AIG's downfall and the transparency of derivatives
I read with interest Kevin Hennosy's article, "Supervision & Regulation Aren't the Same," in the June 2011 issue of Rough Notes.
I understand that many of Mr. Hennosy's articles focus on the McCarran-Ferguson Act, as this one does. However, the Gramm-Leach-Bliley Act, like the McCarran-Ferguson Act, is the law of the land. Unless and until Congress repeals it, its provisions are the guidance regulators must use.
My perspective is different from Mr. Hennosy's. He assumes that AIG is an insurance company rather than a conglomerate. At its peak, AIG was involved in more non-insurance activities than it was in U.S.-based insurance. To suggest that U.S. insurance regulators ought to be regulating airplane leasing operations, aircraft sales, advice on airline route planning, or the AIG insurers domiciled in other countries—or the AIG Financial Products Corporation based in the United Kingdom—would be granting U.S. insurance regulators a lot more power than Congress (or anyone else) has or should provide to them.
In AIG's case, Dr. Vaughan was correct: Regulatory arbitrage was evident. The AIG leaders picked the Office of Thrift Supervision as its de facto U.S. regulator. However, the AIG Financial Products Corporation was located in the U.K. Thus, it is the U.K.'s Financial Services Authority that should have been charged with watching over the AIG Financial Products Corporation. Neither regulator did. As a result, we have all suffered from the fallout.
What really occurred was that the deals consummated with AIG Financial Products Corporation were completed in a regulatory vacuum. Ordinarily, free markets operate quite well without much oversight as long as everybody knows the rules and plays by them. In this case, there were no rules and the supposedly sophisticated parties to the transactions took advantage of each other at every turn. The arrogance of managers at AIG Financial Products allowed the corporation to be duped by a relatively small number of broker-dealers. Joseph Cassano was convinced that AIG would never lose a dime on these exotic transactions. All this noted, I agree with Mr. Hennosy's point: It was AIG's greed that led to its downfall.
Mr. Hennosy wants to blame the insurance regulators for AIG's failure. While there is plenty of blame to go around, we would all be better served by carefully identifying the problem and addressing it. The problem was not lack of supervision or regulation; it was lack of transparency in the type of derivatives that AIG Financial Products Corporation and others were issuing—and the fact that AIG sought the protection of a failure in oversight that results from regulatory arbitrage. One cannot effectively supervise or regulate risks kept opaque and valued by proprietary models. To manage systemic risk, one must be able to see the dots in order to connect them so that all systemic risks can be known and quantified. Systemic risk regulators cannot connect the dots if no one regulator can see them.
There are two fixes that address this problem. One would involve a lot of potentially heavy-handed and expensive government regulation with as massive a data collection effort as the financial world has ever known. (This is the model under development to serve the needs of the Financial Stability Oversight Council.) The other solution is a cost-effective free market alternative. It is a private sector solution that, in its simplest form, matches buyers and sellers in a reasonably transparent, neutral environment so that all parties know what assets and risks are actually assembled in the resulting derivative product—and what these instruments are worth.
This solution has been adopted in the insurance sector by the LexisNexis Insurance Exchange. It is a model that is market neutral and "friendly" to all market participants: carriers, agents and brokers, and the consumer. In fact, this is so much the case that the participants refer to their model's neutrality as "Switzerland." I encourage your readers to visit our Web site to see an "Overview Demo" and other details of our proposal at www.marketcore.com and to learn more about our company's role at www.lexisnexis.com/risk/insuranceexchange/marketcore.aspx.
No one can attempt to fix the problem until they know the problem. Addressing the lack of transparency in capital market transactions and the job of supervising or regulating the insurance industry also gets easier. A significant benefit then occurs: confidence in market function is restored. Then we can all look forward (and with reasonable speed) to a much more prosperous future with greater financial market product differentiation for risk transfers of every sort with an accompanying and very significant increase in business volumes.
Down with the "big-box" approach to client service
While I am reviewing insurance for a client, I look over the existing agent's renewal review for last year. (Our firm only consults with buyers—we do not sell policies.) I sometimes come across a statement that the agency never recommends limits of coverage.
What exactly is your job then? Are you a clerk for the insurance companies? "Here is what we can offer. Buy what you want." It's the big-box approach to insurance service! Why exactly do people buy insurance from you?
This comes from the world of errors and omissions loss prevention, a pervasive cult that insists that everything an agent does must foil the perverse suit-happy public.
Take no risks, offer no advice, is the mantra.
Horse-hockey! Insurance buyers need informed advice and counsel. The world of insurance is complicated and complex. It is the agent's job to stand up and advise the client. Why else would they need you?
While you are at it, remove the message from your voice mail: "Coverage cannot be bound or amended using a voice mail system." Show me one case where a customer successfully sued an agent because a voice mail message included a coverage change, and I will donate $100 to the Red Cross in your name.
Pablum for the mindless insurance lemming.
—Scott Simmonds, CPCU, ARM, CMC
Insurance Assurance Consulting