Public Policy Analysis & Opinion

Regulated by state law

State and federal officials argue over unsupervised reinsurance sector

By Kevin P. Hennosy

If I had not suffered through high school Latin, I might accept the playful explanation that “reinsurance” is a Latin word for “cartel power.” Now if that were true, I still would not be worried because anti-competitive behavior is legal in the business of insurance to the extent that it is regulated by state law.

Reinsurance controls the scope and price of every kind of insurance policy and, by extension, large swaths of the economy. Reinsurers wield financial power which I believe is unmatched by other commercial sectors because without adequate reinsurance capacity those sectors simply cannot function. Congress understood this when it created the McCarran-Ferguson framework.

In the days after the terrorist attacks of September 11, 2001, it was a small number of reinsurance executives who basically shut down the commercial lines sector until the federal government provided a financial backstop. I am not criticizing the action because extraordinary times call for extraordinary action—within Constitutional tenets.

The reinsurers worked in concert to withhold product from the marketplace—a blatant act of anti-competitive behavior that was protected under the McCarran-Ferguson Act.

Of course, there is that nasty little phrase “regulated by state law” drawn from the McCarran-Ferguson Act of 1945, which is fraught with legal peril. Acting in concert to withhold product in a way that would affect the entire economy would set off alarms in the U.S. Justice Department’s Antitrust Division if reinsurance was not subject to regulatory oversight.

Historic mystique

The regulatory oversight of reinsurance has always been a little star struck. There is a mystique around reinsurance that puts sleepy state capitals in awe.

In 1990, the National Association of Insurance Commissioners (NAIC) launched a regulatory reform plan called the Solvency Policing Agenda. The grand plan to revive state insurance regulation was drawn up on a cocktail napkin in a bar at the Broadmoor Hotel in Colorado Springs by Earl Pomeroy, then North Dakota Insurance Commissioner and now a member of Congress.

One major provision of that agenda concerned improving the regulation of reinsurance. Post mortem investigations of insurer insolvencies found that many reinsurance treaties were actually convoluted narratives which transferred risk to the reinsurer in paragraph four and then transferred the risk back to the ceding company in paragraph 37. Earl Pomeroy wanted to hire a couple of people at NAIC who could read more than 36 paragraphs.

The reinsurance provision called for a clearinghouse to review reinsurance contracts. While most of the Solvency Policing Agenda was adopted by the NAIC and ultimately the states, the reinsurance provision never saw the light of day.

I was on NAIC staff at that time and I remember the discussions of “Earl’s @&%#!^$ Reinsurance provision.” I picked up right away that reinsurance was untouchable politically. No one … messed … with the reinsurance sector. Senior staff regaled me with stories of dynastic reinsurance agreements based on a handshake. Reinsurance was where the real money was made, and made again.

It became clear to me that there were legends and lore surrounding reinsurance that made it impervious to accountability—a powerful mystique that defied reason—a religion unto itself. Insurance is a business based on trust, but reinsurance is cloaked in faith.

Yet McCarran-Ferguson does not shield insurance from antitrust enforcement based on faith.

Congress continues to discuss whether the states are up to applying regulation to the business of insurance. In late October 2007, the House Financial Services Committee’s Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises heard testimony on the mystical world of reinsurance. The testimony was part of a larger hearing on the future of insurance regulation.

U.S. Representative Paul E. Kanjorski chairs the subcommittee and chaired the hearing. In the chair’s opening statement he opined:

The vast majority of interested parties in the debate on insurance regulatory modernization agree that the system is not perfect and needs improvement. Today, we hear from additional parties, including state legislators, consumers and industry repre-sentatives, on the need for reform in insurance regulation.

Rep. Kanjorski has introduced legislation that would create an optional federal charter for insurers. The chairman’s bias in favor of creating a federal charter seems to have led the testimony writers at the National Conference of Insurance Legislators (NCOIL) to adopt the mantra: Congress does not need to recall the states’ borrowed authority to regulate insurance, because the states do not use it anyway.

Deregulated markets

The October 30, 2007, NCOIL testimony to Congress provides some interesting evidence for use by the plaintiffs in that case. The testimony points out that “According to a November 2005 compendium of state property-casualty laws, approximately

A. 39 states have some form of commercial lines deregulation.

B. 23 states have some form of more open personal lines regulation.

C. Seven states have some form of flex-rating for commercial and/or personal lines.

So let’s review. We know that the McCarran-Ferguson Act stays the application of federal antitrust law and enforcement from application to the business of insurance “to the extent that the business of insurance is regulated by state law.” And, as NCOIL testifies “39 states have some form of commercial lines deregulation.” Somewhere, there is a plaintiff’s lawyer who will understand just what kind of gold mine is being presented here.

The deregulation bills adopted in the states over the past decade invite the Mother-of-all-Class-Action suits, which could force the application of federal antitrust law on the insurance sector by simply demonstrating to a federal court that the business of insurance is not regulated by state law—as required under McCarran-Ferguson to stay application of federal antitrust oversight.

Plaintiff’s counsel’s cut on triple damages and legal expenses under federal antitrust law on the denied claims for business interruption coverage generated by Hurricane Katrina alone would generate a sum in excess of the annual budget of many states and small countries. The incentive is there.

And yet this is a column about reinsurance, which is also shielded from antitrust law under the same 1945 act. The reinsurance sector’s claims to be regulated would be just as difficult to prove if they were ever challenged.

The Reinsurance Association of America (RAA), a trade group that represents the interests of domestic reinsurers, testified before the House Subcommittee in October. The RAA outlined three approaches to amending the regulatory framework through federal statute:

A. A single-state passport system that allows a reinsurer to be licensed in, and regulated by, one state, but with the ability to “passport” and assume business in all other states; or,

B. An optional federal charter that allows a reinsurer to remain in the 50-state system or obtain a federal charter and be regulated at the federal level pursuant to federal standards; or,

C. A modified optional federal charter that allows a reinsurer to choose between a single federal regulator, a single state regulator, or remain in the current 50-state system.

All of these proposals would require congressional action, because the Supreme Court has ruled that under current law no state may regulate on behalf of another or cede the authority to regulate insurance to a private entity. The RAA’s proposals would address these concerns in law, but the political viability of the proposal is doubtful.

Overreaching NAIC

The NAIC addresses the political viability concerns by ignoring the Supreme Court—it is the NAIC after all. The association of insurance regulators proposes to act as an unaccredited national authority, which can negotiate with foreign lands.

Contrary to a half century of case law, a task force of NAIC appears poised to recommend transferring regulatory authority over alien reinsurers operating in the United States. Where is Lou Dobbs when we need him?

The NAIC Reinsurance Task Force, chaired by Georgia Insurance Commissioner John Oxendine, has been considering a reciprocity agreement with overseas jurisdictions. The agreement would allow companies admitted in one signatory jurisdiction to operate in all jurisdictions that join the agreement.

The reciprocity agreement is the type of thing that someday will earn an NAIC official a seat on the set of Lou Dobbs Tonight, if not before a skeptical congressional committee.

The reciprocal idea would introduce a rather virulent dynamic into the already weak oversight of reinsurance companies. The reciprocal process would mean that if a large American company wanted unfettered entry into a country, it would persuade the NAIC—which is historically responsive to persuasion—to sign a reciprocity agreement with that country, thus granting entry to reinsurers from that country into the U.S. market. Or, if an overseas company wanted entry, it would simply have to persuade a few NAIC officials to sign a reciprocity agreement with the jurisdiction that they claim as their home.

Under the NAIC proposal, before the NAIC considers signing a reciprocity agreement, the overseas jurisdiction (or federation like the European Union) would have to show that they have “functionally equivalent” regulatory framework.

Of course, discerning whether a regulatory framework was “functionally equivalent” could prove to be less than scientific. One can assume that the more glamorous state capitals might require a visit by a delegation of state regulators and senior NAIC staff before the functional equivalency of the regulatory framework could be determined. Now those cases where a reinsurer that has chosen to domicile for privacy reasons in a jurisdiction that has a dreaded disease named after it might simply need to be discussed with an NAIC delegation over dinner at a fine dining restaurant.

Leaving the NAIC to determine what is functionally equivalent presents a mighty opportunity for shenanigans. If you think I am kidding, just look at the way the NAIC has run its accreditation program for financial regulation. In that system, a state just about has to try to remain unaccredited because the NAIC views everything “substantially similar” to NAIC recommendations when the proper persuasion is applied to NAIC executives.

The McCarran-Ferguson Act lends congressional jurisdiction over interstate commerce in insurance to the states, to the extent that the business of insurance is regulated by state law. In other words, states hold jurisdiction to regulate insurance under a use-it or lose-it arrangement. Furthermore, the Supreme Court has told the states that they may not transfer that borrowed authority to private entities or other jurisdictions, or concentrate it in one state.

New York deal

In September 2007, New York State officials sought affection of foreign reinsurers in a time-honored manner, cash on the barrel. Empire State regulators proposed eliminating collateral requirements for overseas reinsurers doing business in the United States. At present, an overseas reinsurer is supposed to keep a collateral deposit in the United States equal to 100% of the reinsurer’s exposure in this country, if it does not hold a U.S. license.

New York officials seem particularly thrilled with their proposal, but the rest of the “College” of Commissioners has called the idea heretical. Georgia Commissioner Oxendine, who loves to engage in debates on (physically) both sides of the Atlantic, told the Financial Times that any reinsurer that took advantage of the New York initiative would be “subjecting itself to retaliation from 49 other states.”

International reinsurance giants see the requirement as protectionism designed to keep the American reinsurance sector from going the same way as the American tire plant.

The RAA’s Franklin Nutter testified to the loss of U.S.-based reinsurance capacity:

This can be best illustrated by the number of reinsurers assuming risk from U.S. cedents. In 2006, more than 2,300 foreign reinsurers assumed business from U.S. ceding insurers. Although most insurers principally engaged as assuming reinsurers are located in a small number of countries, the 2,300 reinsurers identified by U.S. ceding insurers were domiciled in more than 95 foreign jurisdic-tions. Their share of the U.S. market underwritten directly by foreign-based reinsurers has grown steadily to 53% in 2006 from 38% in 1997.

Some foreign reinsurers also establish U.S. subsidiaries. If the amount of U.S.-based ceded revenue to these foreign controlled entities were added to the percentages I quoted above, the total non-U.S. share would be 85%. However, these percentages should not be misconstrued.

Non-U.S.-based reinsurers and their U.S. subsidiaries bring much needed capital and capacity to support the extraordinary risk exposure in the U.S. and to spread that risk throughout the world’s capital and capacity providers.

Those who expect the NAIC or Congress to find a quick resolution to this reinsurance debate should not take comfort in history. The NAIC has had this issue on its agenda for five years. Since the NAIC’s founding in 1871, it has not been able to arrive at a consensus definition of “consumer complaint.” *

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. He is currently writing a history of insurance and its regulation in the United States and is an adjunct professor of political science at Avila University.