Regulating without a net: States must walk a tightrope of regulatory reform and consumer protections or risk losing their oversight of the nearly $1 trillion insurance industry.

When Kentucky Representative Steve Riggs discusses the value of state insurance regulation, he likes to tell the story of the Lakedreamland Volunteer Fire Department of Jefferson County. The small local company took out a group life insurance policy from an out-of-state company. Years passed until a tragic event took the life of one of the firefighters. When the widow filed the claim on her husband's life, however, the insurance company falsely told her that the policy only covered career firefighters--excluding the entire company of volunteers who had paid a decade's worth of premiums. Riggs called the state insurance department, and the claim quickly was paid.

This story isn't an isolated incident. But it is an example of how state regulation works--at a time when some in the industry are pressing for federal oversight of the $956 billion business.

"One hundred and ninety-nine claims out of 200 are paid without a problem, but it's important that the state has the authority to act when that one problem occurs," Riggs says. "If insurance was federally regulated, consumers would have to go through Washington, D.C., and an IRS-style bureaucracy. The policyholder probably would have to hire an "inside the Beltway" attorney, claims could take months, if settled at all, and people could miss mortgage payments or go without basic needs."

Insurance serves as the cornerstone of the economy. It guards against unforeseen risk and allows people to take chances that they otherwise may not. In a day when a corporate giant like Enron can disappear virtually overnight and take with it billions in retirement funds, insurance companies maintain reserves to pay claims when and if benefits are due, years in the future, even if the company goes bankrupt. And if the unthinkable occurs--as on Sept. 11--insurers provide the money to rebuild and cover economic losses.

Yet the insurance marketplace has changed. State regulators are under continuous fire to reform the 150-year-old system of regulation to meet the needs of the modern economy. The industry wants some combination of uniformity, deregulation and greater coordination among states. It now has the support of key members of Congress, who echo industry calls for modernization and show serious interest in direct federal oversight. Some in the industry have backed proposals for an optional federal charter, which would preempt state laws and allow companies to select state or federal regulation.

What's become clear is that states will no longer regulate the industry simply because they always have. State insurance commissioners have made impressive strides over the last two years to upgrade and coordinate regulatory practices--and their work continues--but Congress wants states to go further. The real test is whether legislatures can enact reforms that meet federal and industry pressures while maintaining the consumer protections that give state insurance regulation its value.

A MODERN MARKETPLACE

When Congress dealt with insurance regulation in the past, the industry united behind continued state oversight. Now some groups are leading the charge for a federal role.

These groups argue that state inefficiencies and patchwork requirements place some national insurers at a competitive disadvantage against federally regulated banks and securities firms in the modern financial marketplace. Pressure on insurance companies heightened with the passage of the Financial Modernization Act of 1999-also called Gramm-Leach-Bliley. This act tore down Depression-era barriers and allowed insurance, banking and securities firms to affiliate with one another.

Traditional industry supporters--like groups that represent life and some property and casualty insurers-haven't turned to the federal option casually, but are responding to specific grievances. For example, as the growth areas of life insurers have shifted from traditional policies to annuities and other innovative products, these companies find their primary competitors to be banks and securities firms. Where federally regulated banks may self-certify that new products meet federal standards, and mutual funds can obtain the approval of the Securities and Exchange Commission in a couple of months, it commonly takes 12 to 18 months for a life insurer to get an annuity product approved in all 50 states.

"That was fine when the shelf life of a new product was seven or eight years," says Gary Hughes, general counsel for the American Council of Life Insurers. "But it's now about two years, and that's just not good math for the industry."

Life insurers don't seek to avoid consumer protections, Hughes says, but instead want consistently applied uniform standards that allow them to speed products to market in all states within a reasonable time.

Property and casualty insurers, on the other hand, want reduced state regulation. For decades, they have urged reform of laws that require state regulators to approve insurance rates and contract language before policies can be marketed. They argue that these systems increase costs, stifle competition and divert insurance department resources from more important responsibilities. These insurers favor competitive rating laws that allow them to raise and lower prices to reflect costs and respond to market forces without regulatory interference. Although several states have adopted competitive rating, most maintain some form of a prior approval system to guard against rates that are excessive and unfair and to mitigate erratic market swings.

Most property and casualty insurers remain committed to state--rather than federal--regulation. The exception is the larger, national carriers that disproportionately sell commercial policies. These insurers are challenged by an explosion in alternative markets, which doubled their share of the commercial insurance market over the last two decades to take 34 percent of total premiums. Buyers are attracted to the increased flexibility found in these largely unregulated alternative markets, according to the industry. Their increasing market share shows that they are attractive to businesses even without rate and form oversight.

"Commercial consumers tend to be more sophisticated buyers who commonly research, negotiate and purchase a wide array of products and services," says David Unnewehr of the American Insurance Association. "They typically have designated risk managers or professional agents and brokers to help them make insurance decisions."

State micromanagement of commercial insurance forms and rates is not necessary, he says, and can be counterproductive when it delays or curtails the introduction of innovative products tailored for businesses to meet their specific needs.

PROTECTING CONSUMERS

Although some companies turn to Congress, state officials underscore the fact that insurance regulation is supposed to be about protecting consumers. It's on this point that they believe states have the advantage.

"I haven't heard one consumer ask for a federal insurance regulator," says Ohio Insurance Director Lee Covington. "They don't like enormous federal bureaucracies, and they don't want another one for insurance regulation."

Key to the state argument is that insurance is unlike other financial services.

"Some in the industry are saying that because insurance is a financial service like banking and securities, it can be regulated the same," says New York Senator William Larkin. "That's not true. They serve fundamentally different functions in the economy."

While most services provided by banks and securities firms create and distribute capital to promote business, he says, insurance helps spread and manage risk of losses if something bad happens.

Insurance policies typically are more complex than other financial products like bank loans or mutual funds, which tend to provide tangible products along clearly defined terms. "Insurance is a promise," says Larkin. "It's an actual contract steeped in tort law and court interpretations that varies from state to state and may not be self-evident, even if the policyholder reads the fine print."

State officials argue that their understanding of local social and economic conditions better prepares them to help consumers as they evaluate needs, select a company, negotiate terms and collect benefits.

"Is the federal government going to be there to respond quickly to consumer complaints or to ensure the availability of coverage at an affordable rate in rural parts of the state?" asked Texas Representative David Counts. "Congressmen are in Washington, D.C., to focus on national and international issues while we're in our districts taking phone calls, seeing people around town and finding out the real world problems that people have with insurance.

IMPROVING STATE REGULATION

Federal and industry pressure have directed a powerful spotlight on state oversight, and state regulators have responded with remarkable vigor to make insurance regulation more effective and responsive. Much of this effort has aimed to streamline systems across state lines.

"Markets are different and issues are different from state to state, but you can't go on your merry way without consideration of what other states are doing," says Terri Vaughan, Iowa Insurance commissioner and president of the National Association of Insurance Commissioners (NAIC). "We must reach that balance where we have differences only where they're necessary."

Immediately following passage of Gramm-Leach-Bliley, insurance commissioners working through NAIC declared a full-scale re-evaluation of state regulation to modernize and streamline systems.

In response to a provision of the federal act that requires states to establish a system of reciprocity to license out-of-state insurance agents and brokers, commissioners adopted a model law that has been enacted in 38 states. This already exceeds the 29 states required by federal law to prevent establishment of the National Association of Registered Agents and Brokers-a quasi-governmental entity that would have preempted state laws-with a full year to go before the Nov. 2002 deadline.

In response to another provision that states set minimum standards to keep insurance information private, regulators drafted model privacy regulations. Forty-three states and the District of Columbia now meet the federal requirement with legislation pending in the remaining states.

Perhaps their most impressive moves are in those areas where there are no direct federal mandates. Regulators began the process of cleaning up the needless regulatory requirements not supported in state statute or formal rule. They organized and posted checklists of standards so that companies would be able to make sure that products were in compliance before they were filed. Regulators also have overhauled department Web sites to improve information for consumers and make it easier for them to file complaints.

Some changes already have had major impacts on how fast companies can get products to market. For example, SERFF-System for Electronic Rate and Form Filing-is a streamlined Web-based system that allows companies to file insurance products electronically. Regulators met their goal of getting all states licensed to use SERFF by the end of 2001. Recent returns show that 94 percent of first-time filings that use SERFF are approved in an average turnaround time of 16 days.

Once the mindset of regulatory reform took hold, greater state coordination followed. Four states--Illinois, Nebraska, Ohio and Oregon--informally agreed to review to-gether companies' conduct in the marketplace, avoiding duplications that are costly for departments and even more expensive for companies. Departments now are looking for new opportunities to coordinate efforts to stretch limited resources and reduce regulatory burdens.

THE CHALLENGE FOR LEGISLATURES

"The industry is rightly concerned about competitive issues such as their ability to speed products to market," says NCSL's President Senator Stephen Saland of New York. "State legislature must take an active role in streamlining and simplifying state regulation to allow insurance companies to respond to the more competitive environment of the 21st century."

As impressive as the reforms and coordinated efforts of state regulators have been, they increasingly have run up against statutory barriers. The ultimate success or failure of regulatory moderation may rest with legislatures.

"Change is hard," says Commissioner Vaughan. "State insurance departments must deal with legislative concerns, regulatory matters, information systems and cultural issues. We're looking at changes across the board. Any support legislatures give to these efforts increases the chances that state regulation will continue to be effective."

To address life insurers' concerns, state regulators created CARFRA-the Coordinated Advertising, Rate and Form Review Authority-a state-based entity that provides one-stop filing and review for the same product in multiple states according to a set of newly formulated national standards. Regulators launched CARFRA in 10 states for limited health and life insurance in May 2001. Since that time, only one company has used the system.

Why? Life insurers cite state deviations from the national standards as the principal reason. The national standards are a sort of middle ground among state requirements-higher than some, lower than others. Even if a product receives CARFRA approval, an insurer may have to change the product and submit it again in some states to meet specific statutory requirements. And there are lots of deviations-as many as 400 for the few products currently cleared for CARFRA. New York alone has more than 120. Consumers argue that they should raise the national standards to meet the highest protections in any state, but even this may not be possible because some deviations aren't higher or lower-just different, such as specific fraud disclosures that must be included in every life insurance policy.

The question then is whether legislators are willing to re-evaluate their statutory requirements for specific life insurance products to see which ones are necessary, which ones are not and which ones can be changed to achieve greater uniformity among states without sacrificing consumer protections.

"We want to create an efficient, value-added regulatory system that allows us to fulfill our mission of consumer protection while eliminating unnecessary burdens on the insurance industry," says Covington. "State legislators are vital to the success of these efforts."

An even more controversial issue relates to reform of property and casualty commercial lines. Insurance commissioners gave tentative approval in December to a model act that uses a competitive commercial rate and form filing system that would include about 95 percent of insurance bought by businesses. The act relies on a presumption that a rate cannot be excessive. The commissioner would be required to evaluate competition each year and would retain the authority to act against a specific company if a product was shown to be out of line or unfair.

"State commissioners have realized that competition in the marketplace is the best regulator for commercial lines," says Covington.

Consumer groups have applauded insurance regulators' efforts to rid the process of unnecessary inefficiencies that slow down the approval process, but they strongly oppose any efforts they view as deregulation.

"Insurance commissioners haven't just cut the fat. They've gutted consumer protections to the point that bad products can enter small commercial markets without review or any method of redress for small mom-and-pop stores," says Robert Hunter, insurance director for the Consumer Federation of America. "State legislatures need to oversee that regulators do not go administratively below the intent of state legislation."

WALKING THE TIGHTROPE

Reforming insurance regulation for the modern economy is a tightrope that states must walk between a new financial marketplace and the consumer protections that give state oversight its value. But Congress has removed the net.

"If we can't get to a more efficient regulatory system, the calls for a federal answer will get stronger," says Vaughan. "Congress is watching what we do before it decides what direction it will take."

Some observers may think federal insurance regulation is only a matter of time. These naysayers can point to the first bill for an optional federal insurance charter introduced by U.S. Senator Charles Schumer of New York. Others who never thought states could reform so much so quickly still call attention to pending potential pitfalls.

Still, many who work to streamline and simplify insurance regulation point to the state track record of tackling difficult issues while staying true to consumer protections.

"State initiatives have set the nation's policy direction over the last decade," says Senator Kemp Hannon of New York.

Specifically, he points to the small-group health insurance reforms of the early 1990s that paved the way for the Health Insurance Portability and Accountability Act of 1996. He also mentions patients' rights, which more recently have been enacted in virtually all states.

"States have demonstrated the ability to act, to do so quickly and to do so when the Congress cannot come together," he says.

Cheye Calvo is NCSL's expert on employment and insurance issues.

STATE INSURANCE REVENUES

Federal regulation of insurance threatens state revenues, as well as state authority. States collected nearly $10.5 billion from insurance taxes, fees and fines in 2000. Of this amount, only $880 million-8.4 percent-was spent on the oversight of insurance while the remaining $9.6 billion went to general funds to pay for other programs.

Current proposals for an optional federal insurance charter are revenue neutral to the states, but many believe that the federal government would preempt or diminish this important source of revenue soon after a federal insurance regulator is in place.

More than 87 percent of state insurance revenues come from premium taxes. These are gross. receipt taxes, which place a flat levy--typically between 2 percent and 3 percent, but as low as 0.75 percent in Wyoming and as high as 4.265 percent in Hawaii-on all premiums paid.

Where most corporations pay taxes on net profits, which typically apply higher rates but allow companies to deduct the cost of doing business from the tax base; insurance companies pay taxes on all the money they receive, regardless of whether they make a profit;

As a result, states generate more money from premium taxes on insurance than they do from other industries.

Insurance Taxes, Fees and Fines in 2000

State                 Total Revenues
                       (in millions)

Alabama                        $ 204
Alaska                            34
Arizona                          179
Arkansas                         128
California                     1,438
Colorado                         134
Connecticut                      228
Delaware                          56
District of Columbia              41
Florida                          516
Georgia                          517
Hawaii                            75
Idaho                             65
Illinois                         252
Indiana                          166
Iowa                             139
Kansas                            85
Kentucky                         170
Louisiana                        158
Maine                             53
Maryland                         213
Massachusetts                     36
Michigan                          22
Minnesota                        174
Mississippi                      120
Missouri                         185
Montana                           43
Nebraska                          59
Nevada                           141
New Hampshire                     59
New Jersey                       378
New Mexico                        94
New York                         737
North Carolina                   322
North Dakota                      30
Ohio                             379
Oklahoma                         170
Oregon                            60
Pennsylvania                     291
Rhode Island                      58
South Carolina                   110
South Dakota                      46
Tennessee                        312
Texas                            839
U.S. Virgin Islands               12
Utah                              93
Vermont                           37
Virginia                         289
Washington                       283
West Virginia                    107
Wisconsin                        113
Wyoming                           12
Total                        $10,459

Source: NAIC, 2001

RELATED ARTICLES: TASK FORCE SEEKS TO STREAMLINE AND SIMPLIFY

NCSL's Executive Committee established the Task Force to Streamline and Simplify Insurance Regulation in September 2000 to lead state legislative efforts to modernize state insurance regulation.

The task force is co-chaired by Senator Kemp Hannon of New York and Representative David Counts of Texas and consists of 26 politically and geographically diverse state legislators. NCSL's President Senator Stephen Saland of New York directed the task force to undertake four primary objectives:

1. Review the correlation between state regulation and the business of insurance and financial services modernization, electronic commerce and globalization.

2. Coordinate efforts to streamline and simplify state insurance regulation with the National Association of Insurance Commissioners and the National Conference of Insurance Legislators.

3. Formulate an NCSL slate of principles with regard to streamlining and simplifying state insurance regulation and on state-federal relations with regard to the future of insurance regulation.

4. Develop and review draft legislation for state legislative consideration.

A SHORT HISTORY OF INSURANCE REGULATION

Insurance regulation began in Massachusetts in the mid-19th century and other states followed. Insurance wasn't seen as commerce, so its regulation existed outside federal jurisdiction. When the Supreme Court ruled in 1944 that insurance was commerce, Congress the following year passed the McCarran-Ferguson Act, which endorsed state oversight and exempted, insurance from federal anti-trust laws as long as it was regulated by the states As a result, insurance regulation grew up independently in states to create a patchwork of different laws and requirements.

States created regulations to protect consumers. Laws, were enacted principally to safeguard against inadequate rates and insurer insolvency and to make certain that the promise of benefits if and when certain events occurred--often many years in the future--would be kept. Insurers generally were required to obtain the approval of insurance rates and contract language before they could sell them.

Over time, however, states adopted different approaches. Most maintained their prior approval systems, and some actively began to mitigate or repress insurance prices. Others, introduced systems that relied on the competitive market to regulate insurance and concentrated their resources to monitor how companies conducted themselves in the market.

Congress first looked at a federal role in insurance regulation in the early 1990s after some companies became insolvent as a ripple effect of savings and loan failures. But legislatures worked with insurance commissioners to craft model legislation that was enacted in every state to safeguard insurer solvency and forestalled congressional action.