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Public Policy Analysis & Opinion
Supervision & regulation aren't the same
NAIC chief rejects McCarran-Ferguson Act, again and again
By Kevin P. Hennosy
In the 1990s, one long-time attendee at National Association of Insurance Commissioners (NAIC) meetings opined over a libation in some hotel sports bar that the perfect insurance regulator consisted of anyone with a big ego, short arms and bad eyesight.
According to this NAIC sage, each of the three traits played an important role in making the regulatory system work. The big ego allowed the regulator to play the part of a champion of the public interest. The short arms made it possible for lobbyists to influence the regulator's actions without violating the standard of an arm's length relationship. The bad eyesight obviously allowed the regulated industry to operate without the fettering qualities of law and regulation.
I cannot claim to know whether the eminent observer of NAIC legend and lore brought forth a mental picture of Therese M. "Terri" Vaughan, Ph.D., as he described that perfect regulator, but I would not be surprised if he did.
In a recent speech delivered to the NAIC Solvency Modernization Initiative (SMI) Task Force, Vaughan, the NAIC's chief executive officer, called for the creation of a "supervisory" function over international insurance groups. The issue has become a top agenda item in insurance public policy circles since the catastrophic failure of American International Group (AIG)—once the world's largest insurer.
Vaughan's comments demonstrate two troubling aspects of her involvement in the creation of insurance public policy. First, the comments seem crafted to tell the regulated—yes, regulated—industry what it wants to hear, rather than what it needs to hear. Vaughan appears to be trying to demonstrate how proverbially short her arms are. It is as if she is saying to the international insurance lobby, "Come here and get a big hug from Terri."
Second, if Vaughan is not "spiking the punch to keep the party goers happy," then she demonstrates a remarkable lack of intellectual curiosity about the statutory basis for the several states' involvement in insurance public policy. One would not expect a person who holds a Ph.D. to lack intellectual curiosity, but Vaughan observes: "This is more about supervision than regulation."
The problem with Vaughan's observation is that state officials do not hold statutory authority to "supervise" insurance.
Insurance is interstate commerce. Under the United States Constitution, jurisdiction for interstate commerce and all foreign commerce rests with the Congress. In 1945, the Congress granted to the states a limited and contingent delegation of authority to regulate insurance. If the business of insurance is not regulated by state law, the jurisdiction over that business reverts to federal antitrust law and Federal Trade Commission oversight.
Obviously, based on Vaughan's choice of words quoted above, she understands that there is a material difference between regulation and supervision.
Supervised commercial sectors do not receive limited exemptions from federal antitrust and fair trade enforcement. The regulatory framework over insurance is the basis of its exemption from federal enforcement mechanisms that most insurance professionals view as detrimental to both insurer and insured.
Congress did not grant the states authority to sit back and watch for trouble; the Congress loaned the states authority to seek out trouble before bad actors like AIG come to dominate markets and collapse under the weight of their own greed.
In addition to operating outside of the McCarran-Ferguson framework, Vaughan's fixation on "supervision" is myopic, which makes her a great regulator in the opinion of some. She repeatedly refers to the role of "financial supervisor," as if solvency oversight was sufficient to fulfill the role of state officials.
As noted in previous editions of this column, the Supreme Court defined "regulate the business of insurance" under the McCarran-Ferguson Act in very expansive terms. The opinion in Securities and Exchange Commission vs. National Securities, Inc., 393 U.S. 453 (1969) defines that business as "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.'"
Over the past decade, Vaughn has been an advocate for a "risk-based approach for supervision" of insurer solvency. Under that approach, officials have no role in regulating the relationship between insurer and insured unless somehow it is deemed that an activity places the solvency of the company at risk. Supposedly, this approach provides incentives for insurers to "manage" for solvency.
Once again, even if one squints and wears "cheaters" it is impossible to find a provision of McCarran-Ferguson that either limits state action to solvency oversight, or shields antitrust enforcement from the business of insurance managed by state incentives.
We are the black holes
Vaughan warns, "Let's take as a given that any common framework for supervising internationally active insurance groups has to address the AIG problem—the problem of risk concentrations in unregulated entities."
Oddly enough, based on the recent history of financial regulation in the United States, Vaughan opines that American insurance regulators could teach the world a thing or two about how to supervise across jurisdictional lines.
Vaughn references AIG while acting like she never heard of it. Despite the fact that it went broke while under American regulatory "supervision," Vaughn smugly decries "regulatory arbitrage" which has created "what some call 'regulatory black holes,' where insurance sector capital and risk become concentrated in particular, less well-supervised jurisdictions."
Why not name names? In the case of AIG, the biggest regulatory black hole operated under the name: The New York State Insurance Department. Another regulatory black hole with responsibility for the AIG collapse does business as The Pennsylvania Insurance Department, which chartered several AIG subsidiaries. Under McCarran-Ferguson, every state that tendered operating authority carries responsibility for the collapse. Someone should have stood up and said that the emperor had no clothes.
Now I realize that state insurance regulators claim that the AIG failure was not their fault. According to insurance regulators, it was the nasty old federal thrift regulators who failed to do their job. As a matter of fact, they claim that the world's largest insurance company—which paid a huge sum in insurance premium taxes to state governments year after year—was not even really an insurance company.
Sure, Commissioner, and do you want to sell me a bridge next, or will it be Florida swampland?
The specious argument that state insurance regulators have no culpability in the failure of AIG might be more convincing if state officials had issued warnings about the company's operations before the failure. If state officials had told the world that federal thrift "supervisors" were not acting to preserve the solvency of the company and protect the "relationship between insurer and insured," then the argument that state officials were fulfilling their regulatory role, but were stymied by the fraudulent concept of "functional regulation" perpetrated by the Gramm-Leach-Bliley Act might hold some water.
Yet even then, Vaughan's argument that the United States is a paragon of virtue when it comes to working across jurisdictional lines would be fantasy.
As support for her contention that American insurance regulation offers a model for the world, Vaughan offers another example of a common state practice, which falls outside of the McCarran-Ferguson Act: Domiciliary Deference or Lead State Supervision.
"What I mean is that we generally tend to defer to the domestic regulator," said Vaughan.
Domestic regulators are most susceptible to the "regulatory capture," where the regulator acts to please the entity it is charged with regulating. Companies like AIG are too big to regulate long before they are too big to fail.
The legislative history of McCarran-Ferguson contains a warning against domiciliary deference: "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." The Supreme Court cited this warning in FTC vs. Travelers Health Association, 362 U.S. 293 (1960).
Other states "can" act, but regulation by "foreign" jurisdictions is seen as a violation of the concept of Omertà, which governs both state insurance regulation and the Mafia.
Omertà is a real problem in American insurance regulation. It remains a common practice for state officials to enter into "consent agreements" with insurers caught engaging in wrongdoing. An ethical bankruptcy is often the precursor to a financial bankruptcy, but consent agreements usually prohibit the regulator from telling other regulatory agencies, the news media or the NAIC of compliance failures.
In addition, the American system of statutory accounting for insurance companies serves to understate the damage done to the sector by the Financial Panic of 2007-2008. If life insurers were required to carry bond portfolios at market value rather than par value, the argument that insurance weathered the storm better than banking would not be so convincing. In the days of fixed premiums and fixed benefit life insurance, carrying bonds at par value made sense, but today's market-sensitive products do not merit special treatment.
Devolution
When I take to task the NAIC and its senior leadership in this opinion column, I do so because I understand what an important role the association can play in the regulation of the business of insurance. Affirmative regulation of insurance serves the public interest and makes it possible for insurers and their producers to compete for business in an ethical fashion.
Vaughn is the spokesperson for a fraud being perpetrated on commerce, markets and consumers: the pretense of insurance regulation.
To paraphrase Pogo: We have met the black hole, and it is us.
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.
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