Not long ago, I did some research into the recent history of the struggle between state and federal regulators, each of which want to have the big job (and big budget and headcount) of regulating the largely self-organized global insurance network. As we have seen in recent scandals, there are plenty of opportunities for the unscrupulous to take advantage of the complexities of this byzantine industry, yet somehow it runs, grows, absorbs horrendous losses from earthquakes, hurricanes and terrorist attacks and still survives and attracts new capital. Would it be as robust if its regulation became less diverse, more interconnected, more of a monoculture? If it were federalized, as proposed by some and opposed by others? A new chapter in the saga of federalization proposals was written this month in the committee rooms of the U.S. Congress, under Rep. Oxley.
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Those who think that the solution to any thorny economic problem is to have the United States Government run it should think first about 1) the Postal Service 2) the War in Iraq and 3) government handling of intelligence prior to September 11. With that firmly in mind, let's review some of the thrust and parry that has been going on in the last few years over who gets to make sure the insurance industry is regulated "efficiently." As we do, let's not forget that someone should make sure that it is also robust, and able to absorb financial shocks like September 11 and Hurricane Andrew.
The rhetorical record grew this month with testimony in hearings and a presentation by the National Association of Insurance Commissioners (NAIC) before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises. "Impact of SMART Act on State Insurance Regulation" (June 16, 2005) (PDF). Keep in mind that since the McCarran-Ferguson Act was passed decades ago, the federal government has left insurance regulation to state law, with only minor reservations, as reviewed in Hartford Fire Ins. Co. v. California, 509 U.S. 764 (1993).
For the acronymically challenged, here is a lexicon of some of the dueling manifestos floated over the past few years.
Optional Federal Charter for Insurers ("OFC"). The OFC champions propose to create a federal insurance charter like the existing federal bank charter. Those insurance companies that got a federal charter could elect to be regulated by the federal government instead of by every state where it sells insurance. Insiders sometimes refer to this as being regulated by "One giant gorilla instead of 50 chimpanzees." The organization of insurance legislators in the various states (NCOIL) opposes OFC, concerned that states would be unable to shape insurance regulation to local needs, like making insurance companies subsidize bad drivers in metropolitan areas or purchasers of expensive homes right on the beach. A new federal regulatory regime would create thousands of jobs both in the government and private industry to provide and comply with the new federal regulation, which would be competing with the existing state regulation. Some state insurance regulators may be concerned that their roles will diminish in importance, and that if enough big insurers (such as those operating in all fifty states) switch to federal charters, state revenues for insurance department budgets (based on premium taxes) would plummet.
Oxley “Road Map” and “SMART” Bill. Early in 2004 speech, (see: New Momentum for Letting U.S. Help Regulate Nation's Insurers (March 14, 2004)) House Financial Services Committee Chair Michael G. Oxley of Ohio unveiled what he called a “Road Map” of changes he says are needed in state insurance law, to get more uniformity and efficiency. Feeling a breeze, the NAIC (which has no legislative authority) came back with a draft for implementing some of Rep. Oxley's proposals in state law, and called it a “Framework.” In 2004, Rep. Richard H. Baker of Louisiana joined Rep. Oxley to sponsor the State Modernization And Regulatory Transparency Act ("SMART"). Its purpose would be to make the Road Map into law. If it became law, SMART would leave state regulators in place, but override some of the state rules that Baker/Oxley see as inefficient (like state rate approval). They would also require the state insurance commissioners to agree on standard regulations, and put a federal overseer in place to knock heads ("mediation and enforcement") in case of disagreement. Some think that without such a federal referee, states will never agree on standard regulations. A long history shows even agreeing on model insurance laws and regulations has been slow going and often leaves major states refusing to enact the model laws agreed to by their own insurance commissioners. SMART seems like a stalking horse or trial balloon intended to motivate state legislatures to hurry up and agree or see the feds stepping in with the classic line: "We're from Washington and we're here to help you."
NAIC Responses to Federal Initiatives ("Interstate Compact"). Sure enough, the NAIC blinked and came up with an improved proposal, their “Framework” of modernization plans, including uniform standards for licensing agents and brokers, supervising insurer's conduct in the marketplace and handling the mundane but bread-and-butter work of regulating insurance policy language, premium rates and company financial solvency. To move their cooperation along, the NAIC members created an Interstate Insurance Product Regulation Compact (“Interstate Compact”) that included many of the reforms called for by Baker/Oxley. They have since been working to get major states to become signatories to the Interstate Compact, by which they would voluntarily agree to implement the regulatory reforms.
Many key states have a poor history of following, and a tendency to want to lead. This can be a disaster on the dance floor and also in "voluntary" organizations of proud players who are nominally peers but who know that some are more equal than others. In late 2003, for example, California, Florida and Texas agreed to work together to standardize approval procedures for certain life and annuity products. Illinois, Pennsylvania and New York also have a history of going their own way in insurance regulation. Getting these heavies to cooperate could take longer than Baker/Oxley are willing to wait.
The latest episode in the circling of these sumo wrestlers was a hearing on June 16 before the Baker Subcommittee (clearly a more wieldy title than "The Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises") In the announcement of the hearing ("Baker Subcommittee to Continue Oversight of Insurance Markets"), Rep. Baker said: “Of all areas of regulation which our Committee has examined, insurance regulation is easily one of the most in need of modernization and uniformity. Price controls and patchwork regulation benefit neither consumers nor providers. I look forward to hearing from our panel of commissioners their views on the SMART proposal and our efforts to bring insurance regulation into the 21st Century."
Rep. Oxley said, “As a former State legislator and member of NCOIL, I have been one of the strongest proponents of the NAIC and its efforts. But as we have demonstrated throughout the hearings in this Committee over the past three years and the numerous hearings held previously in the old Commerce and Banking Committees, the States cannot get the job done by themselves. The collective action barrier to getting legislatures and regulators to act in complete unison is, and will always be, insurmountable, absent Congressional legislation.”
The usual cast of characters at these hearings again appeared last week, represented by six present or former insurance commissioners from states (Illinois, Pennsylvania, New York, Ohio and Arkansas) that have been active in the NAIC's movement to preserve its member's authority.
NAIC President, Hon. M. Diane Koken (Insurance Commissioner of the Commonwealth of Pennsylvania) declared the NAIC's public service orientation and timeliness at achieving modernization without sacrificing consumer protection. She then went on to tell Congress what they really felt about SMART: "Third, the draft SMART Act incorporates unacceptable levels of federal preemption that would create both legal and practical problems for the insurance industry and its customers. A thorough analysis of the SMART Act by 117 insurance regulatory experts from your home states identifies concerns where the bill would preempt many important state laws that protect consumers from unfair or discriminatory marketing, inadequate or excessive rates, and unsound products. Federal preemption of state insurance regulation denies your Congressional constituents the benefits of important state services and protections, as has already been proven in existing federal programs, such as FEMA in its administration of the National Flood Insurance Program, and ERISA through its taking away state authority to assist your constituents. The states believe it is constructive to point out basic constitutional, legal, and operational problems that would undermine the SMART Act’s stated purposes." Her full testimony is online, including the reports of seven teams of regulatory officials and staff. (51 pages in PDF)
One of the strengths of complex systems is the capacity of its components to interact independently because of the existence of diversity. That independence has repeatedly been shown to protect the overall system from vunerability to unexpected consequences that lead to cascading failures in "monoculture" systems that are highly interlinked. (See: Unintended Consequences: Reading: Barabasi, Linked: The New Science of Networks (2003))
The vulnerability of monoculture systems to catastrophic results of otherwise survivable errors or attacks has been observed again and again, from the Irish Potato Famine (Fraser, "Conservation Ecology: Social vulnerability and ecological fragility: building bridges between social and natural sciences using the Irish Potato Famine as a case study" (2003) to the recent New England electrical blackout (Unintended Consequences: Blackout Report: Maintenance, Training and Communication Errors (2003). During the Blackout of 2003, only the systems that were able to independently decide to disconnect from the "efficiency" of the centralized, unified controls avoided being sucked into the collapse of the highly connected network.
Looking back on decades of ill-conceived centralized government "solutions" to insurance availability and affordability "crises" in state after state, in automobile insurance, workers compensation insurance, medical malpractice insurance and product liability insurance, we see a record of attempts to solve political problems with price controls and lock-ins that caused long-term damage to the whole economic system. If our decentralized insurance system gets federalized, mistakes that would have an impact on only one state may impact every insurance transaction in the entire nation. Time will tell if the game of "chicken" going on between state and federal regulators has a net positive or negative effect. Whatever happens, I'm counting on unintended consequences.
Posted by dougsimpson at June 23, 2005 09:06 PM