Public Policy Analysis & Opinion

Financial system modernization?

Ensuring that our markets function fairly and freely

By Kevin P. Hennosy

On September 15, 2009, President Barack Obama spoke at Federal Hall on Wall Street in New York City. White House staff characterized the speech as a major policy address to outline the administration’s aims in modernizing the regulation of financial services.

The president called the plan “the most ambitious overhaul of the financial regulatory system since the Great Depression. But I want to emphasize that these reforms are rooted in a simple principle: We ought to set clear rules of the road that promote transparency and accountability.”

At the end of the speech the president revisited this unifying theme:

“One year ago, we saw in stark relief how markets can err; how a lack of common-sense rules can lead to excess and abuse; how close we can come to the brink. One year later, it is incumbent on us to put in place those reforms that will prevent this kind of crisis from ever happening again, that reflect the painful but important lessons we’ve learned; and that will help us move from a period of recklessness and crisis to one of responsibility and prosperity. That’s what we must do. And I’m confident that’s what we will do.”

The collapse of Wall Street came nine years after the repeal of the Glass-Steagall Act, which for the first time since the 1930s allowed the commingling of banking, securities, and insurance. Various types of risk that previous generations of policymakers kept separate after the experience of the Great Depression were suddenly allowed to leach together like the Mother of All Superfund sites.

At the very least, our financial system became a cocktail shaker filled with risk, which produced a deadly dram that first induced inebriation but ultimately resulted in the destruction of Wall Street’s brain cells and America’s corporal tissue.

To make matters worse, the Bush administration and conservative governors from both parties placed personnel in financial regulatory agencies who were not willing to provide adult supervision to the party. They did not believe in moderation. The hangover hurts.

Congress will take up the task of prescribing a cure for the woozy financial services sectors, but there are those who advocate for home remedies. As is the case in the drinking population, these remedies range from “Satan get behind me” to “the hair of the dog.”

In late August, the Professional Insurance Agents Insurance Foundation published a white paper authored by former Illinois Director of Insurance Mark Boozell that recommends retaining state insurance regulation. Boozell calls for a more coordinated regulatory structure, without shifting responsibility for insurance regulation to the federal government.

“It should be remembered that seeking improvements in a current system is not the same as seeking an entirely new oversight system,” writes Boozell.

The white paper can be categorized as a “take two aspirin” approach—which is probably the most common response for any hangover. That said, Mr. Boozell’s white paper deserves at least to be a starting point for discussions that state regulators have proved unwilling or unable to initiate over the past year.

Without pointing to specific actors, Boozell addresses the reality that some factions of the insurance industry will use the upcoming debate over insurance regulation as a mechanism to serve parochial purposes. In particular, political arms of the larger carrier and broker interests will support federal-based reform efforts in the hopes of creating a regulatory framework that awards them competitive advantage.

The former Illinois insurance regulator argues that the body of settled case law and the established framework of laws and regulations contain so many consumer protections that Congress should not push aside this construction in the name of convenience.

Boozell writes, “The core principle behind regulation is not convenience for regulated entities. The core principle behind insurance regulation is consumer protection.”

The convenience argument is aimed directly at the proposal for an optional federal charter for insurance companies. Defenders of the state-based system of insurance regulation charge that the optional federal charter is really a “get out of jail free” card for insurance interests that do not want to comply with state-based consumer protections.

Boozell makes it clear that the need for insurance regulation goes far beyond the limited scope of insurer solvency. “The goals of insurance regulation articulated by most states include fair pricing of insurance, protecting against insurance company insolvency, preventing unfair practices by insurance companies and ensuring availability of insurance coverage,” writes Boozell. Furthermore, he observes, “The fundamental reason for the government regulation of insurance is to protect American consumers.”

The Boozell white paper concedes that the state-based system is not a perfect system. He notes that the states need to adopt a more uniform approach to regulation; however, Boozell suggests that this end could be achieved through the creation of interstate compacts, and cooperative efforts through the National Association of Insurance Commissioners (NAIC).

Nevertheless, today’s NAIC is not the NAIC of old. In past generations when scandals and failures pushed insurance regulation to the top of the public policy agenda, the NAIC served as an incubator for policy development. Today, after a decade and a half of poor management supported by overzealous trade associations, the NAIC cannot even agree on where and when to conduct its conventions. The association looks captive and weak.

In the film “Miller’s Crossing” an urban political boss named Leo O’Bannon receives a piece of sage advice from a henchman, which the NAIC leadership should take to heart:

Listen to me Leo. Last night made you look vulnerable. You don’t hold elected office in this town. You run it because people think you run it. Once they stop thinking it, you stop running it.

The NAIC is in a very vulnerable position as Congress begins to rewrite insurance laws, and no one believes that the NAIC is running anything.

Since the mid-1990s, the NAIC’s standing in policy-making circles has dropped precipitously. At the same time, compensation for NAIC senior management has grown exponentially. Precise compensation figures are not available because the NAIC defies federal tax law and refuses to file basic financial information with the IRS. At the same time, Rough Notes has received a report that NAIC senior management has been calling insurance trade associations asking hat-in-hand for financial contributions.

As long as the NAIC tries to shield its financial condition and operations from public oversight, it is highly unlikely that the association will receive a public charge from Congress or the administration. The NAIC has announced that it supports the formation of an office in the U.S. Treasury Department with responsibility for collecting and analyzing insurance market data. The NAIC also seems to hold an expectation of receiving a formal appointment to be an advisory commission to that office; however, the NAIC’s shadowy business practices cannot instill confidence in Congress.

Boozell’s white paper recommends that the NAIC continue to expand its self-appointed role in negotiating international agreements on insurance regulation. Unless the NAIC is willing to open its books and apply strict rules to preclude conflicts of interest and insider deals, Congress might turn a jaundiced eye to this kind of proposal.

Activity related to international trade has proved popular with the NAIC membership because it affords numerous state regulatory officials with the opportunity to travel overseas. This travel is usually billed to the NAIC, but at times the NAIC was reimbursed by insurance companies. These transactions give the appearance of a racket to avoid state ethics laws and regulations that forbid a regulated entity from giving anything of value, such as travel expenses, to regulatory officials.

Boozell also argues that any federal approach to insurance regulation would look and behave like the U.S. Department of Homeland Security. This analogy is useful when considering whether Congress will challenge the bond of numerous “iron triangles” and create a new and efficient regulatory agency—and not one that preserves existing agencies in order to preserve existing Congressional fiefdoms.

Yet, Boozell’s argument fails the blush-test when he compares a complex federal bureaucracy to a fantastical state regulatory system that is free from parochial bias. In truth, the state-based “system” consists of 50 state jurisdictions in addition to the District of Columbia and several territories. Elected and appointed commissioners view their roles through different lenses. Local insurers or companies that employ a large number of people in a given jurisdiction receive different treatment from regulators than companies that have little financial connection to a state. State parochialism with regard to interstate commerce was the single greatest motivation for the rejection of the Articles of Confederation and the adoption of a federal Constitution. Boozell undermines his analysis with this straw man comparison of a state “system” to the Department of Homeland Security.

The weakest part of the Boozell white paper deals with the nature of how the states hold responsibility for insurance regulation. The author uses terms like “usurping state authority” or “creating a federal role.” These terms might be rhetorically advantageous, but they do not accurately describe what is happening.

As a matter of settled law, insurance is interstate commerce. The Constitution delegates authority over interstate commerce to the Congress through the Commerce Clause. The states hold a limited and contingent hold on jurisdiction over insurance through the provisions of a single law, the McCarran-Ferguson Act. State jurisdiction is “limited” because federal antitrust law and the Federal Trade Commission hold direct jurisdiction over certain egregious, anti-competitive activities. The delegation of authority over the business of insurance to the states is “contingent” upon the states using that authority. If the business of insurance is not regulated by state law, the deregulated activity becomes automatically subject to federal antitrust oversight.

The Constitutional jurisdiction over insurance rests with the Congress.

Commentators who take a less reasonable tack than Boozell are perpetuating a myth that the insurance sector did not suffer even collateral damage from the “banking” collapse. Some observers even insist on spreading the canard that AIG was not an insurance company, or that the insurance side of AIG is “OK,” and the credit default swaps were not debt insurance.

It is also important to remember that at the urging of the American Council of Life Insurers (ACLI) and individual companies, insurers with thrift institution subsidiaries received emergency federal financial help. Certain insurers received help under the Capital Purchase Program of the Troubled Asset Relief Program (TARP). Furthermore, if not for the quaintly misleading system of life insurance accounting, which allows insurers to report the value of bonds at maturity value rather than market value, the financial condition of the life insurance sector might have received more negative attention.

Pretending nothing happened and moving on is not an option.

Chairman of the House Financial Services Committee Barney Frank (D-Mass.) has promised legislative action before the end of 2009. Unlike Boozell, Representative Frank is proposing the creation of an optional federal charter for insurers, subject to a strong federal supervisor charged with policing solvency and trade practices. Just how strong an agency Frank can craft and still receive Senate approval is yet to be seen.

President Obama observed at Federal Hall, “There are those who would suggest that we must choose between markets unfettered by even the most modest of regulations—and markets weighed down by onerous regulations that suppress the spirit of enterprise and innovation. But if there is one lesson we can learn from the last year, it is that this is a false choice. Common-sense rules of the road don’t hinder the markets, but make them stronger. Indeed, they are essential to ensuring that our markets function, and function fairly and freely.”

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.