Public Policy Analysis & Opinion
A federal case
Senator Nelson faces an unruly teen
By Kevin P. Hennosy
When the National Association of Insurance Commissioners (NAIC) announced the retention of retired U.S. Senator Ben Nelson as its CEO on January 18, 2013, more than a few heads shook in disbelief. Nelson served as chief of NAIC staff operations from 1982 to 1985.
No one expects Nelson's second tour of duty to be mistaken for a homecoming. The "NAIC" where Nelson worked 31 years ago does not exist in place, spirit or law.
Classic vs. Newco
The NAIC that Ben Nelson worked for in the 1980s was basically a sleepy co-op, compared to the sharp-elbowed anti-competitive, corporate predator that it became under the regency of former NAIC Executive Vice President Catherine J. Weatherford and her dowager successor Therese Vaughan.
The Delaware chartered corporation doing business as the "NAIC" wraps itself in the historical significance and legal standing of an unincorporated association formed in 1871. But since 1999 that identity has vanished. It has moved from NAIC-Classic to NAIC-Newco.
The 13-year old NAIC-Newco is a very different entity. Senator Nelson has agreed to foster an unruly teen, which exhibits tendencies toward delinquency. NAIC-Newco grew up with plenty of money and a contempt for rules.
In the 1980s, NAIC-Classic produced videos arguing for state-based insurance regulation. Today NAIC-Newco produces YouTube videos where state officials admit making decisions to purchase products and services from the corporation without using a public bidding process required in most states. (See www.youtube.com/watch?v=23hwiHswkNQ at 2:27.)
The Classic NAIC maintained a staff facility for the cooperative benefit of all state insurance departments called the Support and Services Office (SSO). The NAIC-Newco presents a chief business strategy and development officer, who is charged with selling support and service to state offices and other customers.
NAIC-Newco expects to produce $80 million in revenue from products and services and exhibits the unmistakable traits of a for-profit business; however, it stubbornly claims nonprofit legal status—and it refuses to file basic financial disclosure with the IRS.
If an insurance company operated in this manner, it would eventually be the subject of a multi-state examination.
In this and further editions of Rough Notes, this column will examine the following issues related to the NAIC: 1) the lawsuit that the association is defending in federal court, which alleges anticompetitive activity in the NAIC's extensive profit-making operations; 2) the NAIC's actions that place its members in jeopardy of violating state ethics laws; 3) the continuing problems inherent in the NAIC's gift of travel to state officials, and 4) NAIC's tenuous claim to tax-exempt status based on misleading information submitted to the IRS. Whether Senator Nelson realizes it or not, he has been left a minefield of problems.
Aithent, Inc., a software development company, has filed the complaint against the corporation doing business as the NAIC (case 4-11-cv-001173-GAF).
The suit alleges NAIC's "ongoing breach of its exclusive license agreement with Aithent." In addition, the suit alleges that the agreement between NAIC and Aithent concerns "a valuable software system, developed and marketed by Aithent at great expense over the course of many years, which enabled regulatory insurance functions to be processed over the Internet."
These technological tools reduced compliance costs for the insurance sector while increasing the accuracy and efficiency of regulatory oversight.
Aithent asserts that it developed a first generation software product (LION) for use by insurance regulators "in or around 1998." The company achieved initial success by securing contracts with the New York and Arkansas Insurance Departments.
The complaint further states that when Aithent rolled out a second generation software package (LEO), it received positive response from additional state insurance departments and then the NAIC.
The complaint alleges that the NAIC "suggested" that Aithent should enter into an exclusive licensing agreement with the NAIC rather than marketing to individual insurance departments.
The suit alleges that the NAIC and Aithent entered into the agreement, which granted an exclusive license to the former to market the latter's product to state insurance departments. In return for the license, the NAIC agreed to pay Aithent a transaction fee for every regulatory activity carried over the system.
Furthermore, the suit alleges that the NAIC "betrayed Aithent's trust," developed its own Web-based system rather than marketing LEO, and refused to pay the software company the full royalties that Aithent believes it is owed.
Court records include a copy of the license agreement signed on July 17, 2002, by then NAIC Executive Vice President Cathy Weatherford and Aithent, Inc., Chief Executive Officer N. Venu Gopal.
At the time this column was filed, the court had yet to hear the case.
The suit raises the question: Did NAIC's leadership conspire to remove Aithent from the field of competition though a contract negotiated in bad faith?
The contract dispute between NAIC and Aithent proves particularly interesting in the light of a contract signed by Cathy Weatherford just 55 days earlier.
On May 22, 2002, Weatherford signed a contract between the NAIC and an affiliate corporation with supposed independent standing: the National Insurance Producer Registry (NIPR), represented by then Iowa Insurance Commissioner Therese M. Vaughan, who was NAIC president at the time.
Rough Notes secured a copy of this contract.
Certainly since Weatherford signed the contract, we can assume that she read the restrictions placed upon her actions vis-à-vis NIPR by section 13 under the subhead Status of the Parties:
Nothing in this Agreement shall be construed to constitute or appoint either party as a partner, joint venturer, agent or representative of the other party for any purpose whatsoever, or to grant either party any rights or authority to assume or create any obligation or responsibility, express or implied, for or on behalf of or in the name of the other, or to bind the other in any way or manner whatsoever.
A signatory to Sect In addition, Section 6a commits 50% of the net revenue from designated transactions, which transpired through NIPR. In other words, Weatherford's signature on the Aithent contract spent NIPR money—which NIPR's contract with NAIC does not authorize her to do.
Furthermore, if you are an agent or broker, Weatherford raised your costs with the stroke of her pen by agreeing to Section 6a-v, which prohibited NAIC or NIPR from reducing a price on any transaction fee by more than 15%. No matter what actual expenses demanded, NAIC/NIPR could not lower prices without violating the contract with Aithent.
Rough Notes obtained NAIC documents that denote three years when NIPR revenues triggered price decreases of 15%.What a strange coincidence.
Weatherford's abuse of power continues through the entire contract: 1) Weatherford granted Aithent appropriate use of the NIPR trademark; 2) Weatherford bound NIPR into a general indemnification agreement and breach of warranty policy; and 3) Weatherford grouped NAIC/NIPR customers into a single class in the event of bad debts.
Weatherford committed to all these actions when she not only lacked authority, but when she was specifically prohibited through the provisions of Section 13 of the contract between NAIC and NIPR to act as a representative of NIPR.
Perhaps consulting the wisdom of Steve Martin, the Sage Prince of 1970s Saturday Night Live, is the surest way to understanding Weatherford's actions. Through the knowledge-giving power of the Internet coupled with the Fair Use Doctrine, consider this allegorical explanation:
You can be a millionaire…and never pay taxes! You can be a millionaire…and never pay taxes! You say…"Steve, how can I be a millionaire and never pay taxes?" First...get a million dollars. Now you say, "Steve, what do I say to the tax man when he comes to my door and says, 'You have never paid taxes'?" Two simple words. Two simple words in the English language: "I forgot!"
Other people's money
Anyone who is familiar with NAIC history will understand why the unincorporated nonprofit wanted a steady and independent source of operating revenue. Weatherford's success at expanding NAIC's income, coupled with targeted spending on commissioner travel, seemed to have shielded her actions from critical gaze.
The Classic NAIC operated on the largess of insurers for its first 40 years of existence, when it was convened to harmonize insurance regulation in the interest of stock insurance companies. State "assessments" provided a small amount of dues revenue.
Then, after the New York State's Armstrong Committee, the association gained a revenue line from conducting uniform valuations of insurers' investment securities.
After the Second World War, with the guidance of a former New York Superintendent of Insurance Superintendent and Northwestern Mutual Life executive Robert Dineen, the NAIC looked for means of cutting the financial umbilical cord to the industry. Publications provided a new material revenue stream.
Dineen published a paper entitled Insurance Regulation In The Public Interest; A Stronger NAIC. He decried the dependence of the NAIC on both the industry and a few large states.
Bob Dineen suggested that NAIC should select one of two models for funding. He preferred a plan that gave the NAIC staff function a statutory origin. He offered the Council of ion 13 of the May 22, 2002 contract should find it easy to interpret. Furthermore, if for some reason it just seemed too complex to comprehend, an NAIC executive vice president might ask the organization's hand-picked general counsel for an interpretation. We cannot know what went through Weatherford's mind when she affixed her name to the contract between NAIC and Aithent on July 17, 2002.
The contract with Aithent that Weatherford signed on behalf of the NAIC contains numerous and material provisions concerning NIPR. For example, Section 3b of the July 17 contract provides: "For avoidance of doubt, Aithent shall have a right of first refusal to design, create and implement all modifications to [State Based Systems or 'SBS'] as may be contemplated by the NAIC or its affiliate [NIPR]."
State Governments as a model. Dineen hinted that some portion of insurance premium tax should fund NAIC operations. For his second alternative, Dineen looked to a New York statutory provision used to fund the Securities Valuation Office at the time.
In the late 1960s, Michigan Commissioner Russell E. Van Hooser suggested that the NAIC replicate a computer-based project to enter insurers' annual statement data—both financial and market oriented information—which his department developed with Michigan State University.
According to Commissioner Van Hooser's report, the computer could "complete an audit for an insurer in about three minutes at a cost of about $24." While those figures might sound slow and expensive today, it was certainly something out of the space age in 1969.
Inherent to each revenue stream adopted by NAIC lurked the threat of boycott. Factions within the industry threatened database fee boycott in 1980-81.
In February 1990, Congressman John Dingell, then chairman of the House Energy and Commerce Committee and the Subcommittee on Oversight and Investigations, released a report entitled Failed Promises, which documented regulatory inadequacies that enabled a massive criminal fraud committed by Carlos Miro, a managing general agent. Dingell badgered the NAIC to develop regulatory reforms and push for their passage in the states.
One of the problems brought to light by Dingell was the inability of states to efficiently and effectively track and regulate the activities of agents and brokers across state lines. The NAIC attempted to address a lingering concern expressed by insurance producers: the automation of the agent and broker licensing process.
For more than a decade the NAIC proposed providing such services to the states but could not garner approval from its membership. Facilitating single and multistate licensing was controversial with both the states and carriers. States wanted to protect license fee revenue, so any system had to be revenue neutral to state insurance departments. Insurance carrier trade associations feared providing NAIC with a new revenue stream.
The same concern over unrestricted revenue led to the cancellation of the first incarnation of the System for Electronic Rate and Form Filing (SERFF), which would have resided under NAIC's unincorporated domain.
In 1996, the NAIC took a step designed to assuage fears of regulators and insurance carriers and still move forward with internet-based agent licensing. The NAIC chartered a new corporate affiliate in Missouri: The Insurance Regulatory Information Network (IRIN).
It soon became clear that transaction fees would provide a new and powerful source of revenue.
Although the new corporate entity was legally removed from the NAIC, the arrangement made no one happy. Consumer advocates and liberal commissioners criticized the inclusion of insurance sector representatives on the board of IRIN. Furthermore, if "regulatory" board members voted with the "industry" bloc, then consumer representatives saw an insurance lobby takeover of an NAIC affiliate. Industry advocates noted that "the regulators" had a majority and the executive vice president could exert strong influence over the commissioners on the board. Most important, the seed money for IRIN came from an NAIC credit line.
In the mid-1990s, there was a backlash from elements within the insurance sector to the use of NAIC as a mechanism for reform. A cabal of insurers withheld all, or part, of the database fees owed the NAIC, which resulted in a shock to the association's balance sheet. Allegations of wild spending—which actually reflected the reduction in income—cleared the way for a management change at NAIC.
Upon being hired by the NAIC, Cathy Weatherford worked to put an end to the association's differences with agitated trade associations. She initially achieved this end through submissive capitulation.
In the February 5, 1998, edition of The Wall Street Journal, Scot J. Paltrow reported on a 1996 clandestine meeting which Weatherford attended at Nick's Fishmarket restaurant outside Chicago. At that meeting, Weatherford and NAIC officers cut a deal to retard NAIC support for state regulatory efforts in return for ending the boycott of NAIC filing fees. At the June 1997 NAIC National Meeting conducted in Chicago, over the objection of the late North Carolina Insurance Commissioner Jim Long and a material opposition, the NAIC adopted a resolution endorsing Weatherford's deal.
Shortly thereafter, the NAIC conducted a series of closed door meetings to reconsider its legal composition. The old National Association of Independent Insurers (NAII) and other voices for insurance carriers called for NAIC to be run like a business. Boy, did they get what they wanted!
By the year 2000, I had written about the NAIC for 13 years from three different perspectives: 1) working for Nationwide Insurance's government affairs office, 2) as public affairs manager for NAIC, and 3) as a newsletter writer and consumer advocate.
Regular readers of this column, who know that I am critical of NAIC-Newco, may find it surprising that the readers of my newsletter (pre-1999), considered it to be a "pro-NAIC" publication. That editorial bias shifted as Cathy Weatherford's NAIC-Newco began to operate more like a private business and less like a public entity.
Contrary to the spin which the NAIC has pushed to reporters and new insurance commissioners, my souring on the NAIC did not result from some senior managers leveling a slanderous attack on my family. In my opinion, the causal relationship was the reverse of that description.
NAIC staff members and commissioners began coming to me with examples of misuse of NAIC travel funds and accounts, and personal misuse of a corporate credit card. Sometimes documents in unmarked envelopes ended up stuck in my front door.
Like the old insurance regulatory adage that says examiners will find market conduct problems before solvency problems become clear, there was evidence that pointed to ethics trouble at NAIC-Newco.
The failure of the NAIC to file a standard statement of the corporation's annual finances is particularly troubling. One had to ask whether the management of NAIC-Newco had reason to fear signing an IRS Form 990, which exposes the signatory to prosecution for perjury.
Rough Notes has obtained the NAIC's application for tax-exempt status. That application provides documentation of the incomplete answers provided to the IRS, which could be interpreted as misleading. For example, NAIC management provided the IRS with a 1955 IRS opinion letter, which opined that the voluntary association was an instrumentality of the states, without disclosing the existence of two opinion letters from the 1980s that contradict the 1955 opinion. The incomplete nature of the tax exempt application will be considered in detail in a future edition of this column.
So does what appears to be a bad-faith and corrupted action by a former NAIC executive vice president matter nearly 13 years after the fact? The fact that the NAIC is being hauled into federal court for conflicts arising from that action certainly suggests that the concern is ripe.
Good luck Senator Nelson. I mean it.
Kevin P. Hennosy 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.