Public Policy Analysis & Opinion

The gray lady of insurance regulation flirts with disaster again

The NAIC track record is one of too-little, too-late, and has only gotten worse

By Kevin P. Hennosy

The relative importance of the National Association of Insurance Commissioners (NAIC) to the insurance public policy framework seems relegated to those thrilling days of yesteryear. Beginning in 1996, with the annointment of Cathy Weatherford as executive vice president, the NAIC seemed to throw in the proverbial towel when it came to entering the ring of policy development.

Instead of serving in the role of an informed public-interest advocate, the NAIC conceded its independence to a small number of trade association executives like a kept clandestine paramour. Life became comfortable, at least for upper management that drew compensation packages that the association refuses to report to the Internal Revenue Service through a Form 990 filing. To paraphrase Mel Brooks in “The History of the World: Part 1”: “It’s good to be Queen.”

Income grew; however, because everyone understood from whence the money came, and what the association had to do to earn it, the credibility of the NAIC tanked. Although the NAIC sports the material fashion fitting a Grand Dame, her dance card is not as full as it once was.

In addition, the NAIC has grown tiresome to its benefactors by repeatedly asking for more money. Most recently, the NAIC management floated the idea that the association should enter the dishonored field of financial ratings on a fee for service basis. One can only speculate whether the NAIC will begin to market subprime mortgages or expand in to the cultivation of poppies anytime soon.

The “Gray Lady of Insurance Regulation” still makes every effort to be relevant in the current era.

In June 2008, the financial press was full of stories of the falling stock price of the insurance holding company formerly known as American International Group (AIG) as the Securities and Exchange Commission and Federal Bureau of Investigation agents began investigating the insurance holding company’s operations.

If one reads some of the propaganda produced by the NAIC in the past 18 months, one would think that the association acted quickly more than a year before the financial crisis to “update” financial rules. In fact, the NAIC did no such thing.

In mid-2008, the NAIC had something very different on its agenda. The association still focused on trying to woo from large financial institutions political support for state regulation of insurance. This flirtation centered on the NAIC promising U.S. and international financial interests that state regulation could be reduced to a uniform low-bar that would provide little impediment to national operations. That low-bar would provide little by way of protection to consumers or the economic system, but the NAIC simply viewed the public interest as collateral damage.

Then, the amiable confederation of insurance commissioners launched a new initiative.

Did the NAIC launch an action-oriented plan to undo the previous 15 years of relying on “prudent people” to self-regulate? Did the NAIC aggressively move to address the fantasy-filled balance sheets of AIG and other insurers that ended up on the public dole? No.

Instead, the NAIC concocted an important sounding name for its less than timely response to the financial failure of the world’s largest insurance company: The Solvency Modernization Initiative (SMI). To show that the NAIC was serious, it formed a task force. (If magazines were afforded the opportunity to play menacing chords on the organ, we would insert some here.)

However, the formation of an NAIC task force does not really mean much anymore. Nomenclature is very important at the NAIC. The inclusion of the term “modernization” is particularly meaningful in NAIC-speak. First, it allows the NAIC to pretend that its application of a better-late-than-never level of attention to a problem does not admit that “mistakes were made” by regulators. In addition, “modernization” holds special meaning to the insurance trade association executives that the NAIC looks to for constant approval. Over the past 15 years, the NAIC has used the term modernization every time it has endeavored to deregulate insurance operations—without actually admitting that deregulation was the aim. Orwell, who in 1984 created the Ministry of Plenty to ration food and housing, could not have made it any more clear.

It is clear that the NAIC leadership originally intended to roll back the standards-oriented solvency rules put in place after the insurer solvency crisis of the late 1980s and early 1990s. The association had already instituted a “principles-oriented” approach to reserving. This approach allowed managers at companies like AIG to have much more freedom than they had enjoyed under the traditional system that relied on defined categories of reserves.

Then-Iowa Insurance Commissioner and current NAIC Executive Vice President Theresa Vaughan championed the principles-oriented approach. After all, what financial executive would follow principles that might put his or her company, or the economy, at risk?

The NAIC divided SMI into five sections:

• Capital Requirements

• International Accounting

• Group Supervision

• Valuation Issues in Insurance

• Reinsurance

After the AIG debacle, the NAIC appears to have added another subsection to the SMI. Recent descrip­tions of the initiative note a review of how to conduct “group” supervision. This includes a debate over whether or not insurance regulators should consider “non-insurance” operations of an insurance group.

It is interesting to note that after the failure of the Baldwin-United Companies in the early 1980s, the question of applying oversight to holding companies and non-insurance entities was debated and settled in the affirmative by NAIC officials. Obviously, New York state regulators did not learn from the example of how non-insurance activities must be monitored to regulate for solvency. History is rarely the friend of the NAIC leadership. When it came to AIG, the New York Insurance Department did not do its job.

With very few exceptions in the NAIC’s history, the association has never been known for speed; and the SMI proved no exception to that rule. Before the task force could agree on a wide-ranging scheme for dismantling the regulatory framework, the freedoms already granted to the latter-day robber barons proved enough to invite disaster.

Once the financial sector crashed in the autumn of 2008, even Orwellian-cloaked attempts to deregulate insurance became indefensible. To date, the initiative has only resulted in some changes to reinsurance rules.

The NAIC delayed the effort. Delay would allow the initial political shock of the financial crisis to pass and would allow time for more travel to resort locations for “NAIC business.” (Most recently, this opportunity resulted in a very nice visit to the Arizona Biltmore as most of the United States was suffering a long winter.)

In 2010, the NAIC leadership assigned the task force three charges that seem carefully designed to assure that it never really produces a work product.

• Monitor solvency-related work products of the International Association of Insurance Supervisors (IAIS). Assign papers to working groups to submit comments to the IAIS. Additionally, the Working Groups should review the papers and recommend whether and/or how the ideas in those papers should be implemented in the U.S. regulatory solvency system.

• Communicate and coordinate with the International Insurance Relations (G) Committee and provide technical support to the committee as needed.

• Report the status of its work to the Executive Committee no less frequently than on a quarterly basis.

This is the kind of NAIC activity that builds frequent flier miles and frequent guest points for senior NAIC staff, a handful of insurance regulators and the multitude of insurance lobbyists whose employment security depends on the existence of NAIC’s never-ending charade of public policy development. Just as in Orwell’s novel, the Ministry of Peace reported on the never-ending war with Emmanuel Goldstein. Up is down. Black is white.

It would be xenophobic folly to oppose the ideas of international companies or entities being subject to public oversight solely because they hail from another country. Economic integration fosters peace and generally higher living standards, when coupled with democratic governments. However, the application of European proposals for integrated and uniform insurer solvency rules break down under the American framework because the United States does not send a democratically accountable, national negotiator to the table. The NAIC is neither publicly accountable nor national in perspective.

With regard to the NAIC, the best we can hope for is that individual members’ actions are guided or tempered by democratic processes in their home jurisdictions; however, the oligarchic power wielded by the insurance lobby at the state level undermines this hope.

From a theoretical perspective, through the pressure of democracy, state officials do a very good job representing local interests; however, this same pressure makes it difficult for state officials to represent their constituents’ national interests.

Dating back to the Articles of Confederation, historians document the negative aspects of the parochial­ism of American states. Let us remember that contrary to the common and ill-informed belief that “Federal­ism” centers upon the power of the states, the Federalists argued for replacing the “confederalist” Articles, which sought to preserve power for the states, with a Federal system that created a strong national government.

As quickly became clear in the early years of the United States, the state-based framework breaks down when faced with commercial entities driven by regional, national or international goals.

These commercial interests are not always “the bad guy” in this saga. Unfettered commerce across state lines is often in the national interest. Too often, local commercial interests seek the protection of state govern­ments from national commercial actors, which may or may not damage the interests of that state’s citizens.

On the other hand, when national or international commercial institu­tions apply political pressure, even state officials that want to do the right thing quickly find themselves overwhelmed in the face of national or international corporate entities.

Proponents of the SMI regularly suggest that domiciliary state commissioners can take the lead in regulating companies and holding companies in order to provide a single set of rules under the state-by-state system.

In recent congressional testimony, the Property Casualty Insurers Association of America (PCI) described one aspect of the lead state concept as follows: “Coordinated financial examinations are conducted for insurance groups, with a ‘lead state’ regulator (generally the state of domicile of the parent or largest company) coordinating the exam.” In addition to examinations, state regulators take a tribal approach to “protecting” companies domiciled in their jurisdiction from oversight by other states.

When I hear the people tout the lead state concept, I remember this story from the spring of 1990, when an Alaska director of insurance nearly started a fistfight with the California insurance commissioner at an NAIC Commissioners Roundtable.

Just prior to the NAIC meeting, the New York Insurance Department placed an Empire State affiliate of the California-chartered holding company First Executive Corporation under supervision. This action intensified speculation over the holding company’s financial solvency. First Executive and its lead subsidiary, Executive Life, used junk bonds to fund single premium and unallocated annuities. Disgraced corporate raider Michael Millken sold junk bonds to First Executive while buying the insurer’s unallocated annuities to replace “overfunded” pension plans at companies Millken had acquired with the money raised through junk bond sales. The price of the unallocated annuity, which was guaranteed only by the soundness of the insurance company, was far less than the balance of the pension fund. Millken and his dishonorable cronies pocketed the difference.

In the 1980s, California insurance regulators saw no problem with this scheme. First Executive rapidly grew to become a leader of the life insurance sector. Premium tax revenue and campaign contributions followed.

The theft of pension fund money was not limited to the private sector. Without the intervention of Millken, Alaska officials had fallen victim to the pension conversion scheme and purchased an Executive Life unallocated annuity.

When the controversy arose over the New York subsidiary, the Alaska governor asked Director of Insurance David Walsh to contact the then new California insurance commissioner, John Garamendi, for a report on the financial soundness of Executive Life. The company’s soundness was very important because California did not have a Life and Health Guaranty Fund, and many state guarantee funds at the time did not cover unallocated annuities.

Garamendi did not return numerous phone calls. Certainly, Garamendi had troubles of his own, because many California companies had converted pension plans into Executive Life unallocated annuities. For whatever reason, Garamendi chose not to work cooperatively with a fellow regulator. It appeared at the time that Garamendi was stonewalling the Alaska regulator in order to keep secret just how broke Exectutive Life was. The concept of the domicilary state commissioner working cooperatively with other regulators quickly proved to be a farce.

Even when Garamendi and Walsh were in the same room at an NAIC Commissioners Roundtable, which is closed to the public, Garamendi’s stonewalling continued. Walsh just about lost it. As a witness to the exchange, I still believe Walsh was very close to striking Garamendi. As someone who has made a financial contribution to a John Garamendi campaign, I still wish Walsh would have hit him.

History and anecdote not only damn the concept of “lead regulator,” a Supreme Court ruling forbids the practice. In the case of FTC vs. Travelers Health, the court interpreted the McCarran-Ferguson Act by opining, “It is clear that Congress viewed state regulation of insurance solely in terms of regulation by the law of the State where occurred the activity sought to be regulated. There was no indication of any thought that a State could regulate activities carried on beyond its own borders.” To support this interpretation, the Court opinion quotes the conference report on the bill: “Nothing in the proposed law would authorize a State to try to regu­late for other States, or authorize any private group or association to regulate in the field of interstate commerce.”

I hope the representatives of European governments take a look at this case before they next sit down to negotiate with the NAIC or a single state in hopes of achieving an international agreement.

The author
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.