Public Policy Analysis & Opinion

Senate launches hearings on insurance regulation

Subcommittee calls on outside experts to probe for weaknesses in oversight

By By Kevin P. Hennosy

The Subcommittee on Banking, Securities and Insurance of the Senate Banking, Housing and Urban Affairs Committee launched hearings on insurance in mid-September 2011. The hearings were the start of the committee's legislative oversight of the Federal Insurance Office and other insurance topics related to the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The hearings carried the notably vague title of Emerging Issues in Insurance Regulation, which leaves the senators a great deal of room to operate.

To further document the wide net being cast by the subcommittee, the senators received testimony from the Congressional Research Service (CRS), an arm of the Library of Congress. The CRS produces research and analysis to congressional committees and individual members of Congress. These activities can aid the analysis of existing law and policy, but often the CRS is called upon to initiate informed discussion leading to legislative drafting.

The CRS testimony provided a survey of the scope of insurance regulation and the causes of the financial crisis of 2008. In a discussion of the collapse of American International Group (AIG), the testimony addressed the oversight of the insurance sector by the Financial Stability Oversight Committee (FSOC):

Of particular interest going forward will be the decision by the FSOC as to which, if any, insurers might be designated as systemically important and what actions the Federal Reserve takes in its role of overseeing systemically significant insurers. Insurers are generally arguing that the pre-crisis view that the sector presents little systemic risk was correct and that AIG was an outlier. The overall expectation seems to be that few insurers will be deemed systemically important.

This assumption seems reasonable if one accepts the traditional view that life insurers' bond holdings should be carried at par value rather than market value. This standard was adopted in insurance accounting at a time when insurers generally held bond investments for a long time in support of fixed-premium/fixed-benefit products. Such products are rare in the modern market for life insurance. As we will see in other testimony delivered to the subcommittee, if life insurers were required to carry bond holdings at market value, the sector's financial condition would not look as strong as it is assumed to be.

One aspect of the CRA testimony that demands concern is the unsophisticated analysis of the McCarran-Ferguson Act.

The act's primary purpose was to preserve the states' authority to regulate and tax insurance. The act also granted a federal antitrust exemption to the insurance industry for "the business of insurance."

While the act does enable the states to tax insurance, the act is more complex than just preserving authority or granting an antitrust exemption.

More accurately put, the Congress used the McCarran-Ferguson Act to grant a limited and contingent delegation of authority over this sector of interstate commerce to the states.

The delegation of authority is limited because federal antitrust law and Federal Trade Commission (FTC) enforcement remains the primary legal remedy to "boycott, coercion and intimidation."

The delegation of authority is contingent upon state action. If the states do not act to apply regulation to the business of insurance, then jurisdiction over insurance remains with the federal government, as established in the Commerce Clause.

Under the act, "regulation" means public oversight of "the relationship between insurer and insured, the type of policy which could be issued, its reliability, interpretation, and enforcement—these were the core of the 'business of insurance.'" (See SEC vs. National Securities 1968)

The senators should and must understand these nuances. Too often in recent history of Congressional oversight over McCarran-Ferguson, assessment has been based on legend, lore and propaganda—to the detriment of the public interest.

Regulating the relationship

Testimony from Professor Daniel Schwarcz, Ph.D., of the University of Minnesota Law School, explained how most states fall short of complying with the McCarran-Ferguson Act. At present, the states are neither affirmatively regulating the business of insurance nor providing the passive regulatory framework of market competition.

Professor Schwarcz proposed to the subcommittee that the Federal Insurance Office use the authority given to it by the Dodd Frank Act to collect and publish insurance industry data.

At the time of the McCarran-Ferguson Act's passage, insurers and public officials alike assumed that the state agencies would take over the rate and form review process that private cartels had conducted before the Supreme Court decision in US vs. South-Eastern Underwriters Association in 1944. In the last 40 years, the consensus opinion of insurers and officials has shifted to a "competitive markets" approach.

One could argue convincingly that if competition could protect the public interest in insurance markets, there would be no reason for McCarran-Ferguson; states would not need to regulate and insurers could operate under antitrust law and FTC oversight.

Professor Schwarcz's testimony documented how state officials fail to require and enforce the dissemination of insurance information to the consuming public. Without transparency in product, pricing and financial solvency information, competitive markets are not possible because informed comparison shopping by informed consumers is not possible.

He observed:

Currently, most states do a remarkably poor job of promoting transparent insurance markets. This failing occurs at two levels. First, most states do not empower consumers to make informed decisions among competing carriers.

For instance, in personal lines markets—such as home, auto, and renters insurance—consumers have no capacity to identify or evaluate the substantial differences in carriers' insurance policies. Consumers cannot acquire policies before, or even during, purchase; instead, they receive them only weeks after the fact.

Meanwhile, no disclosures warn consumers to consider differences in coverage, much less enable them to evaluate these differences. Similar deficiencies prevent consumers from comparing carriers' claims-paying practices. Consumers neither receive nor can access reliable measures of how often or how quickly carriers pay claims. Finally, consumers are almost never informed that ostensibly independent agents typically have financial incentives to steer them to particular carriers who may not provide optimal coverage.

Professor Schwarcz's testimony also revives an argument leveled by the FTC at life insurers in 1979. The professor argued that the lack of transparency in the life insurance sector makes comparison shopping much more difficult than necessary. The FTC report opined that the lack of transparency is so prevalent that the market for life insurance is anticompetitive. Professor Schwarcz testified:

Perhaps the most notable example is that consumers have virtually no means of comparing prices or costs for the cash value life insurance products that different companies offer. When combined with skewed (and non-disclosed) salesperson incentives, this too has produced distressing results. For instance, a substantial majority of life insurance sold in this country is cash value, even though less expensive (and, for insurers, less profitable) term coverage is a better option for the vast majority of individuals.

The scary part

Professor Mary Weiss, Ph.D., of Temple University. provided further testimony concerning the life insurance sector. She presented data demonstrating the concentration of toxic assets lingering on life insurers' books.

Life insurers hold 18.4% of their assets in mortgage-backed and other asset-backed securities (MBS and ABS), including pass through securities such as CMOs. Even more startling, the amounts invested in MBS and ABS represent 169.8% of life insurer equity (policyholders surplus).

If the life insurance sector had to carry its bond holdings at market value, it is difficult to see how the solvency of the sector could not be called into question. But insurance accounting does not require the truth to be told, so the Big Lie goes unchallenged. The Big Lie protects the management that ordered the concentration of risk to be compiled, and protects the state regulators who lacked the courage to say "No."

As Professor Weiss testified:

The capital to asset ratios of life insurers was approximately 6.3% in 2010, while that for banks was 10.9%. Therefore at the present time, banks have about 75% more capital relative to assets than life insurers. Excessive leverage is risky because it exposes a firm's equity to slight declines in the value of assets. Therefore, the statutory statements of life insurers make them appear excessively leveraged, especially considering their exposure to mortgage-backed securities.

Also at the hearing was The National Association of Insurance Commissioners (NAIC), that moribund she-devil of American insurance regulation.

The NAIC testimony provided a rhetorical pat on its own back. Its testimony touted the state-based system's "strong track record of protecting consumers and maintaining effective solvency oversight." The testimony did not offer supporting documentation.

One can assume that the names Fred Carr, Carlos Miro, Doug Green and Martin Frankel would not punctuate this revisionist view of history. The NAIC testimony failed to point out that the shortcomings in the regulatory system documented by the professors were caused by the NAIC's submissive relationship with its lobbyist overlords. Most of the proposals made by Professor Schwarcz have been considered by the NAIC over the decades. Lobbyists told the NAIC, "No." The NAIC whimpered, "Thank you sir, May I have another?"

Since the passage of McCarran-Ferguson, the NAIC has played a constructive role in improving insurance regulation, but only after some scandal aroused the Congress to hold hearings and force the NAIC's hand. The insurance regulatory framework is only as strong as congressional leaders named O'Mahoney, Proxmire, Hart, and Dingell pressured the NAIC to build it.

The NAIC testimony also stresses the association's role in international relations, which should scare the Hades out of peace-loving people of the world. The NAIC testimony even described the association as "the U.S. standardsetting [ sic ] and regulatory support organization created and governed by the chief insurance regulators from the 50 states."

Huh? By what authority can the NAIC claim to set standards for anything?

One might also ask what happened to the District of Columbia and the U.S. territories that the NAIC used to claim as association members? Certainly, the NAIC made a special effort to expand its membership to include at least one U.S. territory, which was represented by disgraced-lobbyist Jack Abramoff at the time. Now it appears that these NAIC members have been thrown under the proverbial bus.

The standards-setting role for the Delaware-chartered corporation doing business as "the NAIC" should set off alarm bells at the U.S. Departments of State and Commerce if the association wants to persist in acting out this fantasy. Neither the private corporation nor its transient association with state officials provides authority for the NAIC to negotiate or bind American trade policy. Based on the failed experience of the Articles of Confederation, the Constitution preserves the ability to set trade policy with the federal government.

Furthermore, such an action clearly lands outside the parameters of the McCarran-Ferguson Act. Standard setting is a regulatory act. The Supreme Court, borrowing from the committee report on the bill that became the McCarran-Ferguson Act, opined in 1960, "Nothing in the proposed law would authorize a State to try to regulate for other States, or authorize any private group or association to regulate in the field of interstate commerce."

The storm magnet

This is not to say that the NAIC is unable to do anything. Recent history seems to show that the NAIC is particularly adept at attracting hurricanes. This might seem an extreme position to espouse, until one reviews the record.

In the words of Rod Serling, "submitted for your approval," in the last week of August of 2005, the New Orleans bars and restaurants awaited the arrival of the camp-following-corps of expense accounts that together make up the conventions of the NAIC, but before the first cocktail could be ordered, Hurricane Katrina swept across the city. The resulting surge of water undermined several poorly constructed levies and flooded the city.

The NAIC cancelled its convention—after taking several days to think it over. Certainly some may argue that the NAIC had nothing to do with the weather (or engineering) disaster that flooded the "city that care forgot."

As the calendar advanced toward August 28, 2011, it was the City of Philadelphia that awaited the arrival of the NAIC. No doubt its millions of citizens looked forward excitedly to the visit of the NAIC. Parents probably took their children to the sidewalks waiting and hoping for a glimpse of such luminaries as Dr. Terri Vaughan—Insurance Genius. But, alas, these families were doomed to disappointment.

Once again, the NAIC cancelled its convention as the result of a killer storm closing in on a large American city, which had prepared for the arrival of the regulators' association. This time it was Hurricane Irene that seemed drawn to the site of the NAIC convocation.

Now some might dismiss this trend as "mere coincidence." However, can learned people ignore this data set of disaster associated with the NAIC? At the very least, would it not be prudent for the actuarial societies to assess special premium surcharges for jurisdictions subject to NAIC visits?

The author

Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide Insurance Cos. and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.