NAIC ANALYSIS AND OPINION
The regulatory framework is vital to public trust
By Kevin P. Hennosy
Trust is vital to the financial sector. Frightened consumers do not make technical differentiations among banking, securities and insurance.
According to the historian William Manchester, the economist and life insurance executive John Maynard Keynes was asked in 1932 if anything like the Depression had occurred before in history. Keynes answered: "Yes, it was called the Dark Ages and it lasted four hundred years." Let's not think about that too much.
Greed is not good and trust is vital. If we did not learn this compound lesson from our parents, maybe the capital markets have delivered the message in the past year. We've gotten the message: enough already!
Had there not been trading curbs and if so many people were not irrevocably dependent on 401(k) retirement accounts, the summer swoon on Wall Street might have been much worse. Some people stayed in stocks because they had no other viable choice.
The volatility on Wall Street this year reveals one thing: The crisis of confidence in capital markets is real. There may be good days, weeks or quarters but the Run of the Bulls has ended.
The widespread violation of public trust has investors fleeing capital markets. For those employed in the financial services industry this panic is cause for worry. Not every financial product and service carries investment risk, but trust is vital to the financial sector. Frightened consumers do not make technical differentiations among banking, securities and insurance.
Earning trust is difficult. Rebuilding trust is painful. The job ahead will not be easy.
Wrongdoing
Capital markets have collapsed under the weighty pounding of one instance of wrongdoing after another. Like some sort of water-torture, just when it appears that the bad actors have been taken care of, another case of wrongdoing is exposed. Each occurrence stresses the public trust at the expense of retirement investments, personal savings and financial security.
The wrongdoing at Enron, Andersen, WorldCom and a host of others looks more like a systemic problem than a few bad apples. People on Main Street believe that's the case, and that is what matters for people on Wall Street. People on Wall Street use people on Main Street's money for profit. If the checks stop coming in from the provinces, lower Manhattan is in a heap of trouble.
If policymakers focus only on punishing the wrongdoers, then public confidence will never be rebuilt. To write those checks for financial products (stocks, fund shares, certificates, policies and annuities), people have to trust that markets operate on the up-and-up.
New investors
A larger part of the population holds equity investments now than at any time in American history. When one considers how many people indirectly participate in capital markets through banking and insurance, it is easy to understand what a threat the current market holds for the economy and politics.
On December 3, 1998, then chairman of the Securities and Exchange Commission (SEC), Arthur Levitt spoke to a Consumer Federation of America symposium. He warned the attendees of the dangers of a capital market boom populated by new investors. Levitt said: "Today, we stand at what may be a defining moment in American economic history. This may someday be described as the era of democratization of American finance. But, if the vast majority of investors are not informed and not educated, opportunity will lose out to ignorance."
"The People" are not without blame. Investors wanted to believe that they knew better than past generations who built security through work, savings and social insurance. Greed did not stop at the boardroom doors. Both greedy executives and greedy investors need some attention from regulators, but regulators have been hard to find in recent years.
Deregulation
America's corporate-funded love affair with deregulation began in earnest in the 1970s. Alfred Kahn, an economic advisor to then President Jimmy Carter, led the crusade back then. Kahn, a true believer in deregulation, said: "It's destructive and cruel, but that's the way the market functions."
Kahn got the first part right. Telecommunications was deregulated and today we have WorldCom. Utilities were deregulated and today we have Enron. The "destructive and cruel" part is easy to understand.
After the elections of 1994, a large number of newly minted public officials initiated a deregulation campaign for insurance. In New York, Governor George Pataki took office and issued Executive Order Number 2 that established a 90-day moratorium on adoption of new rules or regulations. The order directed agencies "to identify for modification, rescission or withdrawal those rules or regulations which have unduly burdened the economy of the state of New York and caused job losses or are more demanding than required to meet legislative goals."
On January 31, 1995, the governor's new insurance superintendent, a former Reliance Insurance Company executive named Edward J. Muhl, wrote a letter that was sent to insurance executives to inform them that the insurance department had begun "its review of the nearly 150 regulations issued since 1939."
Superintendent Muhl asked the executives to "furnish us with as specific an analysis as possible of the economic burden imposed by the regulation including the cost of complying with its provisions, its impact on jobs and the effect of its provisions on competition." The superintendent received and acted upon a wish list of regulations that insurers wanted to see go away.
New York was not alone. Pennsylvania Governor Tom Ridge appointed another former Reliance Insurance executive named Linda Kaiser to the post of insurance commissioner. Kaiser's senior financial examination team became a vocal critic of the NAIC's Financial Regulation Standards and Accreditation Program.
Working closely with allies like then Governor George W. Bush's Texas Insurance Department, Governor Ridge's team pushed for changes to the accreditation program that they presented as "results-oriented." Had the effort not run afoul with the life insurance industry that liked the uniformity encouraged by the NAIC, the results-oriented crowd would have struck the recommendation for state guaranty funds from the NAIC financial standards.
Governors Pataki, Ridge and Bush did not get everything they wanted, but many of their deregulation reforms were adopted. Reliance Insurance, the farm-team for the regulatory class of 1995, was declared insolvent in the fall of 2001. The speculation-driven failure will be paid for through the guaranty fund system that was marked for dismantling. Policyholders and taxpayers will foot the bill for the party.
It could have been much worse had it not been for the corporate scandals that erupted in late 2001. Congress spent the first seven months of 2002 trying to find an answer--and raising money. (Congress always raises money.) House Financial Services Chairman Mike Oxley (R-OH) wanted to spend the year bullying state insurance regulators into deregulating personal-lines property/casualty insurance. He said as much in a speech before the NAIC in December 2001.
Chairman Oxley's own state insurance commissioner, Lee Covington, was doing the heavy lifting for him. In hearing after hearing, Director Covington, an Arkansas native, turned on his southern charm. He listened politely as advocates for producers and consumers questioned whether deregulation was the right policy. Director Covington smiled, thanked them for their comments, and then moved adoption of the companies' deregulation agenda.
Contrary to Chairman Oxley's plans, the House Financial Services Committee spent its time drafting and passing particularly weak legislation in response to Enron. Perhaps the only public service the Oxley Bill served was to take up time that would have been used to deregulate insurance. Ultimately the Oxley Bill itself was discarded for a stronger measure sponsored by Senator Paul Sarbanes (D-MD).
Regulation
On July 7, before the bottom fell out of the markets, the conservative columnist George Will made an observation on the Sunday morning talk show "This Week." "Conservatives," Will said, "must learn that markets do not just pop up like dandelions in urban sidewalks; government regulation creates fair markets."
State insurance regulators and the NAIC have no direct role in protecting shareholders, but they play a vital role in assuring broad participation in capital markets. Billions of dollars find their way to capital markets though insurance companies and their products.
A 1969 Supreme Court decision prohibits insurance regulators from acting on behalf of shareholders. In the case of SEC v. National Securities 393 U.S. 453, the court ruled that shareholder protection falls in the jurisdiction of securities law and the Securities and Exchange Commission (SEC).
The same decision spells out a means by which insurance regulators may indirectly restore trust in insurance institutions. When state officials fulfill their regulatory duty under the McCarran-Ferguson Act, they build public trust in "the business of insurance." By building trust in insurance, regulators indirectly build trust in the entire triad of financial services: banking, securities and insurance.
Writing for the court majority, Justice Thurgood Marshall defined the role of state officials under the McCarran-Ferguson Act. Marshall wrote, "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.'"
There is not an insurance regulatory position that should not include Justice Marshall's words in its job description. Congress charged the states with "regulating the business of insurance." Justice Marshall defined what that charge means. If insurance regulators would use the "Marshall Doctrine" to shape the regulatory framework, it would not result in an overly burdensome regulation. It would support public trust.
Iowa Insurance Commissioner and NAIC President Terri Vaughan delivered testimony before the U.S. House Subcommittee on Financial Markets, Insurance and Government Sponsored Enterprises on June 27, 2002. Commissioner Vaughan observed: "Consumers clearly have an enormous financial and emotional stake in making sure that the promises made by insurance providers are kept."
Financial and emotional losses are not easy to make up; therefore, it is prudent to preserve trust through regulation. An affirmative regulatory framework serves the public interest in "making sure that promises made by insurance providers are kept."
Such a regulatory framework stresses vigilance over vengeance, in order to preserve trust. Retribution for wrongdoing is necessary but is not sufficient to preserve public trust. President Bush missed the point when he proposed reforms to securities law that were limited to "punishing wrong-doers" when the public expected government to prevent wrongdoing.
Those who believe in competition and market economies also should believe in affirmative business regulation. Such regulation is in both the public and private interest. Affirmative regulation identifies and enjoins bad actors who undermine free and fair markets through chicanery. In addition, affirmative regulation builds public trust that fosters participation in the marketplace.
Like all financial regulators, insurance regulators will have a role in rebuilding public trust in financial services--if they choose to accept it. Judging by their most recent congressional testimony, the willingness of the NAIC and individual insurance departments to regulate in the public interest is in doubt. At the very best, the NAIC seems to send mixed signals.
Ronald Reagan had a favorite Russian proverb that he used to describe his policy on arms negotiations. It could easily describe the need for financial regulation: Doveryai no proveryai--Trust but verify. Sorry Mr. President, but I did say financial regulation.
Congress charged the states with building an affirmative regulatory framework over insurance more than a half century ago. The job is not done, and thanks to the Covington's and Oxley's view of the world, the job is less done now than it was 10 years ago. It's all a question of trust. *
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 Commiss-ioners) for Rough Notes readers. Hennosy began his career with Nationwide Insurance Companies and then served as public affairs manager
for the NAIC. He is currently writing a history of insurance
and its regulation in the United States.