies, as well as the particular preferences of the insurance
regulators that help make and interpret the rules. Hence, I believe
that substantially greater uniformity and reduction of unnecessary or
excessive requirements would substantially decrease transactions costs,
would not harm the consumers in specific States, and would ultimately
work to their benefit whether they realize it or not.
The regulation of certain life insurance, annuity and health
insurance products do warrant special discussion. Through the years,
there have been periodic problems with the sale and representation of
certain more complex life/annuity products, such as universal life
policies, and variable life and variable annuity products, among
others. Other products can be complex, such as Long Term Care (LTC)
policies and hybrid life-LTC products. I discuss these issues and NAIC/
regulatory responses in greater detail in the second edition of the
text I wrote for the NAIC--A Regulator's Introduction to the Insurance
Industry (NAIC: 2005).
I believe that these areas of product and market practice
regulation will be particularly crucial in the years ahead as more
households will need to consider the purchase of these products. I
think effective and adequate regulation could be accomplished through
uniform requirements among States as reflected in NAIC model laws,
regulations and other guidelines but the requirements must be
rigorously enforced and updated as products continue to evolve and new
products and/or problems may emerge. Hence, regulation in this area may
need to be strengthened, not necessarily in terms of the model
requirements that the NAIC has developed, but in terms of the
allocation of regulatory resources and the intensity of regulatory
monitoring of compliance. Reducing or eliminating regulation in other
areas where it is not needed could potentially make more resources
available for the regulation of life, annuity and LTC products and
practices. Certain other types of insurance products such as ``critical
illness'' policies may also fall into this category.
It appears that the NAIC and the States may be well on their way to
achieving this objective with respect to life and annuity products with
a singular filing process and uniform product requirements with the
development of its InterState Insurance Product Regulation Compact
(IIPRC) which I understand has 27 States signed on and anticipates
becoming fully operational in early 2007. I have not had the
opportunity to fully assess this mechanism nor evaluate any objections
or criticisms by insurers or associations that do not believe that it
is sufficient to address their concerns about the current system. There
is also the question of how many additional States will be expected to
join and how quickly they will do so. At a minimum, the Federal
Government could encourage more States to join with the enactment of
Federal standards.
Deregulation of Rates/Pricing
Because of the highly competitive nature of most insurance markets
(title and credit insurance being exceptions), prospective regulation
of rates (e.g., prior approval of rates or rate changes) is
unnecessary. Numerous studies of price regulation in auto and workers'
compensation insurance effectively reveal no benefits but potentially
severe problems from insurance rate regulation. For the most part,
regulators are compelled to approve the same prices or rates that would
otherwise be set by the market. It is also difficult to sustain cross-
subsidies through the manipulation of rate structures when low-risk
consumers have choices about who they buy insurance from and/or how
much insurance they buy. However, there are instances, some quite
notorious, where regulators have sought to forestall or avoid economic
reality by suppressing rates below adequate levels and/or substantially
compressing rate structures (i.e., the rate differences between risk
classes or geographic areas).
Regulators can ``get away'' with modest rate suppression or
compression for limited periods of time, but if they take it too far
and too long, major market problems result. The amount of coverage that
insurers are willing to supply voluntarily plummets far below what
consumers need or want. Further, rate suppression/compression distorts
insureds' incentives to control risk and losses. In its worst
manifestation, severe rate suppression can result in the collapse of a
market as occurred in the Maine workers' compensation insurance market
in the early 1990s.
Some might blame State insurance commissioners for such behavior
but this is myopic. Most voters and consumers tend to harbor
misconceptions about insurance rates and what is ultimately in their
best interest and special interest groups can knowingly seek cross-
subsidies in their favor. The point is that a commissioner who seeks to
approve adequate and actuarially fair rates when costs are escalating
can encounter significant political opposition that will eventually
remove him or her from office. Hence, the blame should lie with those
who ultimately control the political fortunes of Governors, regulators
and legislators.
This contributes to the argument for rate deregulation. If
regulators have no authority to approve or disapprove rates
prospectively, then this should divert some of the political pressure
that they would otherwise face. Of course, deregulation does not
totally solve the problem if there is always the danger that voters or
special interest groups can reinstitute rate regulation or legislate
rate restrictions.\2\ Still, if Federal standards and interstate
compacts make this less likely, then the potential danger and threat is
reduced.
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\2\ The passage of a popular referendum in California, Proposition
103 in 1988, in which voters approved a mandatory 20-percent decrease
in their premiums for auto insurance offers one of the most egregious
examples of the misuse of political and democratic processes to attempt
to manipulate the price of insurance.
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It should be noted that market-based prices are not necessarily
perfect or stable. Insurers can make pricing mistakes by failing to
anticipate cost increases or decreases or accurately determine
differences between risk classifications. However, such mistakes tend
to be short-term in nature as markets tend to correct these mistakes
fairly quickly. One example of this is that increases in homeowners
insurance rates in the Midwest during 2001-2002 have stopped and rates
are starting to come down in these areas. The situation for property
insurance along the Gulf and East coasts is somewhat more complex and
does not lend itself to simple explanations or predictions.
There is another problem that can last somewhat longer. Certain
commercial insurance markets in ``long-tail lines'' (i.e., lines where
there can be a considerable lag between when premiums are set and
collected and claims are fully paid) are subject to cyclical shifts in
the supply and price of insurance--this is commonly known as the
``underwriting cycle''. The cycle begins with a chronic ``soft market''
phase in which insurers tend to under-price the coverage they sell and
overly relax their underwriting standards. Academics and practitioners
continue to probe and debate why this occurs, but regardless of the
causes the reality is that it happens. Ultimately, after insurers lose
a lot of money and can no longer ignore their under-pricing, the supply
of insurance tends to tighten sharply and prices can rise
dramatically--this is called the ``hard market'' phase. Hard markets
tend not to last too long (roughly 2 years at most unless claim costs
continue to escalate) and once insurers begin earning positive profits
the supply of insurance begins to increase and prices fall. Hence, the
ultimate implications of this cyclical behavior is that commercial
insurance buyers have to deal with some volatility in what they pay for
insurance but over the long term they tend to get a price break because
insurers' long-run profits tend to fall below what would be considered
a fair rate of return.
If rate regulation could mitigate this phenomenon it might provide
a partial argument for retaining some regulatory control of pricing.
However, the research indicates that rate regulation does not mitigate
the cycle and may in fact worsen it because of lags between the filing
and approval of rate changes. Also, in commercial lines, if insurers
want to cut prices they have a number of ways to circumvent any
regulatory attempts to stop them.\3\
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\3\ The reality is that regulators rarely, if ever, try to stop
them. Understandably, commercial insurance buyers would oppose any
regulatory price floors and regulators see little value in taking on
that fight.
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The only strategy that regulators might employ is to take action
against an insurer that is cutting prices to the point that its
solvency is threatened. Unfortunately, Pennsylvania regulators failed
to do this in the case of the Reliance Group until it dug a $2 billion
hole that will be covered by consumers, taxpayers, other insurers and
unpaid creditors. At the same time, firms that bought insurance from
Reliance when it was obviously charging too little and spending too
much conveniently ignored an inevitable reality.
All of this discussion leads me to argue for rate deregulation for
all lines (with the exceptions I noted). It does not seem to offer any
benefits but it can cause a lot of problems. To help satisfy the
skeptics and ensure adherence to the requirements of the McCarran-
Ferguson Act, regulators should monitor competition in insurance
markets and retain some residual authority to intervene if competition
should fail for some reason. This could be accomplished by requiring
insurers to file rates for informational purposes, but not for approval
either before or after their implementation. Further, if insurers'
rates are not subject to approval, it would seem that there would no
reason to require approval of the loss costs filed by advisory
organizations.
There are related issues with the administration and regulation of
what are known generally as State ``residual market mechanisms''. These
are mechanisms established by the States to provide coverage to people
and firms that, in theory, cannot obtain coverage in the ``voluntary
market''. They are typically found in auto, home and workers'
compensation insurance and sometimes in medical malpractice insurance.
If a residual mechanism is managed properly such that it applies
stringent requirements for accepting applicants, charges adequate rates
to cover its full costs, and rates in the voluntary markets are allowed
to rise to adequate levels, then these mechanisms tend to remain small
in volume and do impose a significant burden.\4\ However, if their
rates are suppressed and the other conditions do not hold, then they
can swell and begin to contribute to significant market problems and
distortions. Hence, rate deregulation must be accompanied by
responsible management of residual mechanisms in order for voluntary
markets to work properly.
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\4\ Occasionally residual mechanisms can swell during periods of
significant market adjustments as is occurring for property insurance
in coastal areas. However, they should depopulate fairly quickly if the
market is allowed to adjust to a sustainable equilibrium and new
capital is attracted to the market to help absorb consumers who
temporarily could not obtain coverage in the voluntary market.
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Singular Product Filings and Licensing Applications
The NAIC has sought to greatly improve the efficiency of insurer
rate and form filings which provides a single point for filings that
are not subject to the IIRPC--the System for Electronic Rate and Form
Filing (SERFF). According to the NAIC's testimony, the system has grown
dramatically with complete State participation and participation by a
large number of insurers. While SERFF make filings easier, it does not
fully solve the problems perceived by insurers who operate in a large
number of States. Each State must ultimately approve or disapprove
these filings according to its own laws, regulations and requirements.
Hence, products must be modified for different States and their
approval in a particular State may still be delayed.
A truly ``singular'' process would allow an insurer to file one
product that would be subject to review and approval by one entity that
would automatically apply to all States or at least a large group of
States. Of course, this is one of the major objectives of insurers
supporting the optional Federal charter bill. In order for the States
to replicate the same kind of process they would need to: 1) have
uniform product and licensing requirements; and 2) entrust the review
and approval of filings and application to a central entity. This would
be a major step beyond where the States are currently moving. A number
of States might object to taking this step because they would view it
as a major abrogation of their individual regulatory authorities.
However, as I have Stated earlier, I do not see a need for States
to have differing regulatory requirements nor is it unprecedented for
them to delegate their regulatory approvals to a central entity. Hence,
in my view, it comes down to how far the States are willing to go in
the institutional framework I propose versus the optional Federal
charter approach. If the States would be unwilling to take this step,
it would strengthen the case for an optional Federal charter.
There is also the issue of company licensing applications.
According Commissioner Iuppa's testimony for the NAIC, it has developed
a Uniform Certificate of Authority Application (UCAA) that establishes
the base forms for use in company licensing applications. An electronic
system has been built to facilitate the expansion application and
communication processes, making it easier for insurers to expand to
other States. Commissioner Iuppa also Stated that the NAIC and the
States have largely addressed the issue of State-specific requirements
often cited by the industry and have provided transparency for the
State-specific requirements that remain.
While these developments are commendable, they stop short of a
truly singular licensing application process that would allow an
insurer to file one application and be approved for licensing in
multiple States. Understandably, the States would like to retain their
individual authorities to accept or reject license applications
according to their standards and assessment of an insurer. I do not
know how satisfied insurers are with the current state of affairs and
their views of further streamlining the application process. It would
not surprise me if a gap remains between what the States are willing to
accommodate and what insurers would like to see. If that is the case,
then it seems further progress could be made to ``unifying'' the
application and approval process without admitting ``rouge insurers''
to quote Commissioner Iuppa. It comes down to how much farther the
States are willing to go to concede some of their discretion on
approving applications and how much farther insurers think the States
should go to achieve an optimal balance of efficiency and regulatory
protection.
Financial Regulation and Administration of Insurer Receiverships
The States have made the greatest strides in the financial or
solvency regulation of insurers. Because States' interests are more
intertwined in the financial regulation of an insurer (because the
financial regulation of an insurer by its domiciliary State affects the
interests of all States in which the insurer does business) the NAIC
has been able to go a lot farther in terms of getting the States to
adopt and enforce strong and uniform standards, as well as engage in
more cooperative efforts. Further improvements could be made but the
States tend not to oppose uniformity in this area contrary to their
views on market regulation.
The reforms that have been instituted are beyond the scope of this
testimony. My publications and Commissioner Iuppa's testimony discuss
some of these initiatives. Commissioner Iuppa's testimony did not
address requirements for ``dynamic financial analysis'' for property-
casualty (p-c) insurers consistent with what is occurring in the
development of international insurer solvency standards. In my opinion,
this is an important area for consideration and perhaps one of the
remaining linchpins that could be incorporated into p-c insurers'
financial requirements. However, it appears to be a highly
controversial idea. Most large insurers already engage in this kind of
analysis, but many p-c insurers, both large and small, may resist the
notion of being compelled to perform this analysis and have it
scrutinized by State insurance regulators. Life insurers are already
more acquainted and comfortable with this kind of regulation because it
has been tied historically to their asset-liability management.
I believe that this is an issue on which the p-c insurers must
eventually give in because it makes good sense despite their objections
and it represents one of the final elements of a set of rigorous and
appropriate financial requirements that have already been adopted in
certain other countries with advanced regulatory systems. Of course,
exactly what will be required is a legitimate issue for discussion and
negotiation. Beyond that, the challenge for the States will be to have
the personnel and infrastructure in place to properly evaluate the
analyses that will be performed and submitted by insurers. Another
issue will be how regulators use this information and how they will act
when an insurer's analysis indicates the need for some form of
regulatory attention or intervention.
As with the regulation of market conduct, financial regulators must
deal with a shifting landscape, new developments and threats, insurer
practices and mega-events and catastrophes that could have sweeping
effects on a number of insurers. It appears that the NAIC has tended to
respond to new issues, albeit a little late, but the action or
reactions of individual State regulators within existing standards or
the revision of standards may occur with too long of lag. Spurring
regulators to quicker action within existing standards may be something
that could be accomplished through the strengthening of existing NAIC
committees and mechanisms to coordinate State regulatory action.
Revising standards is another matter because of the long deliberative
process that is somewhat inherent to the NAIC's structure and lack of
actual authority. It is not clear how this might be resolved unless
some central entity would be given the authority to ``fast-track''
quickly needed changes in financial standards and requirements (such as
that kind of authority that is vested with Federal financial regulatory
agencies).
For the most part, the number and severity of insurer failures is
low but there are some exceptions such as Reliance. Why regulators did
not act more quickly still remains unclear. It would be desirable to
vest some entity with authority to conduct ``post-mortem''
investigations of certain insolvencies where there are legitimate
questions either about the causes of the insolvency, or more
importantly, the actions or the timing of actions by the responsible
regulators.
There is also the issue of how the receiverships of impaired or
insolvent insurers are managed. After I and two of my colleagues
submitted a critical report on this matter, the NAIC set forth an
extensive and ambitious program of reforms that in part will be
facilitated and endorsed by the NAIC but ultimately must be implemented
by the States. While the reforms are ambitious considering this area
has been subject to the greatest inertial resistance by certain vested
interests, I still believe they may fall short in a couple of key
respects. Most importantly, there must be effective oversight and
control over appointed receivers and the domiciliary regulators of
insurers in receivership to minimize waste and maximize efficiency.
Second, full exploitation of alternative workout plans for impaired p-c
insurers must be explored as an alternative to liquidations that
typically result in higher ``deficits'' that eventually are paid by
creditors, the ``public'' and others that bear little or no
responsibility for the insolvency. Some policyholders and claimants are
covered by guaranty associations that pass their net costs to other
insurers, their insureds and taxpayers.
State Enforcement of Market Regulations
Even with uniform requirements for and singular approval insurance
products, there will still be a need for the States to monitor and
enforce insurers' and intermediaries compliance with all State laws and
regulations, uniform or not. I believe that this would best be done at
the State level if the States can demonstrate that they can do this
appropriately, effectively, and efficiently. State regulators are
closest to the activities of insurers and intermediaries in their
markets and it would be a costly and substantial enterprise to replace
the compliance infrastructure that is already in place.
The NAIC has pushed an agenda that would make ``market conduct''
regulation more efficient and effective, but its recommendations fall
short of what I would advocate and we do not know yet whether the
States will even implement what the NAIC recommends. Commissioner
Iuppa's testimony cites some promising statistics but there is still a
high mountain to climb in terms of achieving the level of efficiency
that is possible and in the best interests of consumers and insurers.
Based on studies and surveys I have conducted as well as others, it
appears that a large number of States and market regulators still seem
to be resistant to the kinds of reforms that are warranted. Some States
and regulators seem to zealously defend their prerogative to regulate
market conduct the way they think is appropriate, regardless of whether
it conforms with NAIC or other national standards or recommended
policies and procedures.
State preferences can make a big difference in the costs and
burdens of market conduct regulation for insurers with no evidence of a
``return'' on these costs in terms of better market conduct or
increased compliance. Some States insist on conducting their own market
conduct exams of licensed insurers in their States that means that a
given insurer can be subject to 5-10 market conduct exams by different
States in a year that basically plow the same ground. Some States share
information on their market conduct examinations with other States and
others do not. Some States conduct exams relatively efficiently and
others waste substantial regulatory and company resources. Some States
recognize and consider self-compliance activities of companies and
other States ignore them. Consequently, while I commend what the NAIC
is trying to do and acknowledge that it has made some progress in
reducing the amount of inefficiency, I reserve judgment on how much
further progress it will be able to make with its current program and
influence.
If market conduct regulation is going to be really reformed in all
States there will be a need to establish strong national standards and
approved methods that the States will be compelled to implement. These
standards and methods will need to be embodied in the vehicles that the
Federal Government and the States will use to unify and rationalize
other aspects of insurance regulation. I have co-authored reports and
articles that outline a number of recommendations on market conduct
regulation but there are three that I will mention here that should be
included in any Federal standards. The first is that an insurer should
be subject to only one routine or targeted market conduct examination
that will serve all interested States. The second recommendation is
that all States should be required to give some consideration to
insurer self-compliance activities, whether performed individually or
cooperatively through an industry self-regulatory organization. The
third is that all States should be required to improve their monitoring
and detection systems to better target their investigations to
potentially significant and emerging problems and not toward massive
error-finding scavenger hunts. In sum, all States should stop wasting
resources on things that yield little value and focus their resources
on serious problems that have the greatest impact on consumers.
Producer (Intermediary) Licensing and Regulation
It appears that the NAIC has made some strides in facilitating more
efficient licensing and appointment of insurance producers, especially
those that wish to operate in multiple States. I have not had the
opportunity to assess how much progress has been made in making this
process more efficient but I suspect that some national agents and
brokers are not satisfied by what has been accomplished so far. It
appears that even though NAIC systems facilitate electronic
applications to multiple States using a standardized form, the
individuals States still set their own standards and make their own
determinations as to who will be given a license.
Recently, I had the opportunity to review a survey of State
producer licensing and education requirements and it seemed that there
was a significant amount of variation that was difficult for me to
rationalize. Like insurance product requirements, it is not clear to me
why producer standards should vary greatly by State. Further, I fear
that some States' regulation of producers and their educational
requirements are inadequate and instances of producer fraud and
incompetence continue to abound. I would support the concept of a
standardized but rigorous set of producer licensing requirements that
would be closely enforced by the individuals States if they
demonstrated the capability to do so. This would permit a producer to
submit one application to be approved to do business in multiple States
but the producer would be held to high standards that would help reduce
the abuses and mistakes that continue to occur.
Other Recommendations
Time does not permit me to explain the other recommendations I made
in the introduction section of my testimony but I will offer two
related opinions that I consider important. The first has to do with
the data that are reported and maintained that allow legislators,
regulators, researchers and others to monitor and analyze the insurance
industry and its issues. Data from insurer financial statements is
quite extensive and public access is relatively good so I do not view
this as a problem area. The problem lies with other kinds of data that
go beyond financial data in helping us understand how insurance markets
are working and allow us to further probe issues such as cost trends,
causes of increasing costs, pricing and underwriting issues, and a host
of other important questions. Over time, public access to this kind of
information has actually declined as statistical and advisory
organizations have converted from non-profit organizations with a
public mission to for-profit organizations with an essentially
proprietary mission. Insurers are also more zealously guarding access
to their data for proprietary reasons.
As a researcher, I am finding it increasingly difficult to access
data to conduct studies while the actual amount of data held by certain
organizations has actually increased. We need to find some kind of
balanced resolution of this problem that will facilitate better and
more research while addressing insurers' proprietary and privacy
concerns and the costs of collecting such data by the organizations
that have it.
The other serious problem that needs to be addressed is the
tremendous amount of consumer and public ignorance about risk,
insurance and regulation. The ability to rely on consumer choice and
market forces rather than regulation is directly tied to consumers'
knowledge and cost of acquiring information. There is probably a small
segment of the population that read the articles by financial
journalists and are relatively knowledgeable but I suspect there is
much larger group of people who are badly uninformed or harbor many
misconceptions. I personally encounter this ignorance in a variety of
interactions with various people.
Public and private organizations have undertaken extensive consumer
education efforts but most people probably do not avail themselves of
these services. We need to think about even greater proactive and
aggressive public education efforts that reach more people and
``encourage'' more of them to become informed. Ironically, we seem to
accept such a notion when it comes to things like public health but not
financial health which is just as important. Some of my colleagues may
object to such efforts but we are paying a heavy price for consumer
ignorance that will only increase as people are required to make more
decisions. The claimed ignorance about the flood exclusions on
homeowners insurance polices, the failure to save and prepare for
retirement income needs, and the general misconceptions about what
insurance is are exacting heavy tolls and make it harder for
legislators and regulators to pursue economically sound policies. We
cannot expect to get every consumer and voter to become well informed
but we need to see if we can achieve a significant reduction in the
level and breadth of ignorance.
Concluding Observations
Clearly, there are a range of interests and different opinions on
how insurance should be regulated and who should do it. I will not
accuse any group of being insincere in the opinions they express, but
to borrow a concept of one of my old professors, people tend to
perceive the world in a way that best suits their interests. This does
not mean any particular opinion is invalid, but every opinion including
mine must be scrutinized and tested against a set of principles and
valid facts. Ultimately, what matters is what is in the best interests
of consumers and the general public and this is what the Congress has
to determine.
Designing a regulatory system and setting regulatory policies by
necessity is a balancing act. The benefits and costs of relying on
``free choice'' and market forces have to be balanced against the
benefits and costs of regulatory constraints and mandates. The choice
of an institutional framework also affects costs and effectiveness and
may have implications for how incentive conflicts between different
insurance market participants are resolved. I have offered my opinions
on what I think insurance regulation should like but I do not claim to
be omniscient or invulnerable to error. The important thing is that the
Committee is facilitating a full airing of the issues and opinions that
will allow it to make the most informed and best decisions that will
serve the public interest. I would be happy to continue to engage in
communications with the Committee and comment further on any questions
it may have.
Selected References
Grace, Martin F., Robert W. Klein, and Richard D. Phillips, 2002,
``Managing the Cost of Property-Casualty Insurer Insolvencies,''
Report to the NAIC, December.
Hanson, Jon S., Robert E. Dineen, and Michael B. Johnson, 1974,
Monitoring Competition: A Means of Regulating the Property and
Liability Insurance Business (Milwaukee, Wisc.: NAIC).
Iuppa, Alessandro, 2006, ``Testimony Before the Senate Committee on
Banking Housing, and Urban Affairs: Regarding Insurance Regulation
Reform,'' July 11, Washington, D.C.
Klein, Robert W., 1995, Insurance Regulation in Transition, Journal of
Risk and Insurance, 62: 363-404.
Klein, Robert W., 2004, ``The Underwriting Cycle,'' Encyclopedia of
Actuarial Science, Jozef Teugels and Bjorn Sundt, eds. (Hoboken,
N.J.: John Wiley & Sons, Inc.).
Klein, Robert W., 2005, A Regulator's Introduction to the Insurance
Industry, 2nd Ed. (Kansas City, Mo.: NAIC).
National Association of Insurance Commissioners, 2005, 2005 Regulatory
Initiatives: Goals, Action Plans & Deadlines for States, Committees
& NAIC Staff (Kansas City, Mo.: NAIC).