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Wrestling over insurance regulation.

Although states are responsible for regulating insurance companies, Congress is threatening pre-emption in response to company failures.

In April 1991, the California Department of Insurance seized the Executive Life Insurance Company of California. New York regulators acted that same month to seize the New York subsidiary of Executive Life. The failure of one of the nation's largest life insurance companies, which had speculated heavily in low-grade "junk" bonds, shook the confidence not only of big-time investors but also of thousands of working Americans who depend on insurance companies for income protection and a comfortable retirement.

The increasing number of insurance company insolvencies has galvanized state legislators seeking to reform state solvency regulation. Insurance regulation is entrusted exclusively to state governments. The guaranty fund system for protecting policyholders also is a state responsibility. But the rash of insurance company failures has moved Congressman John Dingell and Senator Howard Metzenbaum to introduce bills that would pre-empt state authority and impose a federal scheme of regulation. The state reform effort is intended both to protect the public and ward off this threat of federal pre-emption by demonstrating that the states can do the job.

John Garamendi, California's insurance commissioner, in announcing the Executive Life takeover, noted that $6.4 billion of the company's $10.1 billion in assets was invested in junk bonds. According to Garamendi, a decade of deregulation "fostered an ethic of greed that haunts us today." Among the casualties of the junk bond era, Garamendi continued, were the hundreds of thousands of people who entrusted their savings to Executive Life.

Other major failures in 1991 included First Capital, based in California and Virginia, and Mutual Benefit Life in New Jersey. The failure of Mutual Benefit was particularly disturbing because the company had a reputation for conservative management. Mutual Benefit had trouble with its real estate portfolio, a traditional area of investment for life insurers that was once regarded as relatively safe. But after the shakeout of commercial real estate markets on the East and West coasts, such holdings pose a risk to many insurers.

Altogether in 1991, 27 life and health insurance companies were reported to be impaired or insolvent, according to the National Organization of Life and Health Guaranty Associations (NOLHGA). Until recently, the number of life and health company failures was very low. In 1981, only five life and health companies were deemed impaired or insolvent, and in 1982 only four companies faced such troubles. By 1989, however, the number of insolvent or impaired companies had increased to 44; in 1990, 29 life or health companies were in trouble.

Although its financial characteristics and potential solvency problems are distinct from the life and health insurance industry, the property and casualty insurance industry also has problems. Between 1970 and 1980, 108 property and casualty insurance companies failed. But between 1980 and 1990, the A.M. Best Company reported that 226 property and casualty companies went under. Public confidence was shaken in particular by the 1985 failures of Mission Insurance and Transit Casualty.

Perhaps the best indicator of the accumulating financial problems of insurance companies of all types is the amount of money assessed by state guaranty funds to pay for insolvencies. When an insurance company fails, under the state-authorized guaranty fund system, healthy companies are assessed to compensate policyholders of failed companies. The National Conference of Insurance Guaranty Funds (NCIGF) reports that in 1980 assessments for property and casualty insolvencies totaled $14.4 million. In 1985, property and casualty assessments amounted to $316 million. In 1989, they reached $772 million. Assessments to cover the insolvencies of life and health insurers rose even more rapidly, according to NOLHGA, from a mere $3.7 million in 1980 to $161 million in 1989.

Among the people affected by the Executive Life failure, according to Pennsylvania Representative Curtis S. Bowley, were hundreds of constituents in his legislative district, including 438 retirees and employees about to retire at the National Forge Co. in Irvine. In 1987 National Forge cashed out its pension program and provided in its place retirement annuities purchased through Executive Life. Workers were told that the annuity provided the same security as the pension plan. But when Executive Life collapsed, annuity payments to National Forge retirees were cut by 30 percent. "I don't think it is fair to the workers," Bowley says, "that they should lose part of their pensions."

The threats to retirement annuities and other life insurance investments to date have been largely related to poor investments in junk bonds, real estate and mortgages. But the solvency problems of life insurance companies may be larger than that, according to a March 1990 report by IDS Financial Services: "With an emphasis on selling more guaranteed interest-rate products, many insurers have assumed levels of business and investment risk that are too high relative to their ability to absorb losses."

The solvency problems of property and casualty companies are different. Patricia Wilson of the American Insurance Association says property and casualty companies face liability problems in contrast to the life and health industry where "insolvency is connected to asset weakness from non-performing commercial real estate and junk bonds."

Marty Leary of the Southern Finance Project agrees that "the structures of the industries are different." But he believes that property and casualty companies, despite being more risk-averse than life and health companies, face investment risks in the form of cash flow underwriting, the practice of underpricing policies in the hope that investments will compensate for losses. Leary calls this "betting on interest rates," which is as much a problem of investment as of underwriting. Leary also believes that the easy entry into the property and casualty business allowed by some states further contributes to solvency problems.

The investigation by the U.S. House Committee on Energy and Commerce of property and casualty company insolvencies found that mismanagement and fraud were at the heart of the problem. The committee's report, Failed Promises, concludes that the insurance business is an irresistible target for "financial knaves and buccaneers."

State lawmakers have been candid about the existence of these solvency problems, but have also cautioned against an exaggeration of the problem or responding in panic. Nebraska Senator Don Wesely says there are potential troubles in the industry, but states can handle them. "There will be some insurance company failures," he says. "It isn't a foolproof system, but overall the state track record on insurance is good."

Wesely says states must take immediate action to strengthen state insurance departments and to establish standards of financial regulation to bolster the financial soundness of insurance companies. Federal legislation, on the other hand, he thinks could be counterproductive.

The solvency problems of the insurance industry must be kept in perspective, Wesely believes. Few responsible reports suggest that the nation faces the immediate prospect of another savings and loan crisis in the insurance arena. Moreover, state regulators and the industry itself are to be commended for the responsible way in which they are addressing the problem, he says.

Wesely notes that in December 1990, NCSL--because of its concern about solvency problems--departed from its usual practice of not adopting policy urging the passage of particular state legislation by endorsing the model laws and other financial regulatory standards developed by the National Association of Insurance Commissioners (NAIC). Wesely calls the NAIC models "minimum requirements" for effective state regulation. NCSL's policy further urges each state "to consider whether the enactment of additional standards beyond these minimal requirements would be appropriate." In Nebraska, the Legislature adopted not only the NAIC models but also stringent new regulation of insurance company investments.

Wesely emphasizes the public interest in effective solvency regulation: The public relies on the insurance industry to pay for hospital bills and provide retirement income, income protection in case of death or disability, protection from catastrophic loss and safe investment opportunities.

Effective solvency regulation also serves to protect the state treasury. When insurance companies are assessed by guaranty funds to pay for insolvencies, many states allow such assessments, which now are running annually into the hundreds of millions of dollars nationwide, to be offset against state premium taxes. Marty Leary of the Southern Finance Project says that "the premium tax offset is a time bomb sitting under state capitols. Over the past year a number of states have lost considerable revenue." Leary claims that the Champion failure in Louisiana will cost the state between $200 million and $300 million in badly needed revenue.

Because of the need to protect the public and the state treasury, legislators and regulators are acting to reform state insurance regulation. Senator Richard H. Finan, president pro tem of the Ohio Senate, notes that Ohio moved quickly to pass the recommendations of NCSL, basically adopting the NAIC model code. "It received enthusiastic support from legislators and the Ohio Department of Insurance." Altogether in 1991, more than 40 states adopted new legislation or regulations similar to the Models. And state legislative and regulatory activity has continued at a rapid pace through 1992, with 34 states considering new laws and regulations.

Despite this impressive volume of new laws and regulations, Richard L. Fogel of the U.S. General Accounting Office notes in his congressional testimony that some standards have not yet been widely adopted by the states. For example, in 1985 the NAIC adopted a model regulation to define standards and commissioners' authority for companies in hazardous financial condition, but 32 states have yet to adopt it. Similarly, a model regulation for life reinsurance agreements that was recommended in 1986 has been adopted by only 19 states.

Even as they adopt the NAIC models, legislators are studying a variety of more far-reaching reforms of state insurance regulation, including guaranty fund reform, risk-based capital and surplus requirements, limits on risky investments, and disclosure requirements.

Many labor unions and consumer representatives express interest in strengthening the guaranty fund system. The federal bill introduced by Congressman Dingell would establish a national guaranty fund and would preassess insurance companies to build up guaranty fund reserves in anticipation of expected insolvencies. The current practice in every state except New York is to assess companies after the fact. As an alternative to federal pre-emption, some reformers suggest that state systems move to preassessment. Another idea for increasing the capacity and the equity of insurance guaranty fund is to base such preassessments on the risk of insolvency by insurance companies. In that way, the companies most likely to fail would be required to pay more.

Capital and surplus requirements also could be risk-based. Nebraska Insurance Director William H. McCartney told a congressional committee in April that states have long required life insurance companies to establish reserves for their investments in securities, the size of which are based upon the quality of the assets. But by the end of 1992, NAIC expects to have fully developed a model law and formulas for a system of capital requirements that relates to all types of risk including insurance risk, credit risk, interest rate risk and business risk.

Some states are choosing to restrict speculative investments. Because many life insurance companies failed when their risky investments in real estate, mortgages or low-grade junk bonds soured, the NAIC is closely studying proposals to regulate such investments. And several states have already acted in this regard.

Disclosure requirements are also under consideration. Bob Hunter, president of the National Insurance Consumer Organization, has suggested that states require insurers to disclose guaranty fund coverage, ratings, qualify of service, financial examination information and overhead costs. According to Hunter, rating changes can be an indication of trouble. "If the ratings goes down," he says," consumers should be notified by the company." With full disclosure, consumers can evaluate the risk as well as the reward of investment opportunities, theoretically improving the efficiency of markets and rewarding firms for prudent investment strategies.

The alternative to aggressive state action is federal pre-emption. Although there is no immediate prospect of either the Metzenbaum or Dingell bill passing, if several major insurers fail in the coming year or if states fail to improve the quality and toughness of state regulation, then a federal takeover is more likely. Moreover, an effort to establish federal insurance regulation could be sustained over the long term by international pressure and by the temptation to raid the states' $6.5 billion insurance premium tax base.

A majority of insurance companies and agents oppose federal regulation and support the state system, says Dave Farmer of the Alliance of American Insurers. But he notes that several of the large commercial insurers favor federal regulation. Peter Lefkin, a vice president of Firemen's Fund, which is owned by the German insurance giant Allianz, says that federal regulation, "would probably be a positive event." He notes that "the Europeans are making a case that the 50-state system of regulation is a violation of GATT. We found it duplicative and redundant." Joel Wood of the National Association of Casualty and Surety Agents also sees value in federally imposed uniformity.

In fact, the record of state insurance regulation, while not above criticism, compares favorably to federal regulation of banks and thrifts. In contrast to the bureaucratic lethargy of the federal bank and thrift regulators, Commissioner Garamendi moved swiftly in California to rehabilitate Executive Life. He opened a competitive bidding process that resulted in a $3.25 billion offer from Altus/MAAF for Executive Life's bond portfolio. Other investors will contribute $300 million. And NOLHGA will add $2 billion. This will protect most Executive Life policyholders with contracts of $100,000 or less. In New York, the insurance department negotiated a $1.46 billion deal for Metropolitan Life to acquire the life insurance business and single deferred annuity business of the Executive Life Insurance Company of New York.

Bill McCartney says, "While the state insurance departments have yet to complete some aspects of their plans, they and the NAIC have adequately addressed the problems of the last two years." Senator Richard Finan adds, "Federal regulation will not solve this problem. They do not have the staff, the resources or the administrative will."

State adoption of the NAIC model acts and regulations and state efforts to improve the professionalism and aggressiveness of state regulators are the best ways to ward off federal intervention. According to Jana Lee Pruitt, senior counsel of the American Council of Life Insurance, "We are going to have to prove to Congress and the public that the system works and can be strengthened. They are loath to see a repeat of the savings and loan debacle. So I don't think you can just pay lip service. You have to take positive action to strengthen state regulation." And, says Senator Don Wesely, "we must act swiftly."

Do Retirement Annuities Need Protection, Too?

When a life insurance company collapses, it can wreck the financial plans of workers and retirees who depend on annuity income. The AFL-CIO reports that the Executive Life failure affected 90,792 workers whose 57 employers terminated their pension plans to recapture so-called |excess' pension assets and bought annuities from First Executive as an alternative form of retirement income for their workers and retirees. According to the American Association of Retired Persons (AARP), since 1980 about $20 billion has been siphoned out of corporate pension plans in this way. Also at risk when a life insurer fails are Guaranteed Investment Contracts (GICs), in which public and private pension plans are heavily invested.

Labor unions and AARP have called upon the federal Pension Benefit Guaranty Corporation (PBGC) to take regulatory action to protect retirement annuities issued by insurance companies. The PBGC is a government corporation established by federal law to insure pensions.

Organized labor and AARP argue that PBGC coverage of retirement annuities is required by federal law when workers receive such annuities upon the termination of a traditional pension plan. The PBGC and the U.S. Department of Labor (DOL) disagree with this reading of federal law. James Lockhart, PBGC's executive director, says, "There are no provisions in ERISA that provide for payment of benefits upon the failure of an insurance company." Protection is provided, he says, "by the state regulation of insurance and state guaranty funds." The problem is that guaranty funds coverage of annuities and investment products is often limited.

Extension of PBGC coverage would be welcomed by the workers at MagneTek Inc. According to Meredith Miller of the AFL-CIO, their story dates back to 1984, when the securities firm of Drexel, Burnham, Lambert arranged for an investment group to buy the Louis Allis Division of Litton Industries (then renamed MagneTek). As part of the deal, Drexel had assurances that Executive Life would purchase 40 percent of the junk bonds that would be used to acquire MagneTek. "Thereafter," Miller says, "the control of MagneTek and more importantly its pension assets rested with Drexel partnerships led by Michael Milken and Executive Life."

According to Miller, the workers at MagneTek lost their federally guaranteed pensions, which were replaced with uninsured Executive Life annuities. Since its collapse, Executive Life has been paying most retired workers only 70 percent of their annuities, though MagneTek has been making up the difference.

Model Financial Regulatory Standards

The NCSL Task Force on Insurance Company Insolvencies has been working for almost two years to develop state solutions to the problem as an alternative to federal regulation. The model laws, regulations and policies endorsed by NCSL, which closely track the financial regulatory standards of the National Association of Insurance Commissioners (NAIC), include:

* Adequate authority for insurance departments to examine insurance company finances and to order corrective actions.

* Adequate capital and surplus requirements and limits on risk retained by property and casualty insurers based on their capital and surplus.

* Minimum standards for liabilities and reserves.

* Requirements that insurance companies adopt adequate accounting procedures and that they value and admit assets according to recognized standards.

* Regulations to insure the safety of investments.

* Strict regulation of credit for reinsurance.

* Requirements for annual CPA audits and actuarial opinions.

* Mechanisms for placing an insurance company into receivership.

* Establishment of adequate guaranty funds for both property and casualty and life and health companies.

* Regulation of managing general agents and reinsurance intermediaries.

* Participation in the NAIC's Insurance Regulatory Information System (IRIS).

* Adequate regulation of risk-retention groups and producer-controlled insurers.

Implementation of these model acts, regulations and administrative reforms will cost money. NCSL's policy asks states to consider the imposition of special assessments on insurance companies to defray the increased cost.

The NAIC has also implemented an accreditation program that NCSL has not yet endorsed. States that fully implement the NAIC financial regulatory standards are "accredited" by NAIC. As of April 1992, nine states--New York, Florida, Illinois, South Carolina, Ohio, Wisconsin, Kansas, Iowa and North Carolina--were accredited. The NAIC expects 15 states to be accredited by the end of 1992.

There is a strong incentive for states to meet accreditation standards, Richard Fogel of GAO explained in his congressional testimony: "Beginning in January 1994, accredited states will generally not accept examination reports prepared by non-accredited states on those states' domiciled insurance companies. This could require companies domiciled in non-accredited states to get a second examination, performed by an accredited state insurance department. NAIC expects this sanction to lead insurers to lobby their home states to become accredited in order to avoid the expense of multiple examinations under differing state rules."

Questions have been raised by some legislators about whether the NAIC, a non-profit organization, is intruding upon state sovereignty by controlling the processes of drafting model laws, of accrediting states and, in 1994, of punishing non-accredited states. Although the models issued to date have been widely praised, future models may be more controversial among state legislators. In partial response to these concerns, NAIC will attempt in the future to get legislators more involved drafting models. Moreover, the NAIC sanction to be implemented in 1994, though a form of political pressure, is not a legal mandate. And it does present an alternative to federally mandated minimum standards for state solvency regulation as proposed in bills now pending before Congress.

William T. Waren is an attorney specializing in commerce, labor and regulation issues for NCSL.
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Title Annotation:includes related articles
Author:Waren, William T.
Publication:State Legislatures
Date:Jun 1, 1992
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