NAIC ANALYSIS AND OPINION
When hard-learned lessons fade from memory
By Kevin P. Hennosy
Will your insurance company go broke? A dozen years ago, far too many policyholders, insurance producers and even congressional investigators were asking that question. The late '80s and early '90s saw a rash of insurance insolvencies that shook confidence in the insurance industry.
In light of the glare of publicity that followed those insolvencies, the importance of state regulators' ability to monitor the financial standards and practices of insurers became as clear as the morning headlines. Reform was the watchword of the day. The rules were tightened by regulators who insisted on making an independent assessment of insurers' financial condition.
During most of the 1990s, booming capital markets and business expansion removed the immediacy of solvency surveillance for insurers. In 1995, Republicans performed well in state elections. That landslide brought to office a new class of conservative regulators whose philosophy of regulation was far more laissez faire than that of their predecessors. In addition, the change in government led to the retirement, resignation or dismissal of civil service personnel. These "Life-ers" left their positions in insurance departments and took with them hundreds of years of institutional memory.
Even those officials who remember the "solvency crisis" may not remember how close to meltdown the system was. At one point, the leaders of the National Association of Insurance Commissioners (NAIC) made a then-secret trip to visit the New York Federal Reserve Bank to draw up plans for the Fed to provide life insurers with liquidity. We came that close to collapse.
Today, far too many regulators and executives act as if insurance companies never go broke. This is not to say that there are not insolvencies today. The mega-failure of Reliance Insurance offers a case in point, but the scandal of Reliance was eclipsed by September 11. A chance for enlightenment was lost.
Familiar tune
As someone who watches the NAIC and who has studied the association's history, I think the failure of Reliance raises disturbing parallels to the Baldwin-United insolvency of the early 1980s. Baldwin was a company with a long history. It rested on a solid foundation. Then, new management took over and used the framework of the stodgy old company for market speculation. After a period of rapid expansion, the framework gave way. Baldwin's failure was the largest insurance failure in history up to that time.
When Baldwin failed, state officials focused on cleaning up the mess--forming a consortium of companies to pay claims--to the exclusion of finding out what caused that mess. The NAIC published a pamphlet that outlined the growth and decline of the company but did not mobilize to change the solvency surveillance system.
The NAIC seems to be following the same approach today in response to the Reliance failure. As long as the guaranty fund system can be tweaked and patched to pay the failed company's claims, state regulators seem content. Clean up the mess. Don't fix the problem.
Congress ultimately holds the blame for the states' inaction. Let us remember that the states regulate insurance with borrowed authority from Congress. Congress did not pressure the states to reform the system after Baldwin, and the states did little to improve regulation. After the failure of Executive Life (Regulators took over the company in early 1990), Congress put a great deal of pressure on the states, and the result was a sweeping reform to solvency oversight. Congress has not shown an interest in the Reliance failure.
State budget officers will feel the result of the Reliance failure for some time to come. Reliance will generate claims to the guaranty fund system for years. States grant insurers a partial deduction for guaranty fund assessments from their premium tax liability. The vast majority of most premium tax revenues go into state general funds, and the largest general fund expenditure for most states is primary and secondary education. So when insurance companies go broke, it's like removing textbooks from school kids' desks.
Technology
The advance of technology has made business more efficient. Efficiency cuts both ways. The effect of efficiency is clear when applied to success and productivity. What we do not like to think about is how technology has made failure more efficient. Mistakes can lead to collapse very quickly.
For this reason regulation must constantly change. When the groundwork was laid for the insurance regulatory system, one could not travel from coast to coast by train. Telegraph technology was that day's high-tech. The annual financial statement was cutting-edge regulation.
For the last 131 years, the insurance industry has been a leader in high technology even though it retains a stodgy reputation. For example, insurance companies were among the first businesses to use computer technology in business applications. However, insurance regulators have all too often helped the insurance industry earn its stodgy image. Insurance regulators did not consider using automated systems for solvency oversight until Michigan did it in the late 1960s.
The NAIC led the state regulatory system in introducing automated systems for regulator use in the 1970s. To pay for the technology, the association initiated a schedule of database fees that insurers paid when they filed a copy of their annual statement with the NAIC. The earliest systems looked at both solvency and market regulatory issues, but slowly company advocates narrowed the scope of data analysis to solvency surveillance.
The first test of the new automated system was the Baldwin failure. For the first time regulatory financial analysts had high-level data to look at during a major company's death throes and subsequent post-mortem. This analysis, coupled with examination reports, identified problems that affected accounting and investment rules and holding company law.
Unfortunately, considering what regulators learned from the insolvency, very little was done. To a great extent regulatory advances were stifled at the NAIC level--because the NAIC was controlled by company advocates and trade associations.
Insurance company advocates cajoled and co-opted regulators, trying to persuade them to do as little as possible to correct the problems that brought Baldwin down, and to ignore changes to investments practices, marketing methods and policy design that threatened other companies.
Old guard
In the early '80s, company advocates and trade associations used two NAIC weaknesses to hinder the advance of regulation. First, NAIC's dependence on database fee revenue allowed insurers to force operational changes at the association by threatening that their member companies would withhold fees. Second, the NAIC depended on a system of "industry advisory committees" to propose policy recommendations and vet proposals.
The advisory committees were so entrenched that the obituaries of expired insurance executives regularly made reference to membership on the committees. The advisory committee system transformed the NAIC from an insurance regulatory association into an essentially self-regulatory industry organization.
The advisory committee system did more than give industry advocates control over NAIC recommendations. In addition, it served as a mechanism for regulators to draw expertise from the industry, which officials assumed was superior to that of insurance department personnel. Furthermore, industry participation in developing recommendations assured support for NAIC recommendations by industry lobbyists in the state legislatures.
The advisory committees always attracted criticism from consumer advocates and some sectors of the media. Advisory committees were not open to consumer participation and over-represented company interests at the expense of insurance producers.
Nor was advisory committee participation representative of the broad range of insurance company opinions either. Old Guard advocates handpicked representatives for participation on the committees. The Old Guard did not choose freethinkers to join the club.
Reform
As insurance company failures cropped up at an alarming rate--including Executive Life, Midwest Life and Mutual Benefit Life--Congress and the news media pressured the NAIC to improve its capabilities and clean up its act.
Technological improvements were approved in 1987 before the solvency crisis hit in earnest. In the face of the crisis, NAIC staff levels were increased and the association provided travel funds to insurance departments so that additional staff could attend NAIC meetings.
The availability of insurance department and NAIC staff expertise allowed the NAIC to issue a partial "declaration of independence." The NAIC adopted a resolution that banned advisory committees in 1990. It resulted in at least a "forearms-length" relationship with industry advocates.
The regulators found that they had underestimated the worth of their own experts by assuming that the industry had a monopoly on bright people. Solvency regulation in particular was made more uniform, efficient and effective.
The banishment of advisory organizations did not result in a reduction of insurer input into the NAIC process. In a way, industry input was democratized. Individual insurers and other professionals found that they could take part in the process directly. Their views did not have to pass though the expensive prism of trade association membership.
Revenge
The major property/casualty insurance trade associations were early advocates for the return of advisory committee systems. The National Association of Independent Insurers (NAII) made repeated public statements calling for the return of advisory committees.
These calls fell on deaf ears while the NAIC was under strict congressional supervision. The powerful chairman of the House Committee on Oversight and Investigation, John Dingell (D-MI), did not believe that the insurers should write their own rules. After 1995, with the makeup of regulators turning more conservative, that all changed.
At about the same time, sectors of the insurance industry began withholding fees paid to the NAIC in conjunction with filing the annual financial statement. At the time, this fee income made up about 40% of the association's revenue.
Trade associations were careful not to recommend a fee "boycott"; however, the NAII sent a letter to its member companies to inform them that some companies had chosen not to pay fees to the NAIC until certain changes were made to NAIC policy.
The main area of disagreement was NAIC's non-solvency-related regulatory recommendations. Industry advocates contended that the NAIC could not use financial statement filing fee revenue for market conduct related work--such as investigations into race-based redlining by insurers.
In negotiations described in The Wall Street Journal, major trade associations pressured the NAIC to return control of its budget and policy recommendations to the insurer advocates. One suggested method was the reconstitution of the advisory committee system to transfer control back to the industry.
In the summer of 1998, the NAIC and major trade associations brokered a deal to end what amounted to a fee boycott. Immediately afterward, a more formal system of industry advisory groups began to appear at NAIC conventions and in the official meeting minutes of the association. The new advisory committees assumed various names: "Technical Resource Groups," "Interested Parties," and "Technical Advisors."
VOS
A good example of how advisory committees have returned to the NAIC is the Valuation of Securities (VOS) Task Force. This task force develops NAIC policy on insurer investment rules. It was originally formed in 1908 to provide an independent arbiter of investment rules. Today a review of the VOS Task Force minutes documents that insurers once again control investment rules. The task force formally adopts reports, recommendations and rules developed by company lobbyists.
The co-option of the VOS Task Force by lobbyist control brings to light a historical irony. The task force was formed in the wake of the Financial Panic of 1907 and the Armstrong Committee Investigations in New York. New York investigators faulted the regula-tory system for allowinginsurers to establish the value of their own investments for financial reporting purposes. The NAIC established the VOS Task Force to establish independent rules for insurer investments. Later, the NAIC formed the Securities Valuation Office (SVO) under the task force's jurisdiction to provide independent values for insurer investments. Now, after nearly a century, the independent nature of regulatory valuation of insurer investment holdings is once again subject to question due to the influence of NAIC advisory committees.
Most advisory committees do not wield the complete control that they do in the VOS Task Force, but their influence is growing. More and more NAIC work products come from advisory committees rather than insurance department or NAIC staff.
No one advocates that insurers should not have input in the NAIC process, but advisory committees grant control over that process. If nothing else, when the NAIC relies on advisory committees to develop policy recommendations, the industry receives a "veto-by-omission": if the advisory committee does not present a policy option it is not discussed.
Some regulators claim that the policy change was made because insurer investments have become too complex for public officials to understand; therefore, insurers and accountants must develop their own rules. That sounds like a recipe for another Enron. *
The author
Kevin Hennosy, an insurance writer specializing in the history and politics of insurance regulation, covers the proceedings of the NAIC (National Association of Insurance Commissioners) for Rough Notes readers. Hennosy began his career with Nationwide Insurance Companies and then served as public affairs manager for the NAIC. He has written extensively on insurance regulation and testified before the NAIC as a consumer advocate. He is currently writing a history of insurance and its regulation in the United States.