Washington State Insurance Commissioner Mike Kreidler, Courtesy AP

The current system of state insurance regulation stifles product innovation, limits customer choices, increases costs and inhibits the proper functioning of fully competitive markets, according to a report done for the Financial Services Roundtable’s Cluff Research Fund.

However, there is not one ring to save them, so to speak,  the report concludes unless Congress creates a federal regulator with power of all, with the ability to banish all overlap and inefficiency and to act as the first and last authority, according to the report.

The report, titled Modernizing Insurance Regulation in the United States, was prepared by two partners at Dewy & LeBoeuf  LLP and a law and health sciences deputy dean at University of Pennsylvania’s Law School, and offered two sets of reforms: those that change  the basic overall framework; and those reforms  can be implemented within the existing regulatory framework, according to the report.

However, even the mildest would be an undertaking, and involves binding national standards to sever dependence on state legislatures, while a proposed federal “passporting”system as a mid-range option before outright overall federal regulation of insurance through a network of federal agencies would require Congressional action and agency implementation.

The report comes at a time when the Federal Insurance Office in the U.S. Treasury Department is starting to collect comments from the industry and consumers and government groups on insurance modernization as part of its mandate under Dodd-Frank financial services reform.

No one perfect solution was found, with both federal and state insurance regulations facing inefficiencies, supervisory overlap, balance sheet confusion and more law-making.

The authors were quick to point out that they were mindful of the Roundtable’s longstanding goal of comprehensive reform through uniformity of regulation.

“We work from the basic premise that to the extent there are differences in regulation among states, these differences need to be justified by sound reasons,” they said.

The authors found barriers to market entry and exit in the state licensing process, from the benign form of unnecessary paperwork to real roadblocks that inhibit the development of fully competitive markets. Significantly, the reinsurance regulatory arena was found wanting, resulting in problems for the U.S. in trade negotiations.

Ironically, “recent reform measures in New York, Florida and New Jersey have created a situation where there is an even greater lack of a uniform approach for the regulation of reinsurance,” the report found.

The authors recommended some specific changes many groups have already advocated:

  • Exempt markets from rate regulation
  • Repeal seasoning requirements and state-specific license application requirements
  • Improve coordination of examinations among states and decrease reliance on contractors for exam responsibilities
  • Expand the Interstate Compact process to cover all states and other lines of insurance and completely deregulate form approval requirements for group insurance products and insurance sold to large commercial buyers
  • Deregulate group and large commercial insurance
  • Increase the harmonization, transparency and public understanding of the guarantee fund
  • Consider global best regulatory standards

The report did begin by noting that the financial regulation of insurance is apparently sound and functions well as part of the greater market.

“Solvency regulation met the test, it would seem….at no point did insurance activity appear to add systemic risk to the broader financial system or the general economy. Excluding AIG, the major multiline property-casualty insurance company failures that did occur during the past decade did not result in shocks to the insurance market, let alone the larger economy, and there were no major life insurance company insolvencies,” the report stated.

Although state-regulated insurance industry fared much better during the 2008-2009 financial crisis than the federal regulated banking industry, the report noted, AIG’s failure “pointed to the absence of any meaningful group supervision of insurance enterprises.”

This problem could become more significant due to the overlapping and at times inconsistent regulation by state insurance regulators coupled with Federal bank exercising authority under Dodd-Frank to supervise any insurance holding company designated as systemically significant, the report warned.

The terracing of reforms suggested in the Cluff report begins by apparent retention the existing state-based framework  but fostering  uniform, national standards through state action and with a state voluntary agreement for  binding national standards that are developed on a multistate basis. This action targets dependency on state legislatures, as the report identifies  dependence on these bodies to assure uniform national standards as a weak link in the system of standardization.   

However, the report noted. Even with uniform national rules and standards, there remains a risk of divergent regulation insofar as individual states may apply the rules and standards differently.

A middle tier approach would be establishing federally-enforced passports for state-licensed insurers.

Congress would limit states’ ability to refuse to recognize regulation by the domiciliary state. This approach assures that individual insurers and intermediaries will experience uniform regulation so that an insurer or intermediary would not be subject to inconsistent and overlapping regulatory requirements in the various states in which it operates. However, the risk is a “race to the bottom,” the report said, for lowest standards.

The report identified approaches to solve this in part by establishing national standards that allow “passporting privileges” once licensed.

The national standards could come from  Congress and  the FIO with other parts of the Treasury – if the states don’t work in association to create them.

Of course, the top tier of regulation would be federal.

Although the spectrum of options for insurance regulatory reform and modernization “needs to include” direct federal regulation, this may culminate with direct federal oversight and regulation of all aspects of insurance business, the report predicts.

But that is just the beginning.

Any regulatory reform that places greater regulatory oversight authority in the federal government also must ward off supervisory overlap, according to the report.  

The best way to solve this is “to give a single federal regulator final say over conflicting regulations that affect insurers,” the report says.

But this envisioned federal regulator must have the power to resolve regulatory inconsistencies, some of which are brought about by Dodd-Frank, the authors explained.

As a result of Dodd-Frank, many larger insurers are facing significant dual state and federal regulation, many insurers that qualify as savings and loan holding companies became subject to Federal Reserve regulation and are evaluated as a “source of strength” for the depository institution and some insurers MAY face systemic importance (SIFI) designations.

“Thus, great uncertainty exists as to how this sharing of regulatory power between the federal government and states will be conducted and whether insurers will face inconsistent regulation,” the report concludes.

“We agree with that report.  In the sophisticated commercial markets, we see no justification for micro-regulation of rates and forms,” said Joel Wood of the Council of Insurance Agents & Brokers, whose members are large, commercial producers are engaged in multinational transactions.

The NAIC and the FIO had no responded by presstime. The ACLI declined comment.