It Is Time to Rethink Insurance Regulation

Brendan McDermid/Reuters American International Group's headquarters in New York.

David Zaring is assistant professor of legal studies at the Wharton School of Business at the University of Pennsylvania.

During the financial crisis, the collapse of America's largest insurance conglomerate, the American International Group, along with the failure of a host of its bond insurers, suggested that the insurance industry was not necessarily a stable, staid keeper of our rainy day funds.

Insurance is a global business, with huge firms writing not just life and home insurance policies, but also entering into more exotic lines of business. Most notoriously, the industry regularly uses credit default swaps, which have proved to be capable of exposing those firms to the vicissitudes of international finance and the risk of insolvency.

But the American insurance regulation system has long been focused on the local market and the protection of policy holders, instead of the global market and the stability of insurance firms. Insurance regulation is run by the states, instead of the federal government.

The insurance law taught in law school usually composed of a set of appellate decisions related to contract law and consumer protection, rather than on the regulation of the industry for safety and soundness by expert agencies. To the extent that state insurance commissioners focus on the solvency of insurers, they do so from a consumer protection perspective. That means they consider whether firms are likely to be able to pay out on their policies, rather than on the effect that they have on the financial system as a whole.

The financial crisis suggested that American insurance supervision is focused on the wrong problems. Perhaps more alarmingly for the industry, the crisis's aftermath suggests that the rest of the world is increasingly adopting a different set of priorities.

Last month, the Treasury Department came out with a long-awaited report on the state of insurance regulation in the United States. The report was the response of federal financial regulators to the new reality of the insurance marketplace, and set down a marker for the kinds of reforms that will be part of the conversation when Congress takes the matter up.

Part of what has moved Treasury officials is an effort to keep up with the globalization of insurance supervision. Europe responded to the crisis by overhauling the way it looks after its industry, with renewed attention to its ability to survive financial shocks, and the empowerment of a continent-wide insurance supervisor. The European Union's so-called Solvency II framework, moreover, raises the specter that Europe may use it solvency rules to keep foreign insurers out of European markets, on the grounds that they are too risky to trust with the money of European consumers. That threat, among other things, means that copies of the European approach are taking root across the world.

But keeping pace with Europe doesn't work well with the American system of insurance regulation, where the federal role is minimal and each state has a different regulatory regime. This is where the Treasury Department's call for a stronger federal role in insurance regulation, something that the largest insurance companies probably would like to see, makes sense.

Stronger, however, does not mean exclusive, or at least it does not in the Treasury Department's report, and that is somewhat surprising. In banking regulation, state regulators have been pushed to the periphery of the financial system. But the Treasury Department did not ask for the kind of role the Fed has over banks, or the Securities and Exchange Commission has over the capital markets.

The Treasury Department did not urge repeal of a federal statute, the McCarran Ferguson Act, which ensures a strong state role in insurance supervision. And it seemed happy to let the state court systems and insurance commissioners take the lead on policy payout disputes, market conduct regulation, and the like, though it did urge the states to try to develop a consistent approach to these matters.

Foreign insurance regulators have consistently complained about the difficulties of doing business with their disaggregated American counterparts. But given the long history of state-based insurance regulation, there could be some logic in the Treasury report's recommendation that federal-state cooperation be embraced.

States might perform the consumer protection role, which has never been a strength of federal financial regulation (though as Daniel Schwarcz, a law professor at the University of Minnesota, has argued, the states could certainly do more to foster transparent consumer markets, among other things). The federal government could then worry about overall systemic stability, and perhaps some nationwide insurance markets where it makes little sense to give the states a role.

The Treasury report advocates something like this division of labor, and so might, if implemented, make it possible for the United States to keep up with its international counterparts in thinking about the stability of insurance companies. In that sense, the report is cautiously sensible. It will be good news if Congress gives the department the authority it needs to make a hybrid, federal-state model of financial regulation work.