by: Lori Widmer

While the financial crisis has put all financial institutions, including the insurance industry, under a microscope, it is not as though the latest push for an optional federal insurance charter is unique. In the 1980s, the idea of federally regulated insurance standards was given new life after the savings-and-loan meltdown. The thought then was that insurer insolvencies were in some way related to the insolvencies and mismanagement associated with failed savings-and-loan associations.

Since that time, the debate has continued with supporters promoting the benefits of federal oversight, opponents doing their best to raise awareness of the problems a national insurance regulatory system could create and lobbyists going hoarse waging verbal warfare from either side. Every financial or economic meltdown has brought the attention back to an issue that incites deep passions on both sides of the equation. It seems like all that has changed are the sponsor's names on the bills.

The Search for a Solution

In 2001, Senator Charles Schumer (D-NY) introduced the National Insurance Chartering and Supervision Act bill. In 2002, Representative John LaFalce (D-NY) proposed the Insurance Industry Modernization and Consumer Protection Act, which would have established federal oversight of insurance regulation above the state regulatory system. More recently, Senator John Sununu (R-NH) co-sponsored a bill with Senator Tim Johnson (D-SD) called the National Insurance Act of 2006 (and again with a bill for the National Insurance Act of 2007).

The bill that is receiving the most attention today, however, is House Bill 3200, presented by U.S. Representatives Melissa Bean (D-IL) and Ed Royce (R-CA). Also called the National Insurance Act of 2007, this bill attempts to mirror a dual banking system regulatory structure. The choice is still there-insurers can choose either federal or state oversight.

But is that choice the right solution? According to Francine Semaya, partner at the New York-based law firm Nelson Levine de Luca & Horst, looking to federal oversight is not going to solve the problems. ''Is the optional federal charter the panacea?'' she said. ''Is that what's going to come in and save the insurance industry? Personal opinion-no, and I'm not the only one who will say no. But we're frustrated with state regulation. A lot of people are frustrated. I'm the first to admit we need to modernize and we need to do it more quickly. The insurance industry does not move fast enough.''

Also in favor of federal oversight is Eli Lehrer, senior fellow at Competitive Enterprise Institute in Washington. But Lehrer is cautious in supporting an optional federal charter. ''We think a properly constructed optional federal charter would tend to remove the restrictions that stop the free market from working for insurance,'' said Lehrer. ''We don't support any optional federal charter. It has to be an optional federal charter that more or less eliminates rate regulation, at least upwards rate regulation, and reduces form regulation to a common-sense minimum. A common-sense minimum for form regulation would essentially make sure utmost good faith could be sustained.''

Robin Harbage, senior consultant with EMB America, works with both those supporting and those opposing the charter and believes changes of some form are imminent and necessary. ''The lines between states are blurred,'' he said. ''Unlike the old days when agents operated in one town and never saw business in other areas, this world is completely different. That will accelerate what's going on. But you have so much proprietary concern about my little world from independent agents that do not want national competitors, regional companies that operate one-state or small multiple-state operations.''

So if not federal, why not state? Simple-the state system is antiquated at best, says nearly everyone involved in this debate. While individual states do well to address regulatory issues, the system itself is in dire need of an overhaul.

Minding the Details

What is not clear is how, and frankly which, guaranty fund would respond to insolvency or other issues in the insurance industry. To date, state guaranty funds are the only source of protection for consumers should insolvency, corruption, terrorism or bankruptcy bring down one or more large industry players. The most recent proposed optional federal charter (OFC) bill makes mention of a federal guaranty fund, but questions surround when it would respond, if it would replace state funds, and if not, which one pays first.

The Bean/Royce bill creates an Office of National Insurance and puts branches in every state. It would also create a systemic risk regulator who would oversee insurance firms considered ''systemically important.'' The scope of the regulator's duties and the definition of what constitutes systemic risk has yet to be determined.

Despite the bill providing for an Office of Insurance Information inside the Treasury Department, which is the precursory move to any federal charter system, there remains much uncertainty regarding how a federal charter might be set up, who would be in charge, at what point the federal office leaves off and the state office regulation begins, and who is in charge in an investigation of malfeasance or bankruptcy.

Systemic Risk and Holding Companies

According to William Latza, partner in the New York office of the law firm Stroock & Stroock & Lavan, federal regulation of insurers has been introduced to the industry because some companies desire to position portions of their businesses as holding companies. ''You have insurance groups now buying small banks and so on and turning themselves into bank holding companies so that in some cases they can avail themselves of federal funds,'' he said. ''It's somewhat restrictive now, but nevertheless, you have companies such as The Hartford, which is now a holding company. A bank holding company brings with it a bunch of things, not the least of which is group supervision by [a banking regulatory body]. Banking regulation is quite different from insurance regulation in that banking regulation focuses on the health of the group and focuses its regulatory bite at the holding company level.''

Latza also suggests that moving into holding-company status sets an insurer up for systemic risk exposure, which may make the move toward federal regulation more necessary than ever. ''The poster child for the need for a systemic risk regulator is AIG,'' he said. ''Insurance companies are going along their merry way being regulated by the states, but now are offering financial products, which is exposing the holding-company system to this whole issue of risk and regulation.''

In a situation where the state government is regulating insurance and the federal government is regulating banking, companies like AIG fall through the cracks, said Latza. ''If you have silo regulation, it sets up the situation where it wasn't anyone's job to assess the unregulated risks that AIG was exposing itself to or the systemic impact of those risks. That will be a strong force for some kind of federal regulation.''

Systemic risk and the onset of holding companies within insurance companies may be exactly the situations that might soon require federal oversight of insurance. At worst, it calls for a revamping of the state regulatory system to either deal with or separate out the two disparate business units that, while unconnected, do indeed affect the system.

Given such risks, the current administration is entertaining the notion of a federal oversight system of some sort. Federal Reserve Chairman Ben Bernanke testified before the House Financial Services Committee in February 2009 with thoughts on such oversight. ''The issue of the option of a federal charter for insurers is a complex one and there are a lot of issues involved, but to cut to the bottom line, I think that it would be a useful idea to create a federal option for insurance companies, particularly for large systematically critical insurance companies. And in general, holding company-level supervision of systematically important institutions is very important.''

Opposition Lives On

On September 10, 2008, the National Association of Insurance and Financial Advisors (NAIFA) voted overwhelmingly to support the optional federal charter concept, but with conditions including: true agent choice, enhanced consumer protections and the preservation of state regulation, along with a single federal entity experienced in insurance to oversee it all. NAIFA agreed to support such legislation that clearly addresses those issues. The goal, according to a NAIFA press release, is ''to pursue a dual state and federal track approach to achieving regulatory reform.''

While NAIFA may have come to a compromise of sorts, other groups are not so eager to leave behind a state-based system. The National Association of Professional Insurance Agents (PIA), the National Conference of Insurance Legislators (NCOIL), the Independent Insurance Agents and Brokers of America (IIABA), the National Association of Insurance Commissioners (NAIC) and the National Association of Mutual Insurance Companies (NAMIC) all oppose a federal charter.

NAMIC testified before a Senate hearing on insurance regulation in March, stating ''NAMIC supports a reformed system of the state-based regulation of insurance. Weaknesses in federal banking solvency regulation can be seen in the 25 banks that failed last year and the 17 that have already failed this year,'' said John T. Hill, president and COO of the New York-based Magna Carta Companies and chairman-elect of the NAMIC board of directors. ''Contrast this with the property/casualty insurance industry that had an excellent solvency record in 2008 in spite of a large drop in investment income and Hurricane Ike, the fourth most-expensive hurricane in U.S. history. The state-based insurance regulatory system has, in fact, proven to be one of the few bright spots in our nation's regulatory structure.''

It is important to point out the record of state regulation. According to NCOIL, ''The stability of state-regulated insurance companies during this ongoing financial crisis, as compared to other financial sectors, demonstrates the effectiveness of our state insurance laws and regulations...we are proud to note that state-regulated insurers were largely unharmed when compared to federally regulated banking and investment institutions.''

Blain Rethmeier, spokesperson for the American Insurance Association, which favors a national federal charter, said this about the move: ''We're looking at trying to put forth a structure that has smarter, more effective regulation that supports the growth of healthy and private markets while at the same time providing safety and soundness not only for companies, but also for consumers.''

What About State Reform?

Do not count the states' efforts out, however. Individual states are addressing regulatory reform, mostly in the area of rate regulation, to better streamline the process. While it may not be getting the same amount of press, the reform of the state system is indeed occurring behind the scenes. Last year, PIA released its Roadmap to State Regulatory Modernization, a 16-page outline of current state-based inefficiencies along with proposals to improve. NCOIL and NAIC are working to create a more modern state system, including ''speed-to-market for life products, rate and form filing, market conduct examinations, and agent and company licensing, among other initiatives,'' according to an NCOIL letter dated October 20, 2008 to U.S. House Committee on Financial Services Chair Barney Frank.

States are beginning to realize that more action is needed and at a much faster pace, and that collective efforts involving all states in terms of a commonly shared oversight format would bring harmony to the state system. Yet keeping regulation at a level that is working is possibly one reason why states have not made sweeping changes already.

The goal then is to move to an open, competitive, all-states oversight, coordinated with federal authorities and with all-state-federal insurance authority. The problem is getting there. Individual states are modernizing separately from any combined effort. Beyond the NAIC and NCOIL attempts to drive some degree of uniformity to regulation movement is slow, but opposition to a federal oversight is as strong as ever.

Robert Detlefsen, vice president of public policy for NAIC, concedes that there is one benefit to an optional federal system-streamlined filing. But that the oversight at the federal level, layered onto the state oversight, ''won't be optional-it will be mandatory. Then the only question will be is it mandatory to the exclusion of state regulation, or is it another layer-a federal layer-of insurance regulation on top of state regulation? I think most folks on either side of the debate would agree that the prospects for an optional federal charter approach are very, very slim.''

Nowhere does anyone suggest or expect the current regulatory system to become a single governing entity with streamlined regulations and singular oversight. ''It's going to be the nature of state-based regulation that you're not going to see absolute uniformity,'' said Detlefsen of any move to modernize and standardize. ''Arguably, one of the virtues of the state-based regulatory system is that states can tailor their regulatory regimes to meet the particular circumstances related to insurance risk that vary from state to state.''

Some argue that regulation of insurers has already occurred thanks to the holding-company formations in the past decade. And many say the AIG situation is one more reason why federal oversight is necessary.

Yet the portion of AIG business that was regulated at the state level-the holding company business-was not regulated properly, in the opinion of most experts. Detlefsen finds that confusing. ''There's a certain irony in the fact that we're talking about possibly applying federal regulation to insurance companies when true insurance companies have been among the few exceptions in the financial services sector that have not experienced the kinds of difficulties that other institutions have experienced. That in part is a tribute to a conservative, prudent approach that insurers have historically taken to their investment strategies and their capital requirements they set for themselves, as well as the state-based system of regulation they are responsible to.''

With or without a federal insurance regulatory system, most would agree the status quo is in need of updating. Questions remain, however, about whether federal oversight into holding company units of insurers is adequate, if such oversight will spill into the insurance side, if insurers have demonstrated enough compliance and caution to avoid oversight at the federal level, or even if the states can join forces to improve a system that is sound at the foundation but not growing quickly enough to meet the demands of business reaching far beyond the borders of all 50 states.

How will this all be resolved? Stay tuned.


Lori Widmer is a freelance writer and editor specializing in risk management and business topics.