Public Policy Analysis & Opinion

The chestnut toolbox

McCarty ends his NAIC presidency with a strange description of how insurance works

By Kevin P. Hennosy

In early 19th century America, a nurseryman and proselytizer named John Chapman, earned the name "Johnny Appleseed." Chapman popularized apple trees on farms throughout Ohio, Indiana, Illinois, Western Pennsylvania, and what is today northern West Virginia.

No, Chapman did not really cast apple seeds on the ground and expect groves to grow. He sold small apple trees or "seedlings" throughout the region; however, "Johnny Appleseedling" just does not have the same ring as the moniker that stuck.

Of course, a discussion of Johnny Appleseed delivers our collective minds to the person of Florida Commissioner of the Office of Insurance Regulation, Kevin M. McCarty. Really. It does.

Just as Johnny Appleseed distributed apple trees, Commissioner McCarty has the reputation for distributing "chestnuts" although "Commissioner Chestnut" might not recognize a Castanea pumila if one fell on him.

Commissioner McCarty specializes in another usage for the word chestnut, which served him well as leader of the National Association of Insurance Commissioners (NAIC). Commissioner McCarty's reign as NAIC president ended in December.

In British slang dating to an 1816 play, The Broken Sword, the phrase "old chestnut" referred to a tired, stale joke. The idiom expanded into general British use by the 1880s. In the 20th Century, American usage expanded the meaning to include any unbelievable tale, cliché or anything so often repeated that the message has lost its impact.

Whenever a NAIC spokesperson uses the term "regulatory toolbox," one knows that a flourish of meaningless rhetorical chestnuts will follow, such as: "one size fits all." These terms do not mean anything, but NAIC representatives re-use them ad nauseam. Before long, a whole stand of old chestnuts springs up to obscure the proverbial forest.

Former NAIC President Kevin M. McCarty is a master of rhetorical chestnuts related to insurance regulation, such as the one noted above. The clichés roll off his tongue with both speed and earnestness as if the old chestnuts can be polished into nuggets of information.

For most of his regulatory career, Commissioner McCarty has specialized in those old chestnuts that downplay or discard the need for market oversight. The Magic of the Marketplace and the Grace of Ayn Rand will save rational actors from giving into work products of their lesser angels, such as greed, fear and ignorance.

On November 29, 2012, "Commissioner Chestnut" delivered testimony before a joint hearing conducted by two subcommittees of the House Committee on Financial Services: the Subcommittee on Financial Institutions and Consumer Credit and the Subcommittee on Insurance, Housing, and Community Opportunity.

The joint hearing was triggered by a notice of proposed rulemaking, issued jointly by the Federal Reserve Board (FRB), the Office of Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC). The notice proposed the joint adoption of new reserve requirements for financial institutions.

The proposed requirements were shaped by recommendations from the Basel Committee on Banking Supervision of the Bank for International Settlements. The Third Basel Accord, or Basel III, in general terms recommends strengthening the reserve requirements for banks and related financial institutions.

As noted in previous editions of this column, there are plenty of reasons to oppose extending influence of the Basel Committee on Banking Supervision of the Bank for International Settlements over American insurance regulation—respect for democracy being first and foremost on that list. Nevertheless, the joint hearing of the two House subcommittees appeared to be a raw application of political power initiated by financial lobbies opposed to increasing reserve requirements.

The joint hearing provided what appears to be an epiphany for Commissioner McCarty, who gained access to the keys to the presidential suite at NAIC conventions by ginning up arguments for deregulation. Lo and behold, based on that testimony Commissioner McCarty now loves wide-ranging insurance regulation—as long as the policy percolates up through the parochial potion that burbles out of state capitals. One might call it regulation with a lobbyist's face.

After 13 years of NAIC presidents arguing that consumers demand "one-stop shopping" in financial institutions—banking, insurance and securities instruments—Commissioner McCarty's testimony stressed that "insurance companies are different." Brilliant! It is easy to agree with the commissioner's argument that insurance companies are different from banks and securities firms. That is why we had the Glass Steagall Act, and why we avoided system-wide financial meltdowns under that act, which was repealed in late 1999.

However, McCarty did not point to the Glass Steagall Act. Instead, the Florida insurance commissioner initiated a strange dance down a rhetorical tight rope, with a rhetorical noose around his neck. He offered the odd explanation that what makes insurance companies different is that insurance is an "up-front payment" for future losses.

No doubt anyone who has worked on a consumer complaint line for an insurance department, or answered policyholder calls at a local agency has had to explain that insurance is not an up-front payment. Aggrieved policyholders call to complain that an insurer has denied a claim "after I had paid into that company for (10, 20, 30) years." It is as if the insurance company opens "Hennosy's Account" and assigns premium payments to it over the years. That very money serves to pay for claims.

Then the agent or consumer representative explains that insurance is not a reserve fund where you accumulate pre-paid benefits. Insurance premium is a payment for the service of transferring risk away from the policyholder based on the weight of the commodity transferred.

As such, we see the real difference between banking and insurance.

Banking is about establishing "safety and soundness" for the preservation of depositors' assets. Yes, banks provide a vital economic role in the extension of credit, but that latter role is subservient to the need for safety and soundness. If insurers simply accepted money for pre-paid losses, then insurance regulation would focus only on safety and soundness. The former is not the case; therefore, the latter is not the case.

Insurance is a mechanism to transfer and spread the risk of financial loss. If insurers are not transferring and spreading risk, they are not serving the mechanism's raison d'être. That means insurance regulation is a more complex and affirmative task—which is not something that Commissioner McCarty wants to discuss because it is not something he wants to see done. It runs contrary to Commissioner McCarty's contention that the "fundamental tenet [of the national state-based system of insurance regulation] is to protect policyholders by ensuring the solvency of the insurer and its ability to pay insurance claims."

Commissioner McCarty came dangerously close to falling off the rhetorical tight rope and speaking the truth when he said: "Capital requirements alone cannot enhance the safety and soundness of complex financial institutions—they are just one tool in a bigger toolbox. For instance, the Basel III capital requirement would not have prevented the AIG [American International Group] meltdown," testified Commissioner McCarty.

Of course, Commissioner McCarty did not mention that the vaunted "toolboxes" of the New York Insurance Department, the collective regulatory oversight of every state jurisdiction, and the NAIC also failed to stop the AIG meltdown. To do so, the regulators would have had to engage in market conduct oversight—reviewing and approving the fraudulent insurance products that AIG sold to investment banks—rather than focusing on financial oversight alone.

In other words, insurance regulators would have had to live up to their charge created by the McCarran Ferguson Act of 1945. In general, the states have drifted away from that charge in a way described by Commissioner McCarty: "The system's fundamental tenet is to protect policyholders by ensuring the solvency of the insurer and its ability to pay insurance claims."

Commissioner McCarty's description is probably an accurate explanation of the problem with today's insurance regulation in the United States. Regulators focus on solvency, which does not fulfill their charge and invites problems that cannot be reversed.

As the Supreme Court established the charge to the states under McCarran Ferguson to regulate the business of insurance, it means: "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'" [Securities and Exchange Commission v. National Securities, Inc., 393 U.S. 453 (1969)].

But Commissioner McCarty could not acknowledge that the McCarran Ferguson Act requires states to apply affirmative regulation to the width and breadth of the "relationship of insurer and insured." Had he done so, the results might have been similar to Dorothy throwing water on the Wicked Witch of the West. "I'm melting!"

Basel III

In general, Commissioner McCarty hammered home the probably accurate contention that the Basel III proposals are "bank-centric." In support of this charge, he recounted a large number of state-based insurance financial regulations that he said were vital and lacking from the Basel III recommendations. He did not make the case that these regulatory provisions he described were being implemented vigorously.

"It is for this reason that insurance regulators purposely avoid 'one size fits all' approaches and, instead, opt for company- and product-specific analysis and examination," explained Commissioner McCarty.

In particular, the NAIC argues against establishing capital standards that reflect financial condition at the holding company level. In addition, the NAIC opposes the use of Generally Accepted Accounting Principles (GAAP) rather than Statutory Accounting Principles (SAP) to govern insurers' bookkeeping and financial reporting. Furthermore, the NAIC gently argues that the banking officials do not have a clue as to how Risk Based Capital (RBC) standards work even as they consider applying RBC requirements to various financial institutions.

The NAIC filed a comment letter with the FRB, OCC and FDIC on October 22, 2012, providing an informative overview of aspects of insurance regulation that the banking agencies may not completely understand. That said, the NAIC letter overstates state insurance regulation's response to these aspects.

A lesson from whales

The Basel Committee's desire to increase reserves was not born of a bad drug trip or LSD flashback. Certainly it would have been easier for the central bankers on the committee to assume their usual submissive position before the financiers, rather than tell the financial sector what it does not want to hear.

Financial institutions are loath to hold financial reserves. Their management sees assets kept in cash or highly liquid assets as a loss of investment gain.

Think of the scene in the movie "Casino," where the character K.K. Ichikawa, a high-stakes gambler or "whale," was tricked into returning to the fictional Tangiers Hotel and Casino, where he had just won a large amount of money. Although Ichikawa was not required to put his stake at risk and was advised not to—he went back to the tables.

Once back at the hotel casino, Ichikawa tried to play a reasonable game, "He bet one thousand a hand instead of his usual thirty thousand a hand." As he wins a few hands, the casino manager, "Ace" Rothstein, knew the trick with whales like Ichikawa was that they can't bet small for long. He didn't think of it as winning ten thousand, he thought of it as losing ninety thousand.

Investment officers for financial institutions tend to hold what can be called "The Ichikawa Mindset." Rather than take comfort in the safety and soundness offered by the statutory reserve and its modest investment returns, investment officers cringe at how much gain they most certainly would have garnered from aggressive investment of the same funds. The thought of how much they might lose never enters their minds.

In the movie, K.K. Ichikawa was not constrained by a statutory reserve requirement, "so he upped his bets . . . until he dropped his winnings back and gave up a million of his own cash."

Of course, that kind of thing happens only in the movies and never in a "rational market." However, as explained in Professor David Nasaw's new biography of Joseph P. Kennedy, The Patriarch, those who understand that markets are not rational can do quite well for themselves.

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.