Ernst N Csiszar reflects on the problems within the US regulatory system and looks at the momentum for change
We are at the crossroads of change. It is time to choose between directions and courses of action. In my almost six years as Insurance Director for the State of South Carolina, two of which I also served as an Officer of the National Association of Insurance Commissioners (NAIC), it became crystal clear to me that the state-based regulatory system in the US, last reformed in the early 1980s, was no longer suited to the globalised insurance markets of the 21st century. The current system consists of a historically unprecedented legal colossus, made up of a myriad of conflicting, intrusive, costly and archaic formal and informal rules and regulations. It is a regulatory system that relishes perfection in its failure: it achieves a modicum of modest consumer benefits, but does so at maximum cost. It over-regulates the non-essential and the trivial.
At the same time, it under-regulates or neglects aspects of the essential that actually call for closer regulatory oversight. Let me provide some examples. Many, if not most, states require a mountain of paperwork when a company wishes to change its name. Yet the transaction has no substantive impact on the economic structure of the underlying entity. Assets remain the same. Liabilities remain the same. Solvency remains the same. Market conduct remains the same. So the name has changed? A simple letter informing regulators of the change would do.
Or take another example. In South Carolina, for many years we refused to approve products that included language enclosed within parentheses.
The reason? Someone, decades ago, had decided that parentheses are but a sneaky way to slip things into a product. They are just a mechanism for diminishing broader policy benefits perhaps offered in other parts of the product. It all seems silly, but let me assure you - as all of you who have to deal with this system will know - these are but two of tens of thousands of other examples of a similar nature. If any further proof is needed, let me just add that while only a few states experimented with the NAIC's earlier version of expedited rate and product approval (known as CARFRA at the time), the approval of a simple term life product ran into more than 2,000 state-based deviations.
At the same time, recent financial failures seem to call for an entirely new look at the current financial review process and the state-based accreditation system, something that seems to attract relatively little regulatory attention when one looks at the broader picture. While not entirely neglected by regulators, the failures at Reliance, Legion, Villanova and others, the evolving troubles at Kemper, the creakiness of the guaranty fund system - all seem to call for a total overhaul of a financial examination system that has mostly a historical perspective, produces examination reports that are entirely outdated by the time they are finished, lack qualitative judgment by examiners and rely mostly on mechanical quantitative risk-based capital formulae that themselves are either incomplete or inadequate.
Add to this an accreditation system that relies on process and pays little attention to outcome. One can only wonder what differences there are, if any, between the regulatory shortcomings of the early 1980s that led to the 'Failed Promises' reforms and today's situation. I suspect that were it not for war, terrorism, Enron and mutual funds, the same questions as then would abound. We are shortchanging or neglecting what I consider to be the most essential aspect of supervision - solvency.
Add to this the fact that our current regulatory system is overly reliant on governmental intervention - for instance, in pricing or reviewing new competitive products - while neglectful of the proper role of markets in those instances where competition reigns. Such intervention causes more harm than good as pricing and product approval are left to frequently unqualified bureaucrats who cherish their power over the life and death of a company or a product. It also leaves the entire system exposed to the potential for politically corrupt interference in the economic affairs of a business. Furthermore, it leaves consumers, who might otherwise be more accountable for their purchasing decisions, with a false sense of security.
Regulation does matter! But regulation with an unswerving focus on the essentials is what is needed. For instance, with respect to solvency and perhaps aspects of market conduct, the media and the trial bar seem to do a much better job than regulators. As I look back, almost every major market conduct infraction of the last few years was uncovered by the media first: race-based pricing by the Wall Street Journal, UnumProvident by investigative television, after-market parts by the trial bar. Between over-regulation of the trivial, under-regulation of the essential and unwarranted and harmful governmental interference in legitimate business processes, it is no wonder that some of the participants in the industry are driven into the arms of anyone offering the prospect of a better system.
State vs Federal
Hence, the current debate over state versus federal regulatory oversight.
If the state-based system is to survive and prosper, state commissioners must subscribe to a more aggressive and revolutionary agenda for change, one that is driven by focus and urgency. The incremental changes currently on the table simply do not suffice. Revolutionary change, not evolutionary change at a glacial pace, is what is needed. If not, other entities, be that Congress, the President, the Federal Reserve, the Treasury or other federal agencies, will eventually fill the vacuum.
In recent months, the debate has focussed on what has become known as the 'federal tools' approach to reform. This approach can best be described as specifically targeted and selective federal pre-emption in several areas of regulatory reform. For the moment at least, full federal pre-emption or an optional federal charter seem politically undesirable. The driving force behind this approach is the House Financial Services Committee chaired by US Congressman Michael Oxley of Ohio as well as its subcommittee on insurance chaired by US Congressman Richard Baker of Louisiana. While much discussion has focused on the concepts subsumed in such an approach, at this point we continue to await draft legislation. Until such legislation is exposed to public comment, it is difficult to judge either content or reaction. However, one thing remains certain; the federal authorities will continue to play an increasingly significant role in this industry, a role that has expanded in recent years because of federal initiatives such as the flood and crop insurance programs, the authorisation of risk retention groups, privacy legislation and the Terrorism Risk Insurance Act. Other important issues such as the resolution of the asbestos problem, the longer-term question of how to handle terrorism insurance, meaningful tort reform, taxation issues and the handling of catastrophe reserves call for national solutions unlikely to be found at the state level. In fact, I would venture to say that for all but the few companies that operate only in a very limited number of states, the issues that have traditionally formed the core of state regulation are no longer the issues that are of strategic importance to the industry. While a law or a regulation in South Carolina or a larger state like Texas can certainly cause a blip to the bottom line, for a company that sells across the US, Europe and Asia, the important issues are of an entirely different order and breed.
So the trend to federalise and globalise will continue, and the only question that remains will be the extent to which the state, the national and the international systems complement or pre-empt each other.
It may well be that, eventually, a crisis - perhaps another major financial failure or perhaps the states' inability to implement a more sensible, more uniform, less costly and less intrusive system - will drive the discussion back to full pre-emption or an optional charter. One thing is certain: in the aftermath of 9/11, Washington has become keenly aware that insurance is a product that is fundamental to capitalism and democracy, not unlike a flourishing banking system and well-functioning capital markets. Access, availability and affordability of insurance are essential to entrepreneurship, economic growth and business confidence. That reality in itself will guarantee continued scrutiny of the industry and its regulation by federal authorities.
A healthy and thriving insurance industry within a well-designed regulatory system is not only desirable but essential.
With regard to the insurance market, it is worth noting that prices seem to have softened in recent months. One wonders whether this is the beginning of the chronically disfunctional pricing cycle or whether it is merely a temporary adjustment to an over-hardening of the market in the aftermath of 9/11. Part of the answer clearly lies within the control of the industry.
Part of it, however, I think must also come from the ratings agencies.
Many have commented on the increasing role these agencies are playing within the industry. Their role, in fact, is largely a salutary one I think. It should even be enhanced. It seems clear to me that a significant ratings factor in this industry should not be just the quantity of earnings over time but the quality of earnings. Those companies that consistently produce underwriting profits ought to be rewarded with a higher rating than those who merely park their money in the market. A third part of the answer surely will come from the reinsurers, who themselves must face the issue of cash flow and pricing discipline in what will likely be an increasingly tempting investment environment. The American economy is clearly emerging from a downturn, and stocks and bonds are certain to reflect that fact.
That brings me to the fate of reinsurance. While reinsurance within the US is regulated through the 'credit for reinsurance' mechanism, much of the industry remains sited in jurisdictions that traditionally have exercised little or no regulatory supervision. In recent years, we have witnessed more and more calls for more consistent oversight. As reinsurance behemoths increasingly interact with other parts of our financial systems, the voices calling for such supervision have become increasingly louder. The International Association of Insurance Supervisors (IAIS), for instance, has called for precisely such an outcome. As more and more of the market - the commercial market, in particular - shifts from traditional insurance products to alternative markets via captives, securitised transactions, options, swaps and other financial instruments, the need for a level playing field between banks, securities and insurance - reinsurance, in particular - will become more pronounced. The recent debate over collateral is but one small part of this much larger problem. Once again, the problem seems to call for a national, perhaps even supranational, solution.
None of this will be possible unless the industry learns to speak a common language. That language is accounting. Once again, not only are common international accounting standards desirable, they are a must. The efforts of Sir David Tweedie and the International Accounting Standards Board (IASB) are to be applauded and deserve our full support. That is not to say that such a common accounting system should not be well designed.
Surely, however, to argue that our current US GAAP or UK GAAP or US SAP cannot be improved upon through the efforts of the IASB is disingenuous.
While there may well be winners and losers during a transition from the current to a future international system, ultimately much greater benefit for consumers, investors and companies alike will derive from doing away with the current Tower of Babel that national accounting represents.
This leads me to another broader issue. The global nature of insurance products, the growth of emerging markets such as Eastern Europe, India and China, the enhanced nature of the European market through the European Union's current and future expansion - all of these point to the need for a less parochial and more internationally-driven regulatory regime.
While the US may well be the largest market at present, the world is moving toward greater regional integration, common currencies, similar yet differentiated markets and so forth. These trends call for much greater coordination, cooperation and commonality of regulation across nations. The role of the IAIS, I think, is fundamental in that regard. To succeed however, the IAIS needs a firm footing with sufficient financial and human resources, expanded recognition of its principles and standards, and a more aggressive agenda with regard to the development of best practices, model principles and common standards for insurance regulation in both mature and emerging markets.
While tactical challenges abound, the outline of the strategic goals seems fairly clear. There is no end to the work that needs to be done.
The long-term is but a series of short runs. It is important that the momentum for change be maintained.
Ernst N Csiszar was until recently President of the National Association of Insurance Commissioners and Director of the South Carolina Department of Insurance. He has lately assumed the presidency of the Property Casualty Insurers Association of America, a large property and casualty trade association.