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Insurance regulation: where do we go from here?

THE EFFICIENCY of state regulation of insurance has given rise to emotional and often heated discussions in recent years. Selected members of Congress, consumer advocates, and even some insurers insist that the current state-based system of insurance regulation is ineffective and that the federal government should have a greater oversight of this bedrock industry. State legislators, state regulatory officials, and most components of the insurance industry argue that regulation should remain in the hands of state governments. The stakes are high for corporate risk managers, individual insurance buyers, insurance carriers, and state legislatures and regulatory officials.(1) The purpose of this paper is to examine and place in context the vexing question of whether the federal government or individual states should regulate the insurance industry.


Insurance regulation dates back to the mid-nineteenth century. At that time there was little question as to who should regulate the insurance industry. The Supreme Court, in the case of Paul vs. Virginia (1869), established the clear legal doctrine that states have the legal right to regulate insurance. However, in the Southeastern Underwriters Association (SEUA) case (1944), the court reversed that decision. It said that insurance, when conducted between states, is interstate commerce and would henceforth be subject to federal regulation under the Sherman Act and other antitrust acts. The SEUA decision still stands today.

Strong opposition to federal regulation was immediately expressed by the insurance industry, state regulators, and even by the Congress. To no one's surprise, in 1945 Congress passed a law, now popularly known as the McCarran-Ferguson Act, that exempted the insurance industry from federal scrutiny. In McCarran-Ferguson, Congress reaffirmed its right to regulate insurance but declared that it would not exercise that prerogative so long as states met their regulatory responsibilities. Many both inside and outside the insurance industry believe that McCarran-Ferguson is obsolete and should be overturned.

Insurance is regulated today by the individual states, and each can regulate in the manner it chooses. Every state has an insurance department created by the legislative branch that answers to the governor or a cabinet level officer. These departments vary greatly in size, resources, regulatory philosophy, and state-granted legal authority. A Commissioner of Insurance is appointed or elected for a term of office and is charged with administering insurance regulation in his/her state. Although a part of the executive branch, the commissioner in every state is empowered to make rulings that have the force of law. They may also exercise judicial power in interpreting and enforcing insurance laws.

The commissioner's regulatory authority runs the gamut of insurance operations. It involves the licensing of companies, examination of companies, detection of potential insolvencies and managing those that occur, supervising insolvency funds, evaluating asset and reserve valuations, approving policy forms, investigating complaints of policyholders and others, controlling unfair practices, and determining competency of agents, brokers, and in some cases adjusters and counselors. Regulatory concerns today focus primarily on solvency.(2)

National Association of Insurance Commissioners

All insurance commissioners belong to the National Association of Insurance Commissioners (NAIC). This body has been a constructive force in the formation of policy and the development of regulations for the insurance industry since its inception in 1871. Although it is not a government body and has no enactment or enforcement powers, it is still important. The model bills that the NAIC has promulgated, have brought greater uniformity with respect to laws, regulatory standards, and financial requirements in the fifty states.(3)

Federal Encroachment

While the regulation of insurance is largely left to the states by McCarran-Ferguson, a number of federal agencies, perhaps a dozen or more, carry out federal regulations. The federal government is becoming increasingly involved in insurance regulation as many of the problems affecting the image and questions about the performance of the industry remain unresolved.

In recent years, the failures of several large carriers helped to raise questions about the efficacy of state vs. federal regulation. The issue of who regulates insurance is of increasing concern to those both within and outside the industry as it faces unprecedented public and political challenges. Federal regulation remains a possibility because the SEUA case opened the door that was not completely shut by McCarran-Ferguson. Advocates of both state and federal regulation have strong arguments for their respective viewpoints.


Those supporting state regulation base their case primarily on flexibility and workability. Here are some of their arguments:(4)

1. State supervision of the massive and complicated insurance industry is not perfect, but it has proven reasonably satisfactory in controlling the industry and providing citizen protection. Failure frequency has been relatively low. The system works and it would be unwise to scuttle it for an unproven system.

2. Federal regulation does not always provide a balanced and meaningful path to long-run stability. An excellent example is the spotty quality of federal regulation that led to the savings and loan debacle ($250 billion cost to taxpayers and counting).(5) Other recent Congressional attempts to regulate some part of the insurance business have been only marginally effective, with solvency almost always taking a backseat to affordability, adequacy, and availability concerns.

3. State regulation is by its nature more flexible than federal regulation. There is less red tape. The insurer and the policyholder both have proximity to the regulator, so that decisions can be made in a more timely manner. This is often superior to a universal federal solution with mechanistic, complex, and detailed regulations that do not take into account the myriad differences between states, carriers, or lines of business.

4. Voluntary cooperation of state commissioners through the NAIC has tended to eliminate or mitigate the magnitude of many problems associated with state regulation. While state regulation is admittedly characterized by lack of uniformity, the most important elements of uniformity have been achieved.

5. Even if full-scale federal regulation were implemented, we likely would still have two systems of regulation. Many insurance companies operate in only one state and conduct only intrastate commerce. Presumably, these companies would remain under the control of that state and the need for state regulation would remain. Thus we could end up with a two-tiered regulatory system like that in banking with all of the duplication and confusion inherent therein.

Opposing these arguments are those who seek a solution through modification of McCarran-Ferguson and the transfer of present insurance regulation from the states to the federal government. Here are their major arguments:(6)

1. The multiple state system of insurance regulation is a crazy-quilt pattern of laws, rules, forms, and procedures through which runs only a thin thread of uniformity. Insurers face a bewildering array of laws and regulations and vastly different regulatory environments in the several states. For example, a carrier selling a given policy nationwide is required to amend its policies to meet the regulatory requirements and conditions in fifty jurisdictions, an enormously expensive and complex task. The cost of this regulatory burden is borne by individual policyholders and by corporations who pass it along to employees through lower benefits and pay and to customers through higher prices.

Similarly, little uniformity exists among states with regard to rate regulation. Insurers have charged that states sometimes impose unreasonable and cumbersome controls over how insurance is priced and sold. This reduces availability of coverage to corporate risk managers and individuals, bloats residuals markets because carriers find it unprofitable to provide coverage in voluntary markets, and forces inequitable cross-subsidies. In extreme cases, carriers have been forced to withdraw from one or more states because the commissioners would not approve reasonable rates.

2. State regulation is overlapping, confusing, and relatively ineffective in detecting impending insolvencies, particularly for companies that operate nationwide. In most states, the standard financial examination procedure is performed trienially, but in some states it is performed only once every four or five years. In many cases there is improper oversight for companies in high risk categories, such as new or financially troubled carriers or those not rated by the rating agencies. Also, there is a lack of regulatory coordination between states.

3. Federal regulatory legislation would be better formulated and written because federal legislators are full-time representatives while state legislators serve part-time and have less time to study legislation. Similarly, federal regulation would bring with it more highly paid and more highly qualified staff personnel.

4. Because the insurance industry is becoming increasingly international in scope, the current system of state regulation is a barrier to competition for out-of-country business. Severe limitations exist when fifty separate entities attempt to regulate a business with international dimensions. A comprehensive federal regulatory mechanism is needed because the current state regulatory system is out of date and inappropriate for today's competitive global market.


Congress has leveled harsh criticism at the current system of state regulation in recent years. A number of bills have been introduced that would preempt state regulation of insurance and replace it with complete or partial federal oversight.(7) Before examining the Congressional inquiries, the conditions that gave rise to legislative scrutiny will be reviewed.

An Economy In Crisis

To understand Congressional attention to the issue of insurance regulation in recent years, one must look at the economic condition of the industry during this period of uncertainty and instability. First, there were substantial changes in the structure of the insurance industry in the late 1970s and 1980s. Financially oriented conglomerates began purchasing insurance companies and siphoning off their reserves to provide cash for the current acquisition and/or future acquisitions. This situation helped contribute to severe reserve shortages and the liability insurance crisis that developed in the mid 1980s. The overall impact was to tarnish the image of insurers though the problem was not entirely of their making.

Second, the characteristic "soft market" of the inevitable underwriting cycle lasted from 1975 to 1984, a record number of years. In the face of rising interest rates and excess capital, underwriting ran amok when insurers abandoned their traditional conservatism in pursuit of easy profit. Prices were slashed as cash flow provided by higher investment returns more than offset underwriting losses. Also, coverage limitations were increased on traditional product and liability policies and coverages were expanded on new contracts.

The fierce and prolonged price war ended when interest rates declined in the mid-1980s. Companies that two years earlier were engaged in intensively competitive underwriting now found themselves with inadequate rate structures not offset by investment income. Underwriting losses soared and in the face of a general rise in prices, escalating claims costs outran established premium rates. Competitors began to leave the market and supply diminished, putting great pressure on prices. Capacity was reduced even more when reinsurers began to withdraw their capital, forcing direct carriers to increase their retention or curtail the amount of business they wrote, which further exacerbated the price increases. By the mid-1980s, many types of liability coverage were unavailable or unaffordable. The market practically dried up in some lines, leaving many corporate risk managers without the protection they needed. Carriers that were unable to withstand the double whammy of lower investment income and higher claims costs were forced out of business. There were record operating losses and an unprecedented number of PC insurance company failures in 1985.(8)

Finally, changes in the legal and social systems in the early and mid-1980s created new financial exposures and added to the woes produced by the underwriting cycle. At a time when the public was becoming increasingly litigious, the courts became more liberal in the interpretation of insurance laws and adopted a growing "entitlement" philosophy that often resulted in damages being paid from the deepest pocket. Consequently, extraneous damage awards in almost every liability field expanded enormously as increasing amounts of time and money were devoured in litigation. These costs had a devastating effect on the industry's bottom line, placed greater pressure on distressed companies, and helped to focus unfavorable Congressional and media attention on the problems in the industry.

In this discomfiting milieu Congress began debate on reform that would effect enormous change in the insurance industry. Politicians sensed an emerging issue with voter appeal. The consumer movement generally was gaining momentum and some consumerists had already locked into the insurance reform issue. Also, action was being taken or threatened by state legislatures to change the industry rating system, roll back rates, eliminate underwriting standards, and assess insurers for costs of residual market programs. The time was ripe for broadbased political regulatory challenges.

Several members of both Congressional chambers have introduced bills and held hearings on regulatory reform. Rep. John Dingell (D-Michigan), Chairman of the House Energy and Commerce Subcommittee on Oversight and Investigations, has been the most persistent and outspoken Congressional critic of the current insurance regulatory system. He has attempted repeatedly to show that state regulation is inadequate and has introduced legislation to that effect.(9)

The Dingell Report

Rep. Dingell's subcommittee issued a scathing postmortem report in February, 1990, (ominously entitled "Failed Promises") on the factors contributing to three of the twenty-five PC insurance company failures in 1986 (Transit Casualty, Integrity, and the Mission) and one of the thirty-five failures in 1988 (Anglo American). The report identified several common features of the four insolvent companies prior to failure: unbridled expansion, underpricing, delegation of key operations to outside parties without adequate oversight, maintenance of inadequate loss reserves, poor reinsurance transactions, and fraudulent activity. It noted that state regulators too infrequently cracked down on companies for clumsy underwriting, risky investment and shaky reinsurance. The report indicated that these kinds of problems were prevalent in the PC business and were symptomatic of serious deficiencies in state regulation.

The Dingell Report also strongly criticized the unreliability of financial information contained in the NAIC quarterly and annual financial statements submitted by carriers to the appropriate officials in the states where they operate. The message was clear: the financial statements must be supplemented with additional information (such as the company's spread of risk, soundness of the reinsurance program, competency of management, adequacy of loss reserves, and current market value of assets) before a reliable estimate can be made of a company's financial strength.

Rep. Dingell has also questioned the role and effectiveness of the NAIC. He has asked several questions on the NAIC's policing agenda: how much authority does it have to control state insurance regulation, what resources are at its disposal, does its committee system respond too slowly to meet rapidly changing regulatory needs, and who sets its agenda and influences its actions. Serious reservations were raised about states' commitments in designing an effective regulatory system under the aegis of the NAIC.

Critics took issue with the conclusions of the Dingell Report and decried it as an indictment of the entire insurance industry based on the performance of a few companies. They questioned the parallels it drew between the insurance industry and the savings and loan industry. Irresponsible behavior and fraudulent schemes of the later have been far less frequent than in the former. PC failures per year from 1985 to 1992 ranged between 0.5 percent and 1.0 percent of all companies and never involved more than 0.5 percent of the industry's premium volume. Only forty-one companies failed nationwide in 1992. Proponents of state regulation contend that this is hardly a savings and loan debacle!(10)

The Dingell Recommendation

After months of hearings on insurance company insolvencies and inefficiencies of state oversight, Rep. Dingell introduced a bill (the Federal Insurance Solvency Act; HR 1290) in 1993 that would create federal regulation over insurer solvency. The bill provides for a broader federal preemption of state regulatory powers than the solvency bill sponsored by Mr. Dingell in 1992 (HR 4900).(11)

Mr. Dingell's mandate would create a Federal Insurance Solvency Commission (FISC) to establish standards for solvency for all insurers and reinsurers who sell in more than one state. Insurers could choose between state and federal regulation with regard to solvency. Companies that opt for federal oversight and who meet the FISC standards would be able to write business throughout the country free from state solvency regulations. Companies remaining subject to state regulation for solvency would have to meet those same uniform, national standards, although the states would administer them. The federally certified insurers would be members of a prefunded national guaranty association to pay the claims of those that become financially impaired or insolvent.

States would continue to regulate rates and policy forms, tax insurance companies, and run residual market pools. They could not discriminate against federally certified carriers in any of these areas. States would also be prevented from creating exit barriers on federally certified companies.

The proposed legislation also recognizes the unique needs of large corporate buyers and the carriers that sell to them. Highly capitalized insurers that sell commercial coverages to large corporations would be free from state regulation of rates, forms, or market conduct. The FISC would regulate market conduct but not the rates and forms for these carriers. The Dingell legislation would also nationalize licensing requirements through the creation of a national registry of agents and brokers. This would reduce the duplicative regulatory requirements imposed on producers who sell in more than one state.

In addition, the Dingell bill would federalize the regulation of both domestic and out-of-country alien reinsurers. Reinsurers, like commercial insurers, could receive federal licenses and be regulated by federal authorities, thus relieving them of onerous state licensing procedures. Nonbranch alien reinsurers would have to meet additional requirements, including submission to U.S. legal jurisdiction and maintenance of large trust funds in the U.S. They would also face tougher accounting and actuarial standards and more stringent surplus and financial responsibility requirements than they would under state regulation. However, price would not be regulated for these firms, under the assumption that competition is the best rate regulator for markets where both buyer and seller are sophisticated.

As noted, the Dingell proposal would involve a federal insolvency system that would develop, implement, and enforce a national solvency program for insurers selling in more than one state. Mr. Dingell and others believe that the current guaranty program imposes a double burden on responsible insurers who are undercut on price by companies they sometimes are later compelled to bail out. The costs of guaranty funds become, in effect, taxes on solvent carriers for the sins of those who are less responsible and end up in bankruptcy.

Mr. Dingell has indicated his belief that appropriate legislation and federal regulation could halt many insurance company failures. He points out that, while many insolvencies are due to the exigencies of the marketplace, many others can be traced to incompetent or fraudulent management. The figures bear out his contention. The A.M. Best Co. reported in 1992 that the major causes of the 372 insolvencies from 1969 to 1990 were inadequate pricing/deficient loss reserves (28 percent), rapid growth (21 percent), alleged fraud (10 percent), overstated assets (10 percent), significant change in business (9 percent), reinsurance failure (7 percent), and miscellaneous (15 percent).(12) These data show that a large proportion of insurance company failures can be traced, directly and indirectly, to exogenous factors associated with the urderwriting cycle or to mismanagement/fraud in the failed companies. Mr. Dingell believes that efficient oversight could have reduced the number of failures significantly.

Insurance groups are split over the efficacy of the dual regulatory system. Its advocates, including large national and international insurers, brokers and large corporate purchasers, say that it would be far simpler to deal with a central regulatory authority than fifty territorial protectors. Critics say that the Dingell proposal represents dual regulation at its worst, with no credible evidence that it would either improve regulatory efficiency or reduce costs. They say that it would force insurance company rehabilitation and liquidation proceedings into the overburdened federal courts, delaying resolution of policy holder claims against the failed companies. There would be competing insurance guaranty funds and insolvency administrations for state vs. federally chartered insurers. There would, in short, be a confusing jumble of regulation. As might be expected, the stinging criticisms of state-based regulation in the Dingell Report (and other sources) have stimulated the NAIC and individual state insurance departments to take drastic action to forestall federal intervention.(13)


State governments have cooperated through the NAIC for about 122 years. Although adequate funding to perform regulatory duties has been a nagging problem for state insurance departments from the beginning, the amount of state regulatory resources has improved in recent years. Annual funding for departments rose to $503 billion in 1991, up 116 percent from six years earlier. However, vast disparities exist between states; the budgets of the five states with the largest expenditures make up over one-half of all regulatory dollars.(14)

That some fraud has been involved in the insurance industry in the past decade appears indisputable. However, states and the NAIC have now refined their examination procedures and it will be more difficult for miscreants to escape detection in the future. The NAIC has developed a comprehensive insurance examiners' handbook, a statutory accounting practices and procedures manual, and educational requirements as well as improved educational opportunities for examiners. Also, the Insurance Regulatory Information System (IRIS) tests, while criticized by some as being outdated, have for two decades enabled the NAIC and state regulators to analyze data and procedures to provide an early warning of companies that are candidates for insolvency. Other promising tests to predict insurance failures have also been offered.(15)

To improve the state regulatory system and to develop greater uniformity and consistency in state regulation, in 1989 the NAIC adopted a Financial Regulatory Standards and Accreditation Program. The purpose of the program is to curb federal intervention in insurance regulation by setting rigorous regulatory standards and getting the states to accept them. In 1990, the NAIC began a formal accreditation program under which an NAIC audit team examines state insurance departments to determine if they are in compliance with the standards. As of April, 1993, nineteen states have been accredited and twenty-three others have initiated action to bring themselves into compliance. To encourage states to meet regulatory requirements, accredited states will not accept reports of unaccredited ones beginning in 1994 (except in limited cases). This should goad lagging states to bring their departments up to accreditable standards. The hope, of course, is that a nationwide system of consistent and uniform regulation will develop.(16)

The NAIC is also considering creating interstate compacts as a means of achieving comprehensive and consistent application of guaranty fund and liquidation proceedings. Critics charge that the current patchwork system of handling and controlling guaranty funds is one of the most visible weaknesses in the state-based system of state regulation. A related deficiency is the lack of coordination of rehabilitation and liquidation of insurance bankruptcies. These procedures are expensive and time consuming. Furthermore, the inevitable interstate rivalries that emerge when large multistate insurers undergo rehabilitation or liquidation not only tarnishes the image of state regulators but also compromises the financial security of policyholders and creditors. The NAIC is at present studying a proposal that would create a compact among the states for the establishment of a single commission to oversee the orderly liquidation and rehabilitation of insurance bankruptcies nationwide. The plan has appeal to state regulators, and possibly to the NAIC, because it is a coherent plan for creating a binding and uniform guaranty system that would help forestall federal regulation.

The NAIC has continued to draft model laws as it has since inception. However, the pace has quickened in recent years as the insurance business becomes more complex and Congress continues to scrutinize its activities. Many of the model laws have not received widespread public attention but could be significant in preventing recurrences of abuses leading to insolvencies.(17)


Even though the issues of insurance regulation and solvency have been the subject of Congressional and media scrutiny, it does not appear that the insurance industry is near a financial collapse similar to the savings and loan imbroglio. The asset base of insurance companies is well diversified and key ratios that measure financial strength have improved in recent years. This includes the net present worth to either policyholder surplus or loss reserves. Furthermore, those ratios that are comparable between the insurance and savings and loan industries -- such as net worth to assets -- favor the insurance industry by a significant margin. This relatively favorable position reduces the outcry for regulatory reform.

In spite of increased Congressional scrutiny of the insurance industry, the critical mass for change to a federally based regulatory system has not developed and does not appear imminent. Perhaps the most important reason, aside from Congressional inertia, is the tremendous political pressure from those who benefit from the "industry of regulation" to leave the state-based system intact. If federal regulation were introduced, many state regulatory jobs would be lost and states would suffer financially due to the loss of premium taxes, licensing fees, and penalties for violations. Producer groups and most carriers would vehemently oppose such a move. In spite of the continuing clamor, broadbased support necessary for fundamental change in insurance regulation does not appear to exist.


1 Brenda Noonan and Rick Pullen, "Insurers Search for One Voice, And Find Too Many," Best's Review, March, 1992, pp. 115-117.

2 Emmett Vaughan, Fundamentals Of Risk And Insurance, 6th ed. (New York: John Wiley and Sons, 1992), pp. 90-92.

3 Douglas McLeod, "State Regulation Under Scrutiny," Business Insurance, December 7, 1992, pp. 3, 10 ff.

4 Mary Rowland, "Reflections On Regulation," World, Spring, 1989, pp. 31-35, and Steven Sullivan, "The State Of State Regulation," Life Association News, April, 1993, pp. 84-90.

5 "Society's Position On State Versus Federal Regulation," Society Page, June, 1993, p. 11.

6 Larry Light and Christopher Farrell, "Are You Really Insured?," Business Week, August 5, 1991, pp. 42-48, and Steven Brostoff, "AIG Chief Calls Insurer ROE 'Pitiful'," National Underwriter (Property & Casualty and Benefits Management edition), May 25, 1992, pp. 4 ff.

7 Sullivan, "The State of State Regulation," pp. 84-90, and Steven Brostoff, "Metzenbaum Savages Insurers, Agents," National Underwriter (Life & Health/Financial Services edition), May 31, 1993, pp. 1 ff.

8 "Best's Insolvency Study, Property/Casualty Insurers: 1969-1990," Best's Review, August, 1991, pp. 16-23.

9 Emilio Palermo, "Insurer Insolvency: S&L Does Not Equal P&C," CPCU Journal, September, 1991, pp. 140-151.

10 "Best's Insolvency Study, Property/Casualty Insurers: 1969-1990," pp. 16-23, and Angela K. Calies, "Dingell Seeks Input On Solvency Bill," National Underwriter (Property & Casualty/Risk & Benefits Management edition), March 29, 1993, p. 4.

11 Steven Brostoff, "Insurance Groups Split Over Dingell Bill," National Underwriter (Property & Casualty/Risk & Benefits Management edition), March 22, 1993, pp. 4 ff.

12 "Best's Insolvency Study, Property/Casualty Insurers: 1969-1990," pp. 16-23.

13 Sullivan, "The State of State Regulation," pp. 84-90; and Steven Brostoff, "GAO Skewers State Regulators," National Underwriter (Life & Health/Financial Services edition), September 14, 1992, pp. 1 ff.

14 Meg Fletcher, "Money, Staff Add Up To Superior Insurance Regulation," Business Insurance, December 7, 1992, pp. 3 ff.

15 Kenneth W. Hollman, Robert D. Hayes, and Joe H. Murrey, Jr., "A Simplified Methodology For Solvency Regulation Of Life-Health Insurers," Journal of Insurance Regulation, Summer, 1993, pp. 509-522.

16 Sullivan, "The State Of State Regulation," pp. 84-90.

17 "Alliance Annual Meeting-Critical Choices Face Insurers," Best's Review, May, 1991, pp. 10-11; Fletcher, "Money Staff Add Up To Superior Insurance Regulation," pp. 3 ff; and Donald Helperin, "The Compact Solution," Best's Review, June, 1993, pp. 57-59.

Robert D. Hayes is Associate Professor of Accounting and Business Law, Tennessee State University, Nashville, TN; E. James Burton is Professor of Accounting, Middle Tennessee State University.
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Title Annotation:The Insurance Industry, Retrospect and Prospect
Author:Hollman, Kenneth W.; Hayes, Robert D.; Burton, E. James
Publication:Business Economics
Article Type:Industry Overview
Date:Oct 1, 1993
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