The Regulation of Insurance:
The Struggle Between State and Federal Oversight
By:
Brett Lininger
Graduating Senior
University of Baltimore School of Law
Professor Ronald V. Miller, Jr.
May 11, 2005
THE FORMATION OF STATE REGULATION OF INSURANCEThe federal government has consistently expanded its regulatory reach over industry by means of the Commerce Clause of the U.S. Constitution.
The insurance industry ducked this expansion of federal regulatory reach in part due to timing.
State regulation of insurance companies and agents developed beginning in the early 1800s.
The insurance industry has been regulated at the state level primarily as a result of the 1868 Supreme Court decision in Paul v. Virginia .
The decision in Paul held firm until it was overturned in 1944 in United States v. South-Eastern Underwriters .
Before discussing the details of the case, some background on rating organizations is useful. Many insurance-rating bureaus formed in response to a rash of insurer insolvencies spurned on by the Boston and Chicago fires of the 1870s.
SEAU argued that the Sherman act did not apply to the business of insurance because it was not commerce.
The decision in SEAU produced uncertainty for both the insurance industry and state regulators.
The net effect of this statute was to prohibit federal law from applying to the insurance industry unless those laws explicitly deal with insurance.
Given this clear mandate of state regulation of insurance, each jurisdiction took steps towards that end. For example, states required property-liability insurers to file their rates to be approved by the state insurance departments before being used in the market. In addition, many state laws and regulations made insurers use the rates developed by the rating bureaus.
FEDERAL ACTION AGAINST STATE REGULATION AND STATE REACTIONSThe debate over whether the insurance industry should be regulated solely at the state level has burned strong before and after the passage of McCarran-Ferguson. Starting as early as the 1860s, members of Congress unsuccessfully proposed federal legislation to create a federal agency to regulate the insurance industry. Each of these attempts to impinge upon state regulation of insurance has been met with a response by the states.
Insurer Insolvencies: Federal Action
Insurer insolvency has been an issue producing great debate over who should regulate the insurance industry. Solvency is a term used in the insurance industry to denote an insurer's ability to pay its claims at any given time.
The states responded through action by the National Association of Insurance Commissioners ("NAIC").
Another response to the federal insolvency legislation was the NAIC's creation of a centralized database and "Early Warning System" to assist regulators in identifying and prioritizing their efforts for troubled companies.
The next iteration of the insolvency issue was in response to activity that took place in the first half of the 1980s.
The most telling example was with the insolvency of Mission Insurance Group (" Mission ") in 1987.
To make matters worse, a number of life insurers met the same fate in 1991.
Not surprisingly, the volume and severity of such activity drew attention from Congress.
The Dingell report ("report") was submitted to the Committee on Energy and Commerce on behalf of the Subcommittee on Oversight and Investigations ("Subcommittee").
The report detailed the causes for insurance company failures in the United States in the 1980s.
Perhaps more telling were the findings of failures by state regulators. At the time of the report, the Subcommittee listed six main weaknesses to the then present system of solvency regulation.
The first, labeled as delegated management authority, found that the rapid expansion of business leads to an over reliance on third parties to perform sales and administrative functions for the company.
The third weakness the report pointed to was the reinsurance market.
The fourth jab at the state regulatory system over insurers was that the information used to analyze solvency was unreliable.
Finally, the biggest attacks against the state insurance departments came in the report's listing of the next two weaknesses. It found an overall insufficient regulatory system.
Finally, the Subcommittee found an overall lack of resources devoted to enforcement of insurers' financial well-being.
Although the Subcommittee found no overall crisis to the insurance industry as a whole, it did find "the present system for regulating the solvency of insurance companies [to be] seriously deficient."
Scott E. Harrington, The History of Federal Involvement in Insurance Regulation, in Optional Federal Chartering and Regulation of Insurance Companies 21, 21 (Peter J. Wallison ed., 2000).
The Subcommittee asserted that the insolvencies "encompass[ed] scandalous mismanagement and rascality by certain persons entrusted with operating insurance companies, along with an appalling lack of regulatory controls to detect, prevent, and punish such activities."
As a follow up to the Subcommittee's findings, Dingell introduced H.R. 1290, the Federal Solvency Act of 1993. This idea was similar to how banks are regulated today.
Insurer Insolvencies: State ReactionAfter the insolvencies in 1991, many life companies strengthened their capital posture and improved their asset quality. This is probably in part due to independent agents informing their clients of the appropriate actions to take, which supports the notion of insurance ultimately being a local industry.
The net result was that the stronger companies were given added reason to increase their capital and reduce their risk.
In response to the report's criticism of the reinsurance market the NAIC, in 1990, developed their "Five Components of the Solvency Policing Agenda."
The first ingredient needed to ensure strong financial regulatory standards for solvency regulation was to provide state regulators with the legal authority to oversee an insurer's financial affairs.
The NAIC also took action to improve oversight of reinsurers through the Model Law on Credit for Reinsurance.
The 90-day rule gave primary insurers the proper incentive to make certain that the reinsurers with whom they did business were able to pay claims in a timely manner.
Another effort to address the problems in the reinsurance arena, was the NAIC developed Reinsurance Intermediary Model Act.
The NAIC's solvency policing agenda targeted the overall market conduct examination processes.
The NAIC's efforts regarding risk based capital were also designed to bolster the financial status of insurers by setting standards.
The NAIC and state responses to Congressional action have proven to be quite helpful for both the industry and consumers. Industry could hang their hat on their domestic state financial standards, which in turn have proven to protect consumers from massive insolvency activity since they have been implemented. The threat of federal intervention of insurance regulation based on insolvencies, however, was met with a united front between regulators and industry alike. As will be shown later, this union does not hold constant with every issue.
Producer Licensing: Federal ActionAnother provision of Congressman Dingell's H.R. 1290 would have created a uniform licensing system for insurance agents and brokers.
Producer Licensing: State Reaction
The NAIC responded to this threat in rapid fashion by certifying that thirty-five states adopted the NAIC Producer Licensing Model Act by September 10, 2002, avoiding federal preemption. This avoided the federal preemption of insurance regulation by the states once again. This is a good example of what can be accomplished when true pressure from Congress is applied. Like the solvency issue, this threat from Congress again was met with a united front. This time it was between the regulators and the almost always state-based proponent, the producers.
Anti-trust Issues: Federal Action
The next attack on McCarran-Ferguson was targeted at the antitrust exemption provided in the Act.
The insurance industry's narrow exemption from antitrust law was developed over time by the courts' interpretation of the business of insurance and the meaning of boycott.
In two other important cases dealing with the extension of federal regulation to insurance related activities, the Court narrowed the meaning of insurance.
In response to the critics of the insurance industry's limited exemption from antitrust laws, supporters of state regulation said that property-liability insurance rates vary from company to company and are therefore not price fixed.
In spite of these arguments, twenty Attorneys General filed a federal antitrust suit against the Insurance Services Office ("ISO"), the Reinsurance Association of America, in addition to many other insurers and reinsurers.
Anti-trust Issues: State Reaction
In response to the case, state insurance regulators, through the NAIC, caused ISO to make available only developed and trended loss costs by proposing to prohibit rate service organizations from including expense and profit loadings with advisory rates.
Optional Federal Charter: A Real Threat to State Regulation of Insurance
In the mid-1970's, Senator Brooke of Massachusetts proposed the S. 3884, entitled the Federal Insurance Act. This bill was the precursor for the latest attack on state insurance regulation known as the Optional Federal Charter.
Notwithstanding, the failure of S. 3884, the debate has continued to heat up in light of numerous factors. Factors that will be the likely impetus for the federal intervention over the regulation of the insurance industry once and for all. One important driver behind this latest push is market pressure the insurance industry has faced with the onset of globalization of the business of insurance as it tries to compete with the banking industry on a non-level playing field.
It is very costly and time consuming for an insurer to bring a new product to market in the U.S. because of the required multi-state filing system.
Another problem cited by the industry is the states' unwillingness to allow price increases that reflect market conditions.
In response to these problems, some states have deregulated rates and policy forms for the larger buyers of commercial insurance products.
As discussed above, the debate between federal and state oversight of insurance is not new. The history is long and involved. The attacks on state regulation have been many and quite often justified. Unlike other threats in the past, the proponents of a state-based system are dwindling in numbers.
Once thought of as a local or regional business, insurance is a national and international business and many insurers feel they should be regulated in that manner.
A new study by the American Council of Life Insurers ("ACLI") and Computer Science Corp. ("CSC") reveals that "the life insurance industry in the United States could save more than $2.5 billion annually if members were able to choose an Optional Federal Charter instead of state-based regulation.."
This product convergence also means that banks and insurers are competing for the same customers.
The banks simply need to get approval by the Comptroller of the Currency, which then imposes federal preemption over the states to make its impact felt nationally.
A look at the correlation with the banking regulatory system sheds some light on why federal intervention over the regulation of insurance is more likely now than ever before.
Not surprising because banks are used to dealing with one regulator as opposed to over fifty for insurers. This is in large part because consolidation, the quickest way to show growth for the stock community, is nearly at its peak in the banking industry. At some point, banks will want to grow by buying insurers, which they will not likely do until the regulatory scheme changes to one in which they are more accustomed.
The structure under which insurers are regulated has given rise to still other disadvantages when competing with banks. Unlike banks, insurers have no national spokesperson.
Another practical reality is that each state would have to compete with a federal regulating body for insurance under an optional federal charter scheme.
Currently, it is true that states currently have to compete with one another for domestic insurers and foreign insurers who determine whether or not to do business in their state.
One of the most interesting arguments in favor of an Optional Federal Charter also relates to the international nature of the insurance business today.
Optional Federal Charter: The Arguments Against Federal Regulation of Insurance
Richard E. Stewart, the former New York Insurance Superintendent, said "a .unique advantage of state regulation is that the national alternative always hangs over it."
Some would argue that States cannot afford to be inefficient in the current state based structure because they are always threatened with an insurer leaving their market.
Federal solvency regulation can also be problematic because of the magnitude that comes with oversight mistakes.
Opponents of an Optional Federal Charter also point to the local nature of the insurance industry even today.
An insurer would find it more difficult to file two different products with a federal regulator who has no understanding of the locales in which they are to be sold.
The state-based approach allows insurers to use test markets for their products to determine if they want to roll it out on a regional or national basis.
Finally, it is argued that a federal body could not handle the administrative resources needed to regulate insurance. These numbers point to the unique nature of insurance products as compared to financial products sold by banks.
Insurance produces so many issues unique to any other industry. Insurance also requires so many different forms of expertise that such an entity at a federal level would be so expensive that the costs would outweigh the benefits. Proponents of state-based regulation have said that the choice between state and federal regulation of insurance "should turn on how well the system of state regulation., made up of many agencies, compares with what we might expect of system of insurance regulation made up of one agency that was part of the national government."
While all of these arguments have merit, the reality is that insurers have great financial resources to pave the way for meaningful federal legislation for an optional federal charter. In addition, the banks have a vested interest in the long run as they pursue continued growth by means of acquisition. The momentum is getting stronger especially in light of the political power in Washington with a Republican dominated Congress and George Bush in the White House. The State Modernization and Regulatory Transparency Act ("SMART" Act) is the latest example of this momentum.
Optional Federal Charter and Consumer Protection
Because insurance is so diverse and sometimes geographically unique, consumer protection issues are a real concern under an Optional federal Charter system.
On the other side of the argument, opponents of the current regulatory system argue that the consumer would actually benefit under an Optional Federal Charter regime. By creating uniform standards at the national level, company and producer licensing would be more efficient and the quality of review would be consistent so that consumer protection would be more easily dealt with.
It is argued that a federal regulator would have vastly superior resources than the states do as a whole.
This approach to regulating is based on the philosophy that "informed consumers, not regulators, are in a better position to determine a product's merits, and that the market will reward products that offer true benefits to consumers and punish those that do not."
The best answer to the consumer protection issue is that much of it can be dealt with still at the state level even in an Optional Federal Charter environment. Local and state officials should still regulate all consumer protection issues to ensure that they tie into its tort system. Minimum standards adopted by Congress would be welcome only if the states have the ability to adopt more stringent provisions.
Optional Federal Charter: The View from Insurance Producers
Given that survey data shows the vast majority of complaints against life insurance came from producer misconduct,
The National Association of Insurance and Financial Advisors (NAIFA) has also weighed in on the Optional Federal Charter debate.
These differing views among the producer community really highlight the contentiousness of the Optional Federal Charter debate. In fact, NAIFA of Maine's ("NAIFA-ME") Board of Directors publicly expressed "their concern" over the National Board's drastic policy decision without vetting it throughout the NAIFA membership nationwide.
How States Try to Avoid An Optional Federal CharterThere are numerous ways to avoid federal preemption of state regulatory powers.
The NAIC has tried to deal with issues of speed to market, market conduct examinations and producer licensing in a number of ways.
The producer licensing was addressed by means of NARAB discussed above. NARAB was an example of avoiding federal preemption by means of adopting state reciprocity statutes. The inconsistent implementation of such efforts combined with pressure from Congress has pushed the NAIC towards an Interstate Compact for product approval. Some historical background is called for before getting into the details of the Interstate Compact.
For states to resolve regional disputes, the U.S. Constitution allows for Interstate Compacts to avoid Congressional action.
The key component that makes a compact so attractive to insurance regulators and industry alike is that "[o]nce established as a compact consistent with the Constitutional requirements, legislation establishing a compact cannot be amended, altered, or repealed, except in accordance with the terms of the compact itself.
In light of the broad language of the Constitution, it was not clear whether compacts were enforceable. The Supreme Court, however, in 1959 ruled that "[a] compact is, after all, a contract." Given the well-grounded legal authority supporting compacts, this has been an attractive way for states to address federal preemption issues for insurance.
CONCLUSION
The debate over who should regulate the business of insurance is reaching an apex. Support has waned for a state-based only approach to regulate insurance in light of real market pressures. The political landscape in D.C. sets up a perfect stage to finally break through this more than century old struggle.
The idea of an Optional Federal Charter is a reasoned approach that will in the end create new opportunities for the business world while providing innovative products to consumers. Some companies will opt for state charters much like those in the banking industry. Others will choose a federal regulator. Both will be able to negotiate with each governing body with a real threat of changing their charters.
Consumers can have the best of both worlds if some portion of insurance regulation remains solely in the hands of the states. Consumers would have more products selection with the same protections they enjoy today. State laws are unique to their localities and are the best place for protecting the interests of consumers.
It is time now for a change that will treat the insurance industry like the international business that is has grown to become. There will always be a need for state-based insurance departments because more small regional companies will sprout up as a result. This trend will create more acquisition opportunities for larger companies much like what happened in the banking industry over the last twenty years.
With the right planning, an Optional Federal Charter will be the best way to accommodate the many interests involved in this long fought debate. At the end of the day, an Optional Federal Charter or something like it is coming no matter how sound the arguments are against it.
