Public Policy Analysis & Opinion

Imprudence and roosting vultures

State regulators will have a tough time explaining themselves before the new Congress

By Kevin P. Hennosy

The year 2008 was truly an annus horribilis for state insurance regulation. The year 2009 does not look much more promising. Congress appears to be preparing to hold hearings aimed at restoring a regulated and confident financial services sector, and state insurance regulators are in a very weak position to negotiate.

As 2008 came to an end, the National Association of Insurance Commissioners (NAIC) sat in a state of collective and stunned silence. It was like one of those Looney Tunes cartoons, where the character knows something bad is about to happen, so it stays still with an uncomfortable look on its face while the audience hears a low rumble and twisting wood in the background. Only one phrase could forestall the coming disaster for insurance regulators: Th Th Th That’s all Folks!

Market regulation

The year 2008 began with a controversy over whether or not the NAIC would collect an aggressively expanded swath of market data for the purpose of statistical analysis. The market data proposal would result in a material and powerful increase of regulation of the insurance marketplace, and there are significant and powerful enemies of that improvement.

The property/casualty sector fought this proposal from its inception. This statistical analysis of market data would play a mirror role to what has been done in financial solvency regulation for nearly 40 years.

Until recent years when state officials weakened the solvency surveillance framework in the hope of maintaining political support in the insurance sector for state regulation, the use of statistical analysis to identify insurers facing financial problems had improved state regulators’ ability to target and respond to trouble.

The expanded data filing program would facilitate an early warning system to identify market problems, before newspapers and plaintiff’s lawyers could become involved. More important, regulators could respond before ethical companies would lose market advantage to unethical companies.

The proposal would begin to build a framework to identify uniform elements of market data that would allow the NAIC to produce reports for regulators’ consideration. The reports would show where a company landed outside of statistical norms for the industry—thereby targeting that anomaly for a higher level of review. Anomalies might be easily explainable and even demonstrate a positive aspect of the company’s operations, but they might also identify a problem area where regulators could target attention.

This approach to statistical analysis would actually reduce the cost of regulation to individual insurers. It would negate the need for routine and comprehensive market conduct examinations that theoretically serve as the backbone of the insurance regulation as required under the McCarran-Ferguson Act.

Of course, theory is not reality. In reality, the states have not attempted to regulate the market activity of insurers as envisioned by the drafters of McCarran-Ferguson, which was written to replace Antitrust Law and Federal Trade Commission oversight at the state level.

State officials have not tried to live up to that statutory standard since the 1950s. When it comes to market regulation, newspaper headlines have more to do with whether or not an insurer receives a visit from market conduct examiners than any regular application of state law.

Furthermore, the vague nature of the NAIC’s legal standing remains a strong impediment to passage of the market data initiative. Industry advocates fear that once the NAIC takes possession of the market data it will become subject to disclosure through the courts.

Regulators argue that the NAIC is not a public entity so it cannot be forced to disclose the data it holds through any jurisdiction’s Freedom of Information Act. Yet, when it suits the association’s purposes, the NAIC claims public standing—such as when it refuses to file standard financial disclosure statements with the Internal Revenue Service (IRS).

And if the NAIC is right and is not an instrumentality of the states (which means it has a whole lot of explaining to do to the IRS), then taking control and compiling industrywide market data could raise liability questions under Federal Antitrust Law.

Many NAIC observers believe that the association’s formerly entrenched executive vice president was fired last summer in response to push back from trade associations and major insurers who opposed the project.

As this edition of Rough Notes went to press, the NAIC had not met for its 2008 Winter National Meeting where it planned to give final consideration to the market data proposal; however, conventional wisdom prior to that meeting held that insurers had the votes to stop that from happening.

Insurance regulators often repeated the lie that their primary charge was to regulate for solvency. If one reads the McCarran-Ferguson Act, it is clear that the states are charged with regulating the market activities of insurers. That means that the states must regulate for solvency, so that insurance consumers are not defrauded; however, the primary charge given to the states is to replace federal antitrust and fair trade oversight.

Yet for all the much-repeated reverence for financial solvency oversight, state officials have worked feverishly to remove solvency regulation since the mid-1990s. Regulatory oversight was either eliminated or transferred to private entities that any reasonable person would know could not do the job.

The insurance regulatory system suffered another body blow when federal officials found that the “world’s largest insurer” was just a house of cards. Yes, I am aware that the trade association talking points always stress that the holding company is broke but the insurance companies are sound. But let’s “be real” for a change.

The argument that the holding company is broke reminds me of the old Will Rogers observation: “A holding company is a thing where you hand an accomplice the goods while the policeman searches you.”

The point is that AIG is broke, and state regulators are on the hook for letting it happen. State insurance regulators either did not know that the company was an empty shell, or did not care. In either instance, it is a black eye for state regulators. State regulators had every opportunity to figure out what was going on and take corrective action.

Beyond the regular annual financial filing and examination process, regulators should have known there was trouble just from reading the newspapers. In late 2004, the company was caught using slight of hand accounting to present phony reinsurance arrangements. Its operations were closely tied to anticompetitive activities by a number of large brokerage firms.

In 2005, the company’s longtime chairman, Maurice R. Greenberg, was forced out after investigators for the New York attorney general (and not insurance regulators) uncovered Greenberg’s fraudulent manipulations of the company’s financial statements.

In December 2007, AIG stock traded at $57.05. By mid-June 2008, the stock price had fallen 40% to $34.18. In February 2008, five former insurance industry executives, including one from AIG, were convicted in federal court in Connecticut of conspiring to manipulate the company’s financial statements. As the news broke that the company was under investigation by federal authorities, Martin J. Sullivan was removed from his position as AIG’s chief executive officer. By June 2008, the NAIC and state insurance regulators received word that lawyers and investigators from the U.S. Justice Department and Securities and Exchange Commission had taken up residence at the AIG headquarters.

The occupation of a premier insurer by federal law enforcement agents could not be viewed as a “résumé-building event” for state insurance regulation, but that was not the worst of it. In September 2008, federal officials announced that they would take control of AIG. The company was an empty shell that soon would be swallowing over $150 billion in public money.

The state regulatory system had plenty of warning that there were problems at AIG. Nevertheless, state regulatory officials did nothing to curtail AIG’s slide into insolvency. State officials were intimidated by the world’s largest insurer, which was more powerful than democratically elected governments.

Far too often the NAIC and state regulators approved the insurer’s use of financial instruments that were so complex that they could never have been considered anything but fraudulent. Early warning systems failed to work because they are designed to track real assets and liabilities instead of fantasy promises, blue smoke and mirrors.

Sometimes alone and sometimes with other insurers and trade associations, AIG campaigned for deregulation of the business of insurance. It was this deregulation that made the failure at AIG possible and probable.

In state legislatures and the NAIC, AIG generally got what it wanted with a bow tied around it. What the company could not buy, it tormented into submission.

For example, AIG hired a former New York insurance department chief financial examiner named Martin J. Carus to represent its interests at the NAIC. Carus carried out his new charge like a schoolyard bully.

Carus saved his most virulent attacks for consumer advocates like Birny Birnbaum of the Center for Economic Justice, but he could get nasty with regulators as well. He even threw a few personal attacks at this mild-mannered scribbler. At an NAIC meeting in Chicago, Marty accused me of personally driving up health insurance rates because I am overweight. I think he was trying to hurt my feelings.

When more finesse was necessary than Carus could muster, AIG benefited from close relations with New York state insurance superintendents, who, under Governor George Pataki, ran political interference for AIG and other large insurance interests at the NAIC.

During the tenure of former New York Superintendent of Insurance Gregory Serio, the department lobbied hard for the NAIC to accept without question the investment valuations of Nationally Recognized Statistical Rating Organizations (NRSROs). This was at a time when the Bush Administration was weakening Securities and Exchange Commission rules on the use of NRSRO valuations.

In October 2008, the corporate leaders of the NRSROs were sitting before a panel of exasperated members of the U.S. House of Representatives. They were there to explain why the NRSROs had not identified the growing problems in credit markets. In the process, they explained a system where NRSROs would receive pay to advise companies on one hand, and receive pay to assign ratings of credit worthiness on the other hand. It simply was not in the NRSROs’ financial interest to deliver bad news.

This was all predictable. Going back to rating agency scandals in the first decade of the 20th century, insurance regulators had required insurers to submit investments to a uniform review by the NAIC Securities Valuation Office (SVO). The use of SVO valuations was required because private rating agencies could not be counted on to put aside profit-making concerns and focus on providing unadulterated assessments of investment instruments.

Ultimately, the NAIC did weaken its SVO office, which was never as strong as it should have been. More regulatory deference was paid to private rating agencies. In addition, a version of a model law was adopted by NAIC, which approved just about any half-baked, high-risk investment instrument as long as company personnel could claim with a straight face that a “prudent person” would make a similar investment. Accounting rules were re-written with the “assistance” of insurance company lobbyists, which resulted in little understood carve-outs that tended to shield the true condition of insurers.

The imprudence of state insurance regulators has brought the chickens home to roost, and the chickens look a lot like vultures.